By Cornelius Zeeman & Gavin van der Berg,
Fairtree Portfolio Manager & Equity Analyst
The US homebuilders, experiencing somewhat of a nirvana, have outperformed the S&P 500 index by 32% in 2023. The strong demand environment initially experienced after the onset of the COVID-19 pandemic has been replaced by a tight inventory situation, supporting housing prices despite pressing affordability concerns.
Graph 1: US Homebuilders Relative Performance
Source: Fairtree & Bloomberg LP
In recent earning calls, some of the public homebuilders made the apt comment that their biggest competition lies not between themselves, but rather in competing for sales against the existing housing inventory available for sale. We agree with this sentiment. For every new home sale over the last decade, 8.5 existing homes were sold. The existing home inventory tightness, explored in more depth here, is therefore of considerable benefit to the US homebuilders as their biggest competitor is handicapped.
Our high-level assessment of the competition among US homebuilders is that it is a competitive and fragmented market where the companies have limited bargaining power with both suppliers and customers. For the most part, we see these companies as at the mercy of the market and, over time, would expect excessive returns on capital to be competed away as barriers to entry are low. That said, there are some encouraging trends which should see homebuilders capture the benefits of the current housing environment without blowing up if the market were to make a turn for the worse.
Improved Financial Positions.
After a tumultuous decade following the Global Financial Crisis (GFC), where weak operating results strained balance sheets and caused dilutive rights issues, improved cash flow and equity positions have recently shored up balance sheets across the sector. Lennar Corp’s debt development, as shown in Graph 2 below, illustrates this balance sheet improvement.
Graph 2: Lennar Corporation Debt Development
Source: Fairtree & Company Reports
In general, homebuilders are in a much better position today to weather adverse housing conditions compared to the mid-2000s when they geared up right before the housing market crash. For the larger, listed homebuilders, these strong financial positions offer an additional advantage as financing for regional peers has become more expensive and harder to come by.
In-house Financing and Rate Buydowns.
Sales volumes have been supported via the use of incentives. In a weakening housing market, homebuilders try to minimise price deflation given its compounding psychological effect on overall homebuyer sentiment. To curb pricing pressure while still aiming to move inventory, homebuilders often give up margin by offering the homebuyer alternative incentives to make the current price more appealing. These incentives vary between finishing upgrades, additional home features and closing cost assistance.
Recent commentary has pointed to rate buydowns being the most effective incentive to drive sales volumes in a less affordable housing environment. Rate buydowns occur when capital is paid upfront to temporarily decrease the mortgage rate paid by the homebuyer. Another advantage held by the bigger homebuilders lies in their ability to assist potential buyers in securing a mortgage via their in-house financing business. This eases their ability to facilitate rate buydowns and secure mortgages for potential buyers.
Returns and Margin Progression.
Assessing the profitability of the S&P Homebuilders Index¹ and looking through the cyclicality induced by the GFC, we see a trend of improving margins and economic return on assets. The US homebuilding industry, while still fragmented in our view, has become less so as larger players have consolidated share. A combination of asset purchases, and organically outgrowing capital-constrained smaller market participants, contributed to this consolidation.
Capital discipline amongst homebuilders has also improved. Recent commentary has pointed to the larger market participants shifting to a mindset of prioritising economic returns over topline growth. With permitting bottlenecks experienced in the US, this has allowed for a situation where new home supply is better matched to demand. We see these as other contributing factors to the improving profitability trend but would caution that the jury is still out on how the improved capital discipline holds up in an environment where demand for new home sales declines.
Graph 3: US Homebuilders Index Returns & Margin Progression
Source: Fairtree & Bloomberg LP
Looking at the latest quarterly aggregate data for 7 of the larger, listed homebuilders² (illustrated in Graph 4 below), we can see that since peaking in the second quarter of 2022, volumes have been supported by slight price deflation and homebuilders giving back some margin to the buyer. Although a range of factors contribute to the margin decline, it speaks to the incentives offered by builders, as touched on briefly above. It is worth noting however, that the margin level remains healthy despite this decline.
Graph 4: US Homebuilders2 Quarterly Average Sales Price & Margin Progression
Source: Fairtree & Company Reports
A Note on Spec-Builders.
D.R. Horton and Lennar Corp were the key culprits of the margin and average selling price decline exhibited in Graph 4 above. Referred to as spec-builders, these businesses start the construction process regardless of a signed housing contract with the speculation that they will be able to find a buyer for their homes under construction. During the demand boom in 2021 and early 2022, the cash-flush consumer was willing to pay up for these spec homes, leading to superb profitability for the spec-oriented builders. Being more aggressive in their offering of incentives to ensure that inventory moves and coming off a higher base led to margin underperformance.
The US homebuilding industry has improved post-GFC, and we see many of the tailwinds, such as strained overall housing supply and solid homebuying demand drivers, as structural over the medium term. That said, we remain cognisant of the fact that this industry is highly sensitive to economic conditions and remains competitive.
During the middle of 2022, the industry was trading at depressed valuation multiples and the underlying businesses were trading at below book value, ignoring the structurally supportive factors discussed above. Currently, we see the risk-reward as more delicately poised after the sector’s rally.
- S5HOME INDEX on Bloomberg
- Aggregate of D.R. Horton, Lennar Corporation, Pulte Group, Meritage Homes, NVR, KB Homes & Toll Brothers.
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