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Why do homebuilders watch for rising real estate prices?

Brent Nyitray, CFA, MBA

Why do increasing home prices matter to REITs and homebuilders? (Part 4 of 4)

(Continued from Part 3)

Rising home prices are good for homebuilders

Homebuilders compete with existing homes for buyers, and increasing prices for existing homes means they have more latitude to raise prices for new homes. We’ve seen huge increases in gross margins from virtually all of the homebuilders. Average selling prices have been increasing by double digits—although, in all fairness, these aren’t necessarily apples-to-apples comparisons. Homebuilders are finding that the luxury end of the scale is where the purchasing power is, and those that concentrate on the lower price points are having a more difficult time.

Geography matters with home price appreciation

In the map above, you can see just how dispersed home price appreciation is. In the red-hot West Coast markets, we’re seeing prices increase in the high teens. In the Northeast, however, prices are increasing at a much slower pace. What accounts for the difference? In large part, state foreclosure laws make a big difference. In the Northeastern states—particularly New York, New Jersey, and Connecticut—foreclosures have to be approved by a judge. Judges have been extremely borrower-friendly in these states (New York is legendary for how long someone can stay in their house without paying their mortgage—several years). On the West Coast and the sand states, foreclosures move through an expedited process. The upshot is that the inventory of foreclosed properties in the West Coast has largely been worked through, and prices have been rising rapidly. On the East Coast, the shadow inventory has barely budged.

Pay attention to geographic exposure with the builders

When looking at homebuilders, it pays to analyze their geographic footprint. Builders that are West Coast–centric, like Lennar (LEN) and Standard Pacific (SPF), are experiencing faster growth than East Coast–based builders like NVR (NVR) or even diversified builders like PulteGroup (PHM). Finally, the luxury segment continues to outperform, which means investors should take a closer look at Toll Brothers (TOL). One thing to watch is that it appears that price appreciation is leveling out on the West Coast and may be picking up in the Northeast and Midwest. This would mean you should take a look at more geographically diverse builders like D.R. Horton (DHI) and PulteGroup (PHM).

To learn more about investing in homebuilders, see the Market Realist series Lennar’s 1Q14 earnings: Revenue increases 38% from 2013.

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