The pace of new single-family housing starts is up almost 10% year on year © Bing Guan/Bloomberg

US homebuilder stocks have defied conventional wisdom about the effects of rising mortgage rates, rallying furiously and attracting an $814mn bet from Warren Buffett’s Berkshire Hathaway. Analysts are still bullish, too.

Shares in DR Horton, Lennar and NVR, which Berkshire disclosed it owned this week, have risen about a third apiece this year, far outpacing the S&P 500 stock index. Shares of rival PulteGroup have surged just over 80 per cent.

Mortgage rates have doubled in the past year and a half, raising the cost of financing a home. But rates have proved a blessing for homebuilders because their rapid rise has in effect trapped many current owners in their properties, reducing the stock of existing houses for sale and driving would-be buyers to new properties. 

“No one would argue that this isn’t a cyclical industry, still, but big homebuilders have shown they can manage their balance sheets through what could have been a bad scenario,” said Rafe Jadrosich, an analyst at Bank of America, who noted that homebuilder stock valuations were roughly at long-term averages despite the recent rally.

Line chart of Performance, 2023 (%) showing Homebuilders rise

“Our view is that there’s more upside for the sector,” he added.

About three-quarters of US homeowners have mortgages charging less than 4 per cent interest, according to JPMorgan Chase research. New loans last week averaged 7.16 per cent, matching levels last seen in 2001, according to data from the Mortgage Bankers Association. Many US households typically borrow on 30-year fixed-rate terms.

“Bottom line: supply is short, demand is returning to affordable offerings, and builders will need to produce more homes to fill the void,” Lennar executive chair Stuart Miller said on the Miami-based builder’s latest earnings call. 

Confident outlooks such as Miller’s are underpinning optimism on share prices. The cyclical nature of their business means that homebuilders are not typically big dividend payers so, unless their higher profits are frittered away, their book value will grow.

Jade Rahmani at Keefe, Bruyette & Woods estimated that the book values of industry leaders such as DR Horton and luxury home specialist Toll Brothers should rise by about 20 per cent a year for the next three years.

Line chart of S&P CoreLogic Case-Shiller national home price index showing Home price highs

“If you hold, say, Toll at today’s valuation, you should see a 15-20 per cent return over the next 12 months just extrapolating from the book value,” he added.

Home prices have begun to recover after slipping last year. Analysts at Goldman Sachs this week raised their US house price forecasts for 2023 to a 1.8 per cent rise from a 2.2 per cent fall, citing tight housing supply and better than expected demand.

Robert Dietz, chief economist for the National Association of Homebuilders, said that new construction typically made up 12 per cent of total housing inventory, but currently represented at least 30 per cent of the total market.

Nationally, the pace of new single-family housing starts rose almost 10 per cent in July from a year before, the US commerce department said on Wednesday. Lennar recently raised its guidance and now expects to deliver between 68,000-70,000 homes this fiscal year, up from 62,000-66,000 forecast previously.

Line chart of Number of US single-family homes available for sale, in millions showing Homebuyers' despair

The biggest builders have also benefited from tightening credit conditions because their size and access to funding have helped them offer incentives that smaller rivals cannot match.

Inducements include so-called “buy-downs”, in which the builder offers a lower mortgage rate on a property than is available in the market.  

“Private builders, many of them small players active in one or two markets, are having trouble getting land, labour and materials and now financing [themselves],” said John Lovallo, an analyst at UBS. “The public builders not only have the ability to procure these things, but also can offer financing to their customers.”

Bricklayers working on a DR Horton housing development in Arizona © Caitlin O’Hara/Bloomberg

So what could go wrong? One worry is that as homebuilders boost production, supply chain constraints and cost inflation could return. BofA’s Jadrosich pointed to risks such as a recent increase in the price of insulation from supplier Owens Corning, which cited strong demand. 

This month, US homebuilder confidence slipped for the first time this year according to an index compiled by the National Association of Home Builders and Wells Fargo. NAHB chair Alicia Huey said that some of the slowdown was the result of “a dearth of construction workers”.

The biggest risk, however, is of a sharp slowdown and widespread job losses in the US economy as higher interest rates persist.

 “I’ll take higher rates all day long if you tell me that employment is going to be strong,” Lovallo said. “But it’s very hard to buy a house when you don’t have a job.”

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