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Why household formation will drive builders like Standard Pacific

Brent Nyitray, CFA, MBA

A growing top line: Standard Pacific Homes' 2Q14 earnings (Part 4 of 5)

(Continued from Part 3)

The key to the next level for builders is the first-time homebuyer

While Standard Pacific does cater to the first-time homebuyer, it has de-emphasized that market since the housing bust began. This was a smart decision. But, at some point, the first-time homebuyer will return, and builders that focus on that market will do very well.

Right now, the biggest first-time homebuyer names are D.R. Horton (DHI) and PulteGroup (PHM). In fact, D.R. Horton mentioned on its earnings call that it’s dedicating more resources to this “underserved” segment.

The macro picture for builders looks good

People forget that a housing bust is getting pretty old. The housing market peaked in 2006, which was eight years ago. A lot of excesses from the bubble have been worked off. In many ways, we’ve seen the opposite problem—a shortage of existing and new inventories. Part of this trend resulted from foreclosure laws and the other part from cautious builders.

Take a look at the above chart. It compares housing starts and household formation over the boom and bust cycle. A steep drop in household formation has kept new housing supply and demand roughly in balance. But it’s an artificial balance. The important thing to keep in mind is that those numbers weren’t due to fertility rates 25 years ago. They were due to a lousy economy. This means there’s tremendous pent up demand that will unleash once the economic recovery filters down to the young. For more information on household formation, read  Why household formation matters to homebuilder companies .

To put these current numbers in perspective, from 1959 to 2002, we averaged 1.5 million housing starts a year. After the bust, we spent six years with starts below 1 million. When you consider population growth, that’s a staggering number.

Homebuilders with lots of exposure to the first-time homebuyer—like D.R. Horton (DHI) and PulteGroup (PHM)—will benefit from this demand the most. Standard Pacific could always return to its roots as an entry-level builder as well. Homebuilder investors will want to watch employment growth for the Millennial Generation to time the rotation out of luxury builders like Toll Brothers (TOL) and NVR (NVR).

Investors interested in the homebuilding sector as a whole should look at the SPDR S&P Homebuilders ETF (XHB).

Continue to Part 5

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