Homebuilders: 4 Reasons Margins Are Going To Get Squeezed – Seeking Alpha

Strict American Budget

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The squeeze is on.

U.S. Homebuilders (ITB) are starting to feel it. To an investor the valuations on many homebuilders is quite attractive. But when I looked into the macro it spooked me. If I summarized this thesis in one chart it would be this:

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Data by YCharts

Mortgage rates are screaming higher causing a huge drop in average sale price for new houses. Purchase mortgage origination data is lagging by a quarter and it will be interesting to see how it reacts. This is a problem because if builders cannot make up the lost revenues in reduced costs or volume their stock is likely to decline. Based on the data, I found 4 reasons that margins are going to get squeezed.

It’s all about the Margins

The largest five homebuilders by market cap are D.R. Horton (DHI), Lennar Corp (LEN), NVR (NVR), PulteGroup (PHM), and TopBuild Corp (BLD). Each has performed well over the past three years with total price appreciation ranging from 81-303%. The attractive valuations and recent growth are responsible for the excellent Quant ratings that average over 4.5. Over 40% of the iShares US Home Construction ETF (ITB) consists of these five equities.

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Seeking Alpha

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Data by YCharts

The price performance of these homebuilders correlates with improvements in profit margins. Homebuilders have experienced six consecutive quarters of margin expansion. The gross margin in the fourth quarter of 2021 was 27.3% up from 23% the prior year. You can see how dramatic these profit margins are historically by examining the chart from Yardeni Research. The healthy margins are a function of high demand for housing and low interest rates resulting in high prices.

At the Q1 2022 Earnings Call, DHI stated they expect their gross profit margin to be similar in Q2. Mortgage rates have increased approximately 40 basis points since that statement. If home prices keep up builders will remain very profitable. Now let’s discuss four reasons they won’t.

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Yardeni Research

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Data by YCharts

Reason #1. Cost Inflation

DHI reported a 2.9% increase in cost of sales per square foot last quarter and expect construction costs to continue increasing. The National Association of Home Builders confidence index dropped from 83 to 82 in February. While this is still a strong number the reason cited for the decline is increases in cost and shortage of labor. Residential construction costs are up 21% in 2021 from 2020. Lumber prices are a major contributor to this issue. We can see how the production of wood products has diverged from housing starts since the beginning of the pandemic, creating a shortage. Lumber prices are not expected to improve in the near term.

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Data by YCharts
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Federal Reserve Economic Data

Costs of nearly every construction product has been rising as shortages are abound. Builders are waiting several months for prefabricated home parts including doors, windows, cabinets, countertops, and appliances. Expectations are low for global supply chain disruptions to dramatically improve in 2022.

The industry has been experiencing labor shortages since 2012. There are close to 430,000 open home construction jobs that are struggling to be filled and the industry needs an additional 61,000 new hires each month. This, and cost of living inflation, are pressuring wages higher.

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Federal Reserve Economic Data

Reason #2. The Pandemic

The pandemic is responsible for a series of interesting changes in economic trends. It’s fascinating from a macro perspective. First, it was a tailwind for homebuilders as it motivated a horde of new home buyers who wanted bigger homes, bigger yards, and smaller cities. It ignited a remote work revolution that gave home buyers the opportunity to live anywhere. And it produced the low mortgage rates that fueled the frenzy and rose prices. Even today, traffic of prospective home buyers remains high.

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Yardeni Research

The tailwinds are beginning to turn to headwinds. As I pointed out in my article on Fidelity National Financial, buyer and seller sentiment is positioned to change as the pandemic improves:

Let’s begin with a sense of market sentiment. The Zillow 2021 Mover Report found that 11% of Americans have moved in 2020-2021. They refer to this as “The Great Reshuffling.” The report states that 70% of homeowners would become comfortable moving when COVID vaccine distribution is widespread.

This corresponds with data from the Nerd Wallet 2022 Home Buyer Report which found that 58% of homeowners want to sell their home but 89% are prevented from doing so and 31% of those were due to the pandemic. At 40%, the most common reason for not selling was the concern that the sellers could not find a new home due to short supply. The report also indicated that 26 million Americans plan to buy a home in 2022 because 66% of shoppers were unsuccessful in 2021. 33% of those indicated that the pandemic contributed to their postponement.

The vaccine is now widespread, cases are dropping, and mandates are being walked back every week. As society returns to normal, assuming the improvement continues, more existing homes will enter the market and provide relief to the short supply. This will compete against new homes that continue to increase in cost.

There’s another, more hidden, effect of the pandemic. For a long time landlords could not evict delinquent renters due to moratoriums. Most of these moratoriums have expired or are soon to be expired. And yet, rent payment rates continue to decline and are at three year lows:

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National Multifamily Housing Council

Two reasons come to mind for this occurrence:

  1. There is a continued mentality among renters that do not feel they should have to pay rent.
  2. Renters are struggling to pay rent due to increased living costs and decreased income.

Either way is not good news for homebuilders because the delinquent renters are not likely to become customers and evictions will rise and so will rental availability, pressuring home prices down.

Even more obscure is the trend in assisted living populations. In Q4 of 2020 Senior Housing hit a record low 80% occupancy. And can you blame them? Assisted living facilities were one of the hardest hit places for COVID fatalities and had strict non-contact policies. Who would want to move into that?

The 2021 outlook survey from Senior Housing News found that most respondents expect occupancy to return to normal by the end of 2022. Data from NIC MAP Data Service is showing that a net positive move-in rate started around March 2021 and has been growing since.

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Senior Housing News

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NIC Map Data Service

Seniors are one of the largest classes of home sellers. They have been reluctant to move out because of pandemic risks. As risks dissipate more seniors will move into senior living and put their house on the market.

Reason #3. High Inventory

I get the sense that it is widely understood there is a housing shortage. Well, it depends. There is a shortage in housing for sale, as evident by new homes on the market:

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John Burns Real Estate Consulting

However, the number of housing units per capita is at the same level that it was in 2008:

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Federal Reserve Economic Data

The number of homes under construction per working population is now at all time highs:

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PPG Macro Independent Strategy

Since the pandemic a curious phenomenon has occurred. After an initial drop, new homes for sale-under construction have been rising steadily. In contrast, new homes for sale-completed have been stagnating. This is caused by the ongoing supply chain disruptions.

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Federal Reserve Economic Data

As the construction of these homes finish there will be a large influx of new homes into the market, the most since 2004. New homes for sale have been rising and is already at levels last seen in 2008.

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Yardeni Research

It appears that we’re nearing the peak of construction as prices have declined and consumer sentiment has been forecasting a decline in construction for several months.

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Federal Reserve Economic Data

Reason #4. Rising Rates

Mortgage rates are rising fast. Since October they have risen over 69 basis points and many mortgage brokers are quoting 4% now. This is having a huge impact on refinances but the impact on purchases is yet to be seen. As of February 2022, the MBA purchase index was at levels higher than the 10 year average.

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Data by YCharts
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The Daily Shot

Rising rates are a major issue for homebuilders because home affordability is inversely related to rates. As of November 2021 the Real Mortgage Payment Price Index was still at reasonable levels below the 2008 peak. But rates are 12-20% higher today. The index is approaching new highs at an alarming rate.

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Realestatedecoded.com

Examine this chart to get a sense of what rates do to the affordability of monthly mortgage payments. A move from 3% rates to 4% results in an 11% reduction in affordable price. This translates to an 11% reduction in homebuilder revenue and a far larger reduction to profit margins. That’s what just happened in the last 5 months.

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Chart by Author

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Data by YCharts

The correlation between rates and the NAHB index is remarkable. Mortgage rates are forecasting an imminent drop in the index:

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Yardeni Research Inc

If mortgage rates continue to rise damage to homebuilders will mount. My expectation is that we are nearing a limit that the Fed will allow. We can see that for the past three decades the 30-year treasury rate has never risen above the previous high in the Fed Funds Rate. The last high was 2.4%. The 30Y rate has tested this resistance once already and is attempting to test it again. If it breaks, it signals a trend change. Until that happens, I expect a cap on mortgage rates around 4.25%.

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Chart adapted by Author (TradingView)

Summary

Looking at DHI today it looks attractively valued. It trades at 6.52 blended P/E below its normal P/E of 11.7. Earnings are expected to grow by 37% in 2022.

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FAST Graphs

But look back at the 2008 time period. The similarities are spooky. Growth was strong and the P/E was below normal right before everything fell apart.

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FAST Graphs

The take home message is that falling home prices are not good for margins. We’ve just seen a big drop in new home prices and the macro data suggests the trend has changed. Homebuilder margins are going to get squeezed.

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PPGMacro

I have exposure to homebuilders through the Hoya Capital Housing ETF (HOMZ). I have trimmed my position recently and plan to hold the rest until we get more data. In the meantime, I’m buying Fidelity National Financial (FNF) because I think it is The Safest Way To Play U.S. Housing.

This article was written by

Garrett Duyck profile picture

Garrett has studied financial markets since 2010 and manages an investment portfolio full time. The portfolio is sector inclusive with a tendency towards value. His strategy aims to achieve the highest risk-adjusted total return by emphasizing solid cash flow, growing dividends, and a margin of safety. Garrett is a macro investor who continuously monitors macroeconomic trends to inform investing decisions.

Disclosure: I/we have a beneficial long position in the shares of HOMZ, FNF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This content is for informational purposes only. This content is not investment advice and individuals should conduct their own due diligence before investing. The author is not an investment advisor and is not suggesting any investment recommendations. Opinions expressed in this article are based on the author’s best judgement at the time of writing and are subject to change without notice. Investors should consult with their financial advisor before making any investment decisions.