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US homebuilders: on strong foundations?

Home / Perspectives / US homebuilders: on strong foundations?

Fraser Lundie, CFA, Co-Head of Credit and Senior Credit Portfolio Manager
Anna Chong, Credit Analyst
05 September 2018
Credit

US homebuilders have been hurt this year by concerns that rising interest rates could keep buyers at bay. But, as the sector continues to report strong demand for new housing, we ask: is the backdrop for US homebuilders favourable? 

The recent rise in interest rates – coupled with expectations of further rate hikes from the US Federal Reserve – has weighed heavily on US homebuilders this year: investors fear higher mortgage rates will weaken demand.

But despite talk of a slowdown, industry fundamentals are still supportive of US homebuilders. Strength in the economy and labour market have boosted demand for housing. In Q2, US economic growth enjoyed its best performance in almost four years, increasing at an annualised rate of 4.2%1, while unemployment remains low at 3.9% and job creation is solid. In July, employers added 157,000 jobs2

Moreover, homebuilders’ recent robust earnings results demonstrate that demand has not been impacted by rising mortgage rates, with many reporting strong orders – an indicator of future revenue for homebuilders. Tight existing home inventory should also spur demand for new builds. Meanwhile, in a post-earnings call with analysts last month, Toll Brothers’ chief executive Douglas Yearley pointed to a structural shift towards the new-home industry – with buyers wanting to “create a one-of-a-kind custom home” rather than live in existing homes3.

The new-home industry: in rude health

Concerns about rising interest rates – and expectations of further rate rises – have hurt valuations. But from a relative value point of view, we believe the sector is now cheap: US homebuilders are more than two standard deviations above their three-year historical ratio to the US high yield index.

Figure 1: US homebuilders are trading more than two standard deviations above their three-year historical ratio

Chart 0818Source: Hermes Credit, Bloomberg as at August 2018.

Buying opportunities?

We see value in current holding Miami-based builder Lennar. Its ‘Everything’s Included’ product strategy has simplified the construction process, standardising products and reducing build times. Meanwhile, its improved scale and realisation of synergies following its recent acquisition of CalAtlantic – which made it the largest homebuilder in the US – as well as its focus on deleveraging make Lennar an attractive credit story.

In June, the company reported better-than-expected quarterly profit and its orders jumped 62.3% to 14,440 homes in Q24. At the time, the company’s executive chairman Stuart Miller also said the housing market has remained resilient despite rising interest rates5.

We also have exposure to Toll Brothers. We believe the luxury builder is an attractive credit issuer thanks to the high value add-ons it offers, while a loan-to-value ratio in the company’s fiscal third quarter of 67% does not suggest that affordability is stretched and is below what the company has said is typical. The high-end builder enjoyed a Q3 profit beat last month. Quarterly profit jumped 30% buoyed by strong demand for houses, which showed in both the higher order book and increase in average selling price6. Affordability for wealthier buyers in the luxury end of the market is generally less affected by mortgage rate fluctuations. This has been shown by Toll Brothers seeing cash buyers increased to 24% from typical levels of 20%7.

US homebuilders: a concrete sector? 

There has been a concern among investors that a rise in mortgage rates since January could be a deterrent to the home-building industry.

But in the current environment of rising interest rates, credit investors should be encouraged by the recent underperformance of the US homebuilding sector – and the opportunities they offer.

 

This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

  1. 1 “US second-quarter GDP growth raised to 4.2%,” published by Reuters on 29 August 2018.
  2. 2 “Employment Situation Summary,” published by the Bureau of Labor Statistics on 3 August 2018.
  3. 3 “Q3 2018 Toll Brothers Inc Earnings Call Transcript,” published by Toll Brothers on 21 August 2018.
  4. 4 “Homebuilder Lennar shrugs off rising rate concerns with profit beat,” published by Reuters on 26 June 2018.
  5. 5 “Homebuilder Lennar shrugs off rising rate concerns with profit beat,” published by Reuters on 26 June 2018.
  6. 6 “Luxury home builder Toll Brothers’ quarterly profit jumps 30%,” published by Reuters on 21 August 2018.
  7. 7 “Q2 2018 Toll Brothers Inc Earnings Call Transcript,” published by Toll Brothers on 22 May 2018.
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Fraser Lundie, CFA Co-Head of Credit and Senior Credit Portfolio Manager Fraser joined Hermes in February 2010 and is Co-Head of Credit and lead manager on the Hermes range of credit strategies. Prior to this he was at Fortis Investments, where he was responsible for European high yield credit. Fraser graduated from the University of Aberdeen with an MA (Hons) in Economics; he earned an MSc in Investment Analysis from the University of Stirling and is a CFA charterholder. In 2017, Fraser joined the board of CFA UK, a member society of the CFA Institute. Having previously featured in Financial News’s ‘40 Under 40 Rising Stars of Asset Management’, an editorial selection of the brightest up-and-coming men and women in the industry, in 2015 Fraser was named as one of the top 10 star fund managers of tomorrow by the Daily Telegraph. In 2016, Citywire Americas named Fraser number one in their global high yield manager review, and InvestmentEurope and Investment Week both named the Hermes Multi Strategy Credit Fund top global bond fund at their respective 2017 Fund Manager of the Year Awards. CFA® is a trademark owned by the CFA Institute.
Read all articles by Fraser Lundie, CFA
Anna Chong Credit Analyst Anna joined Hermes in 2017 as a credit analyst, covering basic materials. Prior to joining Hermes she worked at JPMorgan for over four years as part of the Credit Risk department, where she was responsible for covering the Telecoms, Media and Technology (TMT) industries, and had previously covered the natural resources sector and Nordic financial institutions. Anna holds a BSc (Hons) in Mathematics with Statistics from the University of Bristol.
Read all articles by Anna Chong

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