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