Few industries have staged a more remarkable turnaround during the past six months than home builders, and with the promise of low interest rates, a healthy consumer and data showing new home sales surging, it looks like blue skies ahead for the home construction industry.
But investors and analysts interviewed by MarketWatch warned that much of this good news has already been priced into most home builder stocks. They’ve outperformed the S&P 500 index /zigman2/quotes/210599714/realtime SPX +1.34% more than three fold over the past six months, as measured by the iShares U.S. Home Construction ETF /zigman2/quotes/202739297/composite XHB +3.24% , which has gained 26.1% since mid-October, versus a 7.1% rise for the S&P 500.
The central question for investors in these stocks, experts say, is whether home builders can cater to the pent-up demand for affordable, entry-level homes as the millennial generation enters its prime home-buying years.
“Affordability of housing is the key factor,” Pat Tschosik, senior sector strategist at Ned Davis Research, told MarketWatch.
“Median income has risen while housing prices have fallen, and you add on top of that interest rates coming down since October, and you have affordability in your favor,” Tschosik said.
Jack Micenko, senior equity research analysts for housing mortgage and banking at SIG, said in an interview with MarketWatch that despite recent data pointing to a “classic” spring real-estate selling season, investors should be cautious of buying home-builder stocks like D.R. Horton Inc . /zigman2/quotes/202032328/composite DHI +3.94% TRI Pointe Group Inc . /zigman2/quotes/204302452/composite TPH +6.69% , which are set to report earnings Thursday, as well as Lennar Corp . /zigman2/quotes/202536373/composite LEN +5.96%
“Generally, these stocks have seasonal issues. If you buy home builders in the fall and sell them around tax time, you’ll see a good return,” he said. “Similarly, they tend to trade sideways at best starting from mid-April to early August or so as investors sell the news on demand reports” from major builders like PulteGroup Inc . /zigman2/quotes/201694804/composite PHM +4.60% and D.R. Horton.
The home builders that could buck this trend, Mickenko said, are those that prove they can cater best to the healthy demand for entry-level homes, as evidenced by data on prospective home buyer traffic and mortgage issuance. A traffic index from ShowingTime, a technology provider for property showings, fell in March for the eighth straight month, except in the lower two price quartiles.
Meanwhile, the average loan size for purchase mortgages has ticked down in recent weeks, according to the Mortgage Bankers Association, “as applications for smaller purchase loan sizes exceeded that of higher loan sizes – a positive sign that first-time buyers were increasingly active in the market.”
Indeed, home builders are doing their utmost to convince investors that they are laser-focused on the entry-level buyer. PulteGroup CEO Ryan Marshall stressed his firm’s new emphasis on this segment after releasing first-quarter earnings results Tuesday, telling investors that 35% of new land it was purchasing was earmarked for first-time buyers, versus 30% the same time last year.
Meanwhile, Meritage Homes Corporation CEO Steven J. Hilton said in an earnings release Wednesday that the firm has a “strategic focus on the entry-level and first move-up markets, which together represented nearly 90% of our first quarter 2019 orders.”
Micenko said, however, that two firms: D.R. Horton and KB Home are the best positioned to profit from the crush of entry-level buyers looking to own their first home. While he downgraded Horton’s stock from positive to neutral after the stock has risen 35% year-to-date, he said that KB Home has been overlooked by investors.
“My problem with Horton is nothing more than valuation,” he said. “We think KB Home has been underappreciated, and it gets a bit more than 50% of its sales from first-time buyers.”