Is there more upside to homebuilder stocks this year? That's the question investors are hoping the upcoming earnings season will answer as mortgage rates remain at 23-year highs.
So far, large-cap homebuilder stocks have averaged an increase of 34% this year as of Oct. 17, according to a recent JPMorgan note, while the small-cap ones climbed 24.2% on average.
This week, PulteGroup (PHM), NVR (NVR), Taylor Morrison Home Corp. (TMHC), Century Communities (CCS), and Tri Pointe Homes (TPH) all report third quarter earnings. Meritage Homes Corp. (MTH) and LGI Homes (LGIH) follow next week, with D.R. Horton (DHI) capping off the streak on Nov. 7.
The results should portend how homebuilders will fare the rest of the year and into next as mortgage rates approach — and potentially stay at — 8%, home prices remain high, and seasonality sets in.
Read more: Mortgage rates at over 20-year high: Is 2023 a good time to buy a house?
"We are inclined to believe the current rate levels may be the upper bound of affordability for consumers," Jay McCanless, senior vice president of Equity Research at Wedbush, wrote in a note to clients. "We see that as an important question for all of the builders."
Mortgage rates seesawed much of the first half of the year between 6% and 7%. The levels were too high to convince homeowners to sell and sacrifice their much lower mortgage rate, leading to historically low inventory of previously owned homes on the market.
As a result, new construction became the bright spot for many wannabe buyers, surprising analysts this spring.
Newly built homes accounted for nearly one-third of single family homes for sale nationwide in the second quarter, according to the residential real estate brokerage Redfin. New home sales are now up 2% this year compared to 2022 levels, per Morgan Stanley data released Oct. 13. The newest data comes out on Wednesday.
Read more: How to buy a house in 2023
Meanwhile, existing home sales in September remain 15.4% lower than a year ago.
"New homes increasingly represent the only game in town," Sam Reid, Wells Fargo equity analyst, wrote in a note to clients.
Builders also adjusted to higher mortgage rates by pitching incentives to buyers to reduce the interest rate on their home loan — called a mortgage rate buydown.
"Builders have a built-in advantage in a high rate environment via rate buydowns — offering a competitive alternative to both resales and apartments," Reid said.
More recently, mortgage rates have soared higher. The average rate on a 30-year fixed mortgage increased to 7.57% last week, according to Freddie Mac. The rate has stayed above 7% for 10 weeks, a span not seen since the last months of 2000.
Fixed-rate mortgage rates are closely tied to the 10-year Treasury yield, which topped 5% once again on Monday as investors worry that the Federal Reserve will make good on its higher for longer stance on interest rates.
Read more: What the Fed rate-hike pause means for mortgage rates and loans
Some Wall Street firms like Goldman Sachs expect mortgage rates to remain elevated for the foreseeable future, dipping to just under 7% by the end of next year. Other housing economists anticipate rates are likely headed to 8%, a scenario that will impact demand.
Those increases in rates and forecasts for elevated rates have eaten away recently at some builder enthusiasm, and some Wall Street analysts are warning about the downside risks to the rate buydown strategy.
"Based on our recent conversations with our coverage names, we estimate each 25 [basis point] of mortgage rate reduction for consumers is equal to 100 [basis point] of gross margin reduction for the builders," McCanless said. "If 30-year mortgage rates move higher than current levels, that could put additional pressure on builder gross margins."
Home prices and mortgage rates also didn’t ease during those summer months. The monthly mortgage payment including principal and interest on a $348,000 mortgage rose by 7% to $2,440 from $2,281 during the third quarter, Wedbush found. Those costly payments may push more buyers to pass up a purchase even with concessions from builders.
"We anticipate that the relatively quick increase in monthly [principal and interest] payments may have put some buyers on the sidelines," McCanless wrote.
That slowdown in demand this summer could have rippled through builder’s third quarter results and could continue. Another factor to weigh in: seasonality. The summer is typically an important season for the housing market compared to the fall and winter months as many families are more open to moving into a new home before the start of the school year.
"Builder commentary regarding current demand trends likely being more balanced compared to the more optimistic, constructive tones conveyed earlier this year," Michael Rehaut, an analyst with JPMorgan, wrote in a note to clients.
In response, some Wall Street analysts are monitoring their forecasts for the year.
"We lower our '24 builder estimates and price targets to reflect potentially higher incentive levels needed to offset the recent spike in mortgage rates," John Lovallo, wrote in a note to clients.
Meanwhile, Rehaut is expecting a "modest increase in incentives" this quarter, with "the industry to effectively uniformly describe the current demand backdrop as fully in-line with normal seasonality."
The increase in rates has also catalyzed a reversal for homebuilder stocks. While the SPDR S&P Homebuilders ETF (XHB) is up more than 18% year to date as of Oct. 20, it’s off by 16% from its 2023 peak on July 24.
"Regarding the homebuilders, we expect the stocks to at best 'hold their ground' if not still slightly trade down this earnings season, as despite the recent significant pullback in the group as well as, we anticipate, reasonable 3Q results, investors will likely remain cautious following the recent rise in rates," Rehaut wrote.
Joe Ahlersmeyer, research analyst at Deutsche Bank, though, had a brighter outlook for builders.
"The recent and rapid rise in both bond yields and mortgage rates has given investors pause with respect to owning homebuilders, despite strong fundamental demand underpinnings, increasingly attractive industry structure, low leverage, and strong cash flow," he noted.
"We are sympathetic to the compulsion to sell the stocks when demand appears to be weakening, but we expect fundamentals to outperform the downside case already reflected in valuations, and see current share levels as highly attractive relative to many of the homebuilders' returns and cash generation, and potential for book value growth even as margins come down," Ahlersmeyer wrote.
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Dani Romero is a reporter for Yahoo Finance. Follow her on Twitter @daniromerotv.
