Homebuilders Are Worth Watching

Homebuilders Are Worth Watching

Strong economic fundamentals have allowed homebuilders to maintain decent growth and outperform the broad market.


Key Takeaways
  • Strong economic fundamentals and a lack of new housing supply suggest the housing market is well-positioned to continue slowly grinding higher.
  • Recent low valuations for homebuilders may offer an attractive entry point.
  • We expect homebuilders with solid operations and low financial leverage to outperform as the market normalizes.

Strong Start to 2019 for Homebuilders

Last year was a challenging one for homebuilders, as the ISE Exclusively Homebuilders Index fell 33%, after a stellar 68% return in 2017. As a result, many homebuilder stocks are trading now at or below book value, some even at levels indicating the potential for impairments, despite the builders generally maintaining reasonably strong balance sheets. Strong economic fundamentals and a lack of new housing supply suggest the housing market is well-positioned to continue slowly grinding higher and recent low valuations may offer an attractive entry point.

Some reasons for negative sentiment are justified. Single-family housing starts, new home sales and existing home sales have been slowing as mortgage rates have climbed with Treasury yields. Home affordability also remains an issue, as wages have not caught up with home prices, and the tight labor market in construction trades has increased the cost to build homes, pressuring builder gross margins.

But there are several reasons the market reaction is likely too extreme. Housing starts are still well below historic averages: long-term normalized new home demand is around 1.5 million a year, and we have not yet regained that level post the financial crisis. Historically, we haven’t seen a turn in the housing cycle prior to demand surpassing the 1.5 million level, and we do not appear to be close to reaching it. There is also likely a deficit of housing stock as investment collapsed following the housing crisis and inventories are down. On top of this, household formation is accelerating — buoyed by demographic tailwinds as millennials enter their 30s — and job growth is spurring long-term demand.

Vacancy rates have edged down

Source: U.S. Census Bureau, as of 9/30/18.

These strong economic fundamentals have allowed homebuilders to maintain decent order growth despite rising interest rates and suggest we’re still in mid cycle, rather than at the end of the housing cycle.

Recent performance of homebuilder stocks may suggest markets have been overly pessimistic about the area. Mortgage rates falling to their lowest in a year in February, combined with continued strength in the job market and slow but steady wage growth, have created more benign conditions. Homebuilder stocks are up 18.5% year to date as of February 28, well ahead of the S&P 500 Index’s 11.5% gain. Lower lumber prices, which have fallen from recent highs in May 2018, will likely act as a tailwind later in 2019 and perhaps as early as the second quarter.

Homebuilders’ 2019 bounce narrows gap

Source: ClearBridge Investments, Bloomberg LP, as of 2/28/19. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

There are good reasons to be cautious. Consumer home affordability continues to be a headwind to demand — the gap between home price growth and wage growth is still meaningful — but strong underlying demand suggests a significant downturn is unlikely.

With margin pressure from affordability challenges and volatile demand trends due to housing’s sensitivity to changes in mortgage rates at present, homebuilders could be in for a choppy year. But valuations look too depressed and are likely to recover should we see some evidence of market stabilization, particularly if the Fed continues to show signs of accommodation. We expect homebuilders with solid operations and low financial leverage to outperform as the market normalizes.

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