Housing starts have largely recovered from the pandemic trough even in the face of surging materials costs, aided by low interest rates and strong demand. With the Federal Reserve expected to embark on its first round of interest rate hikes this month, questions remain as to whether the growth seen in homebuilding can be sustained.
Bank of America (BAC), however, now has a positive outlook on homebuilders per a recent BofA Global Research report.
“In our year-ahead report we noted that homebuilders stocks could face a challenging setup with rising interest rates, but valuations are now trading at the low-end of the historical range and spike in mortgage rates is now already well known to investors,” the report reads.
On top of attractive valuation multiples, BofA cited appreciating land value, strong returns on equity (ROE), and healthy cash flows as the main reasons for why they think builder valuations are cheaper than they appear. The report noted that the supply chain crunch has accelerated share gains by public homebuilders.
BofA also believes that demand will continue to outpace supply through 2022, pointing to demographics and migration trends which support growth in markets with housing shortages, tight existing home inventory, low new home inventory (expected to remain low given longer build cycles), and growing demand for single family rental units.
“Affordability has worsened with rising mortgage rates and higher building costs (land, materials and labor costs all rising). So why do we think new home demand will stay strong? Because supply is very tight (both existing and new), rents are skyrocketing and vacancy rates are historically low,” the report reads. “Simply put, there is a shortage of shelter and the cost to own is still relatively attractive vs. renting in the fastest growing US markets.”
However, despite positive fundamentals supporting BofA’s thesis on the industry, the report acknowledged the threat that a rising 10-Year Treasury (^TNX) poses, calling it a “key risk” amid falling homebuilder sentiment.
“Rates drive sentiment in homebuilders (for good reason) and higher mortgage rates are the key risk to homebuilder stocks,” the report reads. “We think mortgage rates are already near the highs for 2022 with spreads already widening to price in quantitative tightening and 10-year yields just 28bps away from BofA year-end forecast. Builder valuations imply downward estimate revisions or land write downs - both of which we view as highly unlikely.”
In light of rising rents and the low vacancy rate encouraging ownership over renting, which BofA also believes offsets worsening affordability, BofA is upgrading both Toll Brothers (TOL) and PulteGroup (PHM) to “Buy” (both from “Underperform”).
BofA’s price objective for PulteGroup remains at $58, while their new price objective for Toll Brothers stands at $63, up slightly from their previous target of $61. PulteGroup is down from a December peak of over $57, currently trading at just under $50, while Toll Brothers is down from its December peak of nearly $75 at around $53 today.
Thomas Hum is a writer at Yahoo Finance. Follow him on Twitter @thomashumTV