Housing trends favor builders focused on entry-level buyers

In this Wednesday, March 1, 2017, photo, new home construction is underway in a housing plan in Zelienople, Pa. It’s lining up to be another strong year for investors who own homebuilding stocks as a proxy bet on the health of the U.S. housing market. Housing market trends are expected to remain favorable for builders, but those focusing on first-time buyers could be the safest bet for further gains. (AP Photo/Keith Srakocic)

It's lining up to be another strong year for investors who own homebuilding stocks.

Shares of the 10 builders with the most completed sales in 2016 are up an average of 60.8 percent. And exchange-traded funds, or ETFs, that invest in homebuilders have also notched gains that eclipse the growth in the broader U.S. stock market.

While many economists expect U.S. housing market growth trends to continue next year, homebuilders that focus on entry-level buyers could be the safest bet for further gains.

"The demand, as we see it, is likely to continue to be pretty good, but the builders that will most benefit will be those who have a focus on the low-end homebuyer," said BTIG homebuilding analyst Carl Reichardt.

A growing economy, solid job market, low unemployment rate and low mortgage interest rates have helped drive demand for homeownership this year. And a stubbornly thin inventory of homes for sale has kept home prices headed higher. All that has been a boon for homebuilders. Sales of new U.S. homes hit the fastest pace in a decade last month.

The trends have also driven gains for some ETFs with exposure to homebuilders. The SPDR S&P Homebuilders ETF is up 27 percent this year, while the iShares U.S. Home Construction ETF is up 54.9 percent.

Many economists expect the economic and housing market trends to continue next year, including further increases in sales of new homes and prices.

"The market for new homes is improving steadily," said Patrick Newport, executive director of U.S. economics at IHS Markit. "The prognosis going forward is for further steady growth over the next two years."

Realtor.com's 2018 U.S. housing forecast released this week calls for U.S. home prices to rise 3.2 percent in 2018, down from a projected gain of 5.5 percent this year, as the inventory of homes for sale begins to rise. The forecast also sees sales climbing 2.5 percent.

Still, favorable housing market trends may not be enough to translate into more big gains for homebuilders.

"At these valuations, close to where they've traditionally peaked out, you have to believe that something else has changed, something secular, either in how these companies are run or in what demand for housing relative to other consumer goods is going to look like," Reichardt said. "And I'm not quite ready to conclude that this time it's different."

Most of the builders that were in business during the last housing boom have yet to see their share prices return to those high-flying levels. Even so, they are now trading close to the top end of their traditional price-to-book value, which has typically ranged between 1 and 2 times.

For now, Reichardt has "Buy" ratings on only two builders, D.R. Horton and Lennar.

Earlier this year, D.R. Horton acquired land developer Forestar Group in a deal that helps beef up the builder's access to land that's been cleared for new construction. Last month, Lennar bought rival CalAtlantic Group in a $5.7 billion deal, not including $3.6 billion in debt, that will create the nation's largest homebuilder.

"Those are two companies undergoing transformations to some degree that we think can result in higher long-term multiples," Reichardt said. "It's harder to make that argument for many of the other companies in the group at these valuations right now."

Reichardt has "Neutral" ratings on most of the other builders he tracks. He also has a "Sell" rating on KB Home.

Another reason Reichardt is bullish on D.R. Horton and Lennar: Both are catering to entry-level buyers, which he believes have more potential to make solid gains at this stage in the housing recovery.

Through much of the housing rebound that began around 2012, many homebuilders primarily sought to cater to homeowners looking to trade up to bigger or nicer homes, which were typically pricier and translated into better margins for builders. Those buyers were also generally in a better financial position to put down a big down payment or qualify for financing.

The tax overhaul making its way through Congress is likely to have an impact on the housing market, which could affect builder stocks.

The projected corporate tax cut would benefit homebuilders, given that they tend to have high tax rates. The group of builders that BTIG tracks has an average tax rate of 34 percent. The proposed tax overhaul bills would reduce corporate taxes to 20 percent.

Other possible changes could be a drag on some builders, including a proposal to limit the mortgage interest deduction on newly purchased homes to the first $500,000 of the loan, instead of the present $1 million limit. That would particularly affect companies building pricier homes on the U.S. coastal metro areas, like Toll Brothers.

Another wild card: mortgage interest rates.

The average rate on a 30-year, fixed mortgage is 3.9 percent this week, down slightly from a year ago. Mortgage rates often track the yield on 10-year Treasury note, which is also essentially flat from a year ago.

Higher rates tend to be negative for homebuilding stocks because they make home loans more costly for would-be homebuyers. Realtor.com projects that mortgage rates will hit 5 percent by the end of next year.

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