The Housing Market Index, which is based on a monthly survey of National Association of Home Builders (NAHB) members, posted a higher than expected jump in the most recent release of the monthly survey-based index, and homebuilders are nearly as optimistic as they have been at any point in the past two decades.
Image shown: The iShares US Home Construction ETF’s (ITB) share price performance since the beginning of 2017. Shares are up more than 55% year-to-date (2017).
By Kris Rosemann
The housing market continues its recovery from the Financial Crisis of late last decade, and homebuilders’ confidence has rarely been higher. The Housing Market Index (HMI), which is based on a monthly survey of National Association of Home Builders (NAHB) members, is designed to rate market conditions of the single-family housing market, and its December reading came in at a level not seen in nearly two decades. But what do these ratings of market participant confidence mean for the investment prospects of one of the most notoriously-cyclical markets in the economy?
Though the confidence of homebuilders is a solid gauge for the health of the new housing market, perhaps most noteworthy in the most recent posting of the HMI was the performance of the sub-index designed to gauge prospective buyer traffic, which rose eight points to 58, its highest level since December 1998. This is roughly in-line with the Conference Board Consumer Confidence Index, which sat at a 17-year high as of the month of November. The forward-looking (next six months) sub-index component registered a level not seen since June 2005, but the measure was slightly lower than the sub-index component measuring present market conditions.
The increased optimism of homebuilders comes despite expectations for restrictions on the mortgage interest deduction in the tax bill currently in the works. The restrictions are expected to make home buying relatively more expensive for some compared to previous tax laws, but the NAHB has given the tax reform its full support. US home builders are expecting to reap the full benefits of a lowered US corporate tax rate as the vast majority of their earnings are domestic.
The homebuilders group has performed splendidly over the course of 2017, thanks to the aforementioned tax reform benefits and a continuous stream of positive news and data regarding the ongoing recovery of the housing market. For example, new home sales in the month of October advanced more than 6% from the previous month, easily beating expectations for a sequential decline. The iShares US Home Construction ETF (ITB) is up more than 55% this year as of this writing, but investors should note that this ETF may not be as diversified as they assume. Roughly 45% of the fund is made up of five of the largest US homebuilders: DR Horton (DHI) at over 13%, Lennar (LEN) at nearly 10%, NVR (NVR) at just over 9%, PulteGroup (PHM) at ~7%, and Toll Brothers (TOL) at ~5.5%.
The optimism surrounding the new housing market has obviously extended to investors, given the massive run-up in the ITB thus far this year, and in this group, we’re encountering yet another disconnect in the price-to-earnings ratio at a late stage in the ongoing economic upswing. According to Bloomberg, the median forward price-to-earnings ratio of the largest domestic home builders is roughly 13 times compared to ~8.5 times for top homebuilders at the peak of the housing bubble. Though 13 times may not seem that expensive compared to a market that is trading at over 18 times forward earnings, that homebuilders are ultra-cyclical (think housing meltdown) and that they tend to hold net debt positions weighs heavily on the price-to-earnings ratio, or what investors may be willing to pay for a unit of earnings. The ITB is trading at ~22 times trailing earnings at the time of this writing, according to iShares, a multiple driven in part by the fund’s ~35% exposure to non-homebuilders.
Price-to-earnings ratios have significant shortcomings, so let’s not leave the valuation conversation there. Taking a look at our most recently published price-to-fair value measures for the group, which can be found in our weekly stock screen update here, reveals that each one of the homebuilders in our coverage universe is trading above our fair value estimate (at the time of this publishing), and the average price-to-fair value of the group currently comes in just above 1.3 times. Interestingly, the only homebuilder trading within 10% of our fair value estimate is one that is not in the top ten holdings of the iShares ITB, suggesting there may be a degree of indiscriminant buying taking place across the group. ETFs may be changing the investing landscape, and not in a good way. Regardless, shares of homebuilders are looking overvalued at a time when industry constituents are as optimistic as ever.
Image above: Screen created using Valuentum’s weekly screen update showcasing a portion of the data available on homebuilders within our coverage universe, which are trading well above our fair value estimates for the group and register largely unattractive relative valuation ratings. Dividend metrics across the group leave a great deal to be desired.
Dividend considerations throughout the industry are also not as compelling as other industries under coverage, and even if the yields of homebuilders were noteworthy, we would still have serious concerns about the sustainability of their respective payouts (even for the smallest dividends in the bunch). Each homebuilder for which we publish a Dividend Cushion registers a ratio firmly in negative territory as the capital intensity, bloated balance sheets, and cyclical nature of the industry all come together to provide meaningful reason for pause before considering a homebuilder as a source of income.
All things considered, we’re being very cautious in the current market environment, even though industry constituents rate the current market for new housing as one of the strongest in decades. Remember – it’s all about price versus value, and prices for most industry constituents are stretched. That said, the measure of prospective buyer traffic is encouraging for homebuilders as it relates to near-term demand potential, and we don’t doubt that a notable tax cut will help propel bottom-line performance in 2018 somewhat higher. However, the group appears considerably overpriced at the moment, even if the market may continue run higher in the near term.
Homebuilders: CAA, DHI, JOE, KBH, LEN, MDC, MTH, NVR, PHM, TOL
Related: TLT, TBT