Homebuilders poised for gains but face interest-rate fears

Some investors are betting on shares of homebuilders to outperform US stocks at large, but with interest rates expected to rise they may have to wait several months before those bets pay off.

The US economy looks ideal for homebuilding stocks to benefit. The unemployment rate has fallen to its lowest level in more than 17 years and consumer confidence is near the highest levels in 17 years, according to the Conference Board.

And demand for housing in an already tight market is being supported by the many millennials seeking to purchase their first home, several investors said.

The US Commerce Department’s data on April housing starts will be released on Wednesday, followed by data on new-home sales on May 23.

But other factors could raise costs for home buyers, potentially hampering home sales. A sharp rise this year in US Treasury yields reflects increasing worries about inflation and fears that the Federal Reserve will raise interest rates more aggressively than has been expected.

The yield on the 10-year Treasury note is used as the benchmark for mortgage interest rates; higher rates increase mortgage costs for home buyers.

“The continued rally in yields is a potential red flag,” said Jared Woodard, an investment strategist at Bank of America Merrill Lynch in New York.

The 10-year Treasury yield US10YR=RR has briefly exceeded the 3.0 per cent mark, the highest level since January 2014 and more than 50 basis points higher than where it started the year.

The S&P Composite 1500 Homebuilding index .SPCOMHOME has lagged the broader market, falling 16.9 per cent from its January 22 peak, which is more than three times the percentage decline of the S&P 500 .SPX from its high that month. In 2017, the homebuilding index soared 74.8 per cent from the previous year.

Other factors also cast a cloud on the housing market. Last year’s federal tax overhaul put a cap on deductions for state and local and property taxes and lowered the amount of mortgage interest that is deductible, all of which results in higher costs for many homeowners.

Homebuilders have also pointed to rising costs for materials and labour in their earnings calls, though so far they have had little impact on their margins.

“The factors indicate that there may be some headwinds going forward,” said Michael Cuggino, president and portfolio manager of Permanent Portfolio Funds in San Francisco, which owns shares of Lennar Corp, the largest US homebuilder by market capitalisation.

Shares of the five largest US homebuilders by market capitalisation jumped on April 4, when Lennar reported robust quarterly sales and raised its forecast for the year. Lennar’s shares climbed 10 per cent that day, and PulteGroup Inc, D.R. Horton Inc, Toll Brothers Inc and NVR Inc rose between 4.1 per cent and 6.4 per cent.

The stocks have given up much of those gains since then, even though homebuilders have continued to deliver upbeat results. Lennar shares have tumbled 13.7 per cent. D.R. Horton, NVR and Toll Brothers are down 3.9 per cent, 3.3 per cent and 3 per cent, respectively. Only PulteGroup has added to its April 4 gains, rising 1.8 per cent.

Homebuilders that sell units at multiple price points, from starter homes to luxury properties, and are active throughout the United States are best positioned to withstand investors’ skittishness over interest rates, Cuggino said.

Next up to report is Toll Brothers, which focuses on the luxury market and is scheduled to release its quarterly earnings on May 22.

Still, some investors say this year’s industry underperformance looks like a normal response to the 2017 run-up.

Though housing starts have risen, hitting 1.319 million units in March, demand among home buyers has outpaced the limited housing supply in part because of the many millennials entering the market.

“This is just a pause,” said Brian Macauley, co-portfolio manager of the Hennessy Focus Fund in Arlington, Virginia, which owns shares of NVR. “As fundamentals come through, the stocks will behave better.”

Signs of worries about affordability among home buyers, such as a move toward smaller homes or an uptick in adjustable-rate mortgages, have not yet emerged, said Jack Micenko, an analyst at Susquehanna Financial Group in New York.

Low earnings multiples could also draw investors’ attention. The 12-month forward price-to-earnings ratio for the S&P 500 Homebuilding index .SPLRCHOME, which comprises just Lennar, PulteGroup and D.R. Horton, has fallen to 9.5 from 13.7 at the end of 2017. The price-to-earnings ratio for the S&P 500 is 16, down from 18.5 at the end of 2017.

“If (homebuilders) have solid orders and growth and hold their margins, they could work from here,” said Jonathan Woloshin, head of Americas equities and real estate at the chief investment office of UBS Global Wealth Management in New York. “There are some very attractive valuations out there.”