Homebuilder Stocks Confront Rising Mortgage Rates

Are homebuilder stocks made out of straw, wood or brick

With a big, bad wolf like rising mortgage rates at the doorstep, that's a question some investors might be asking.

Interest rates on fixed 30-year mortgages recently started to climb as the market factored in possible changes pending in the Federal Reserve's monetary strategy.

As rates climbed, mortgage activity slowed and shares of homebuilders such as Toll Bros. (TOL), D.R. Horton (DHI), Ryland Group (RYL) and PulteGroup (PHM) have been shaken. The declines dragged the homebuilders group out of the top 50 among the 197 industries tracked by IBD.

Over the past three decades, homebuilding stocks performed poorly during four separate episodes of rising mortgage rates, notes a Barclays report. Barclays says this time may be different, partly because of rising home prices.

Despite the stock performance, the median price of a newly built home in April jumped 15% year-to-year to $271,600, says the U.S. Commerce Department.

The number of homes being built remains well below the historical averages during prior housing rebounds. Homebuilders have been cautious — increasing construction activity to lift sales and profit, but not fast enough to keep up with demand. This lag in supply has helped keep upward pressure on prices.

The combination could propel homebuilders' profit margins back up to peak historical levels, says Barclays.

1. Business

Homebuilders aim to acquire land and ready-to-build lots in areas close to jobs, with reasonable commutes, and near well-regarded school districts. They build subdivisions or gated communities with amenities targeting families or retirees.

Stockpiling land in the right places is key, though most homebuilders were stuck with overstocked pipelines after the housing bubble burst in 2007. As a result, homebuilders took more than $35 billion in write-downs, according to Standard & Poor's.

Homebuilders with ample land in prime locations are better able to control margins. Land-light rivals overpay when markets heat up.

During the Great Recession, some public homebuilders still had enough cash on hand to buy unfinished new-home communities left by private builders that went bankrupt, said Standard & Poor's in a January report.

Raymond James analyst Buck Horne says that public homebuilders have more land available to meet demand than private ones that rely on financing from local banks.

According to Barclays, Toll Bros. and Lennar (LENB) have the most land inventory, measured in how many years it would take to use up. Hovnanian Enterprises (HOV), which acquired property during the housing downturn, and D.R. Horton, also have strong land holdings, says Barclays.

Industrywide, there's a dearth of well-located land, say analysts.

Developed lots — those with power lines, paved roads, and water and sewage lines available — are especially in tight supply. Many lots in distant suburbs are empty.

Poorly located, mothballed inventory that can't be developed profitably is still a concern for some homebuilders.

S&P says more homebuilders are purchasing land closer to downtown markets instead of far-flung suburbs, as consumers tire of long, expensive commutes.

Name of the game: "Land acquisition is the most important day-to-day decision made by a homebuilder, with a company's success closely tied to it," says S&P.

2. Market

Homebuyers choose between existing homes and newly built ones. New houses cost more and usually are bigger than pre-owned houses, though homebuilders have recently downsized new models to fit smaller budgets.

The National Association of Home Builders says the median value of new homes sold was $230,000 in 2011 compared with $162,000 for existing homes.

Move-up buyers, many seeking larger homes, account for most new-home sales. First-time buyers tend to have lower incomes, less capital to use as a down payment and less firmly established credit. As a result, they often have more trouble getting loans.

With mortgage rates rising, consumers now renting may feel some urgency to buy. A household that qualified at the beginning of the year for a $250,000 mortgage at 3.5% interest, for example, may now only qualify for a $187,000 mortgage at 6%.

Builders increasingly focused on more qualified move-up buyers, and away from entry-level sales, have helped drive up prices.

Luxury homebuilder Toll reported fiscal Q2 EPS and revenue that beat views as profit rose 40% and sales jumped 38%. Toll says it raised prices by $26,000 per home on average in the quarter ended April 30. Its average selling price was $577,000.

Contract backlog — deals not yet closed — is a key financial metric for homebuilders. The contract backlog for most top homebuilders has been improving, signaling a solid near-term sales outlook, says S&P.

"We focus very much on backlog when we decide on price increases," said Toll Executive Chairman Robert Toll, on the company's May 22 earnings call.

"If you ask where it goes for the next few quarters, we will continue to raise price.

Pulte, Standard Pacific (SPF), MDC Holdings (MDC) and Ryland have products that cater to move-up buyers, says Horne. D.R. Horton, Beazer Homes (BZH) and KB Home (KBH), meanwhile, are focused on entry-level homes.

3. Climate

Savvy homebuilders have been slowing down sales in hot markets, so they benefit from rising prices. "Builders are very carefully monitoring each new product, often raising prices after each incremental sale," said Raymond James' Horne in a report.

He says the price spread between new homes and existing homes is about 27% — among the widest levels on record. That's because of a tight supply of new single-family homes, rising construction costs, the sales mix-shift toward move-up buyers, and the un-even recovery across the U.S.

If the housing rebound continues, more would-be sellers of existing units may come off the sidelines. Consumers that have been underwater on their mortgages have been reluctant to sell at a cash loss.

Competition has eased with almost-new, deeply discounted foreclosed homes up for resale.

Foreclosed homes accounted for 21% of all housing sales in Q1, down from 25% in the first quarter of 2012, and 45% in 2009, says RealtyTrac.

Still, there's concern over bank lenders unloading more properties from their shadow inventory (foreclosed or distressed homes not yet listed for sale), which would pressure prices.

"Many homebuilders are trying to price their redesigned smaller homes 10%—15% above existing homes in places like Arizona, California and Nevada, where foreclosures were highest over the past few years," said S&P.

A question being asked by investors is whether earnings estimates for homebuilders will move upward even if gains in home prices level off.

Homebuilders have been able to boost margins by trimming sales incentives to prospective buyers. And while they are hiring briskly on the construction side, builders have held off on hiring more salespeople, helping to keep overhead under control.

They've also standardized floor plans and room sizes, says RBC Capital analyst Robert Wetenhall. "Fewer options equal less complexity equals reduced cost," he said in an email.

4. Technology

Homebuilders need to step up production to keep the housing recovery going, according to the National Association of Realtors' chief economist Lawrence Yun.

But housing starts fell 16.5% in April from the previous month's pace, although building permits rose 14%.

Homebuilders say they're being squeezed by rising costs for building materials and skilled labor. Lumber suppliers and materials makers have been holding off on building new factories, keeping supplies tight. It will take longer to re-establish industry supply chains to pre-2007 levels, analysts say.

5. Outlook

Lending to private builders remains strict. Public homebuilders are expected to take market share because of easier access to capital, giving them an edge in acquiring land.

Ryland has been the most active in acquiring private companies. It purchased Trend Homes in Phoenix, Timberstone Homes in the Carolinas, and LionsGate Homes in Dallas over the past year.

KB Home, whose land holdings have been weighted toward California and Texas, plans to spend $1 billion on land acquisitions in 2013. Meritage Homes (MTH) also has stepped up purchases.

Pulte, already with sizable land holdings, has been cutting debt and may offer a dividend down the road, analysts say.

Upside: Three homebuilders have gone public in 2013, including Tri Pointe Homes (TPH), Taylor Morrison Home Corp. (TMHC), and restructured William Lyon Homes (WLH).

Of the three, only Taylor Morrison is still trading above its IPO price. Half of its land investments is in Texas and California.

Union Community Partners, or UCP, in April filed to raise $125 million in an IPO.

Risks: Mortgage applications have been falling as rates climb.

Millions of vacant and distressed housing units must still be absorbed, though a growing number are being rented. Rising rents have again made homeownership look more affordable but the trend could stall.

Long-range, gains in the housing market will be tied to job growth and household formation.