Homebuilding Industry

Much brain power and ink has been used up in recent months on how rising interest rates would curb mortgage lending that in turn would hurt performance of homebuilding stock. However, what gets lost in translation is the argument that rising interest rates also represent resurgence in economic activity, a fairly strong variable that determines housing demand.

Home Builders

What investors in home builders should count on is that there has been a hiatus in home ownership, when compared to the levels seen before 2008. Especially, first-time ownership. What we do know today is that, broadly, affordability of first time owners is high. And now that Washington has been able to get over the hump on budget and debt limit issues, housing demand will pick up (see chart above).

This is good news for companies like Meritage Homes Corp (NYSE:MTH), Lennar Corporation (NYSE:LEN), PulteGroup, Inc. (NYSE:PHM), D.R. Horton, Inc. (NYSE:DHI), NVR, Inc. (NYSE:NVR) and M.D.C. Holdings, Inc. (NYSE:MDC), all comprehensively covered by CapitalCube. But which of these companies have advantages over the others as far as valuation is concerned?

While several variables determine the value of a home-building stock, some actions on the part of the companies are worth paying attention to. Smart inventory management, balanced concentration, location wise and creative responses to the housing and credit crisis must all be considered before assessing values of home-building companies.

But first let’s consider the appropriate valuation metric. For a traditional corporation price-to-earnings works. For the home-building industry, P/E ratios don’t capture the earnings potential of land or unsold homes. So investors need to look at price-to-book ratios along with the extent to which capital is being invested.

M.D.C. Holdings, Inc. (NYSE:MDC)

On these two metrics MDC Holdings deserves attention first. The company’s stock price trades at 1.3X its book value of assets. For home builders, that’s low. In this sector a price close to 1X book value usually means it’s a strong buy, depending to what extent the company is making progress in its investments. It is advisable to consider selling when the price is in the 2.5X-3.0 book value range.

Homebuilding stock MDC Capital Investment StrategyCapitalCube analysis (relative to peers) shows that the company has been under investing of late (see above). Undoubtedly, that has reflected in its valuation. But the company recently announced that it has spent $189 million to buy 2,800 lots of land in 69 communities across its markets. Some of the investment is towards building single-family homes in Boca Raton, Florida. Admittedly, the take-up of properties in this region is now almost double than the average of MDC’s other markets. The price range of properties starts from around $1 million and also diversifies MDC away from the western part of the country (California, Washington).

Meritage Homes Corp (NYSE:MTH)

Another home builder that is focusing on effectively deploying its capital is Meritage Homes. This Scottsdale, Arizona –based builder has traditionally been in Arizona, North and South Carolina and in Texas. But, like MDC, has been investing towards diversification. It recently spent $156 million to acquire 3,500 new land plots and a good portion of that investment has been in California, Colorado and Florida. Some communities there have seen up to a 50% increase in residential permit approval, a good barometer of future building activity.

Meritage Homes Corp (NYSE:MTH) has been trading at a price-to-book value of around 2.0X. But in the coming months, especially if the U.S. economy maintains a firm trajectory, Meritage is bound to see revaluation of the denominator. House prices will rise steadily in Texas, Arizona, South and North Carolina. And the value of the lots that have been recently acquired ought to reflect in value as well.

Homebuilding stock MTH operating advantage relative to peersCapitalCube gives three out of four stars to Meritage’s sustainability returns, meaning over the last five years, the company’s return on assets has improved from median to better than the median among its peers. In short: it has found relative operating advantages.

Lennar Corporation Class A (NYSE:LEN)

The third home builder that CapitalCube is following is Lennar Corporation. The company currently trades at a P/B multiple of 1.85X, down from its last 12-month average of over 2.2X. Lennar’s advantage is that it sells homes to customers who might not be super-sensitive to mortgage rates – families looking for homes priced below $150,000 or high-end priced homes. In short: As long as there is shortage of supply, compared to the average, Lennar can continue to sell.

Two fundamentals will contribute to guide Lennar’s stock performance in the future. First, the company’s ability to take advantage of the gap between supply and demand of homes. Right now the current housing production is between 900,000 and 950,000, well below the long term average of 1.5 million. Second, the strong affordability of first time buyers. For most of this year, the National Association of Realtors®’ Housing Affordability Index has hovered between 175 and 200. This means an average first time buyer has between 175% and 200% of the income necessary to secure a conventional loan (80% of current property value).

Undoubtedly, as always, rising interest rates will play an important factor in housing finance. But for some home-building companies the advantages will lie in smart allocation of capital and choosing the right geographic areas. Meritage, MDC and Lennar have to be on your radar.

The views expressed are those of the author.

Also of interest from CapitalCube’s archives:

Home Depot (NYSE:HD) bringing new life to old wood? Earnings Analysis
Is Lowe’s (NYSE:LOW) under-investing? Earnings Analysis

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Via: capitalcube.com