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Connecting the dots: Why manufacturing affects homebuilders

Brent Nyitray, CFA, MBA

Why July 2014's ISM releases were good news for REITs and builders (Part 2 of 4)

(Continued from Part 1)

How manufacturing activity relates to homebuilders

Manufacturing activity is a good sign for job growth, which has been the Achilles’ heel of this recovery. Although manufacturing isn’t the driver of the economy that it used to be, it still matters. Having a level of manufacturing that corresponds to 4.6% gross domestic product (or GDP) growth is certainly a positive.

The secular story for homebuilders

Overall, increases in business activity and consumption are starting to drive more business for homebuilders like PulteGroup (PHM), Lennar (LEN), D.R. Horton (DHI), and Toll Brothers (TOL). Housing starts have been so low for so long that there’s some real pent-up demand that will unleash as the economy improves.

This can create a virtuous circle in the economy. Increasing demand raises prices, which reignites the wealth effect and increases consumption. The secular, or long-term, story for homebuilders is optimistic. Household formation numbers will be a real wind at their backs. Investors who want to invest in the homebuilding sector as a whole should look at the S&P SPDR Homebuilder ETF (XHB).

Could margins contract going forward?

Comments from survey participants suggest that input prices are rising but output prices aren’t. Skilled labor is short in many areas of the country. Lennar mentioned this concern on its conference call, although it considered it to be a blessing in disguise, as higher employment and higher wages will drive consumer confidence and growth.

That said, the report noted that raw material prices are increasing. But homebuilders still reported pricing power and margin expansion. An uptick in raw material pricing or labor costs could negatively affect homebuilders. But so far, margins are generally strong.

Most of the builders are reporting increases in average selling prices combined with declines in orders. Once prices have been pushed as far as they can—and judging by the drops in orders, they’ve reached that point already—the builders will be forced to push through volume to increase the top line. This will mean bigger discounts and probably lower margins. If margins haven’t peaked yet for the builders, they’re close.

Economically, this would be fantastic news, as increasing building volume is exactly what the economy needs. The recovery has been tepid largely because homebuilding has been punching below its weight. If housing starts get back to their historic level of 1.5 million, that would generate a lot of economic activity. This would be good for the builders and restart the virtuous cycle we’ve been waiting for since 2009.

Continue to Part 3

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