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Homebuilder stocks have been affected by the coronavirus. Some have lost two-thirds of their market value in six weeks. Will they become profitable investments again?
The economic timeout across the U.S. and resulting stock market swoon and biggest spike in unemployment in history have had a chilling effect on the new home market. Sales in February hit their second-highest level since 2007, but that’s old news as the strength came before the coronavirus crisis took hold.
For now, the bad news is homebuilding stocks always fall sharply during steep economic contractions.
“None of these guys are going to make any money in a recession,” says Mike Kagan, portfolio manager at ClearBridge Investments.
Still, as the economic stop drags on, homebuilders are still trying to build and sell homes. A big focus is conserving cash to survive the slowdown. They’re doing that by pausing land purchases or pushing out closings, adjusting construction start times and dialing back the number of developments. Less exposure to land, in general, lowers the risk of losses if land falls in value.
In a late-March conference call with analysts, Lennar’s executive chairman Stuart Miller summed up the outlook this way: “As the economy slows, we expect that our traffic will decline, and we will see the corresponding slowdown in sales.”
The good news? Shares of publicly traded homebuilders already reflect a lot of the negative headlines. Through the first week of April, PulteGroup was 66% off its February peak, luxury builder Toll Brothers was down 64%, KB Home was 60% lower and Lennar and D.R. Horton shares lost about half of their value.
Investors in search of long-term opportunities, analysts say, shouldn’t rule out homebuilders.
Get in for the long haul
The economy will eventually recover. People will again resume their lives and buy brand-new homes again. And homebuilders, which are so-called cyclical stocks that move up and down with the economy, have a history of rebounding after big plunges.
“Homebuilders are hyper-cyclical,” says Ken Leon, an equity analyst at CFRA.
A year after the stock market bottomed in March 2009, for example, Lennar had nearly tripled in value with a gain of more than 175%. KB Home and NVR more than doubled with gains of 111% and 131%, respectively. D.R. Horton, which mainly targets lower-price buyers, rebounded 90%.
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With many homebuilding stocks now trading at book values similar to the trough levels seen in the Great Recession, it’s likely that investors who buy at today’s depressed prices should make money if they can stomach volatility and hang on for a while, Kagan predicts.
“If you close your eyes for a couple of years then you will make money on these stocks,” Kagan says. “But you will also be gripping your chair for a while.”
The best buying opportunity, Leon counters, is “not now.” The coronavirus crisis is still playing out and “the pace of new orders and (buyer) traffic will be low” for at least six months, he warns. During this period, it will be a buyer’s market. As a result, homebuilders could be forced to lower prices, or offer concessions, such as granite counter upgrades or bonus rooms, which will reduce profit margins.
Research firm Capital Economics expects total U.S. home sales to drop about 35% in the April-through-June quarter compared to the end of 2019. But the drop, they predict, will prove to be “short-lived.” Pent-up demand and the strong aid from the Federal Reserve and Congress, they predict, will likely shorten the duration of the virus-related slowdown.
There are other signs of a coming slowdown. A recent survey of realtors found that about half (48%) said home buyer interest has “decreased” due to the coronavirus outbreak, the National Association of Realtors said. Similarly, after hitting a record high in December, homebuilder sentiment has fallen in each of the first three months of 2020, data from the National Association of Homebuilders show.
Eventually, once the economy and markets signal a coming recovery “these stocks will be great buys,” Leon says.
Stocks will come back
To get a sense of how homebuilding stocks might perform when investors start to price in better days ahead, consider how homebuilder shares performed on Monday, April 6th when the Dow Jones Industrial Average rallied more than 1,200 points. Homebuilding stocks jumped 15% to 22% in a single day.
Despite the current gloomy outlook, there are a few reasons why homebuilder stocks could emerge in decent shape and be winning investments once the economy begins to heal, analysts say.
Unlike the crisis back in 2008-09, when there were a glut of homes and prices were high, the supply of new homes today is in short supply. Production levels never caught up to the levels seen in last decade’s real estate boom.
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“I’d argue that the inventory of new homes out there is on the light side,” Kagan says. “That means whatever kind of downturn we’re going to have, at least from a supply-demand standpoint, we’re likely to recover pretty fast. As bad a recession as this is going to be for homebuilders, I think it’s going to be less bad than” the financial crisis, he says.
What’s more, builders ranging from Lennar to NVR have shifted from a model of owning a lot of land to a so-called “land-lite” approach. Many homebuilders now gain exposure to land via options to buy rather than outright purchases, Wall Street analysts say.
So how does an individual investor know when it’s safe to buy these stocks?
Here’s what to watch for:
Identify homebuilders with strong cash positions, fortress-like balance sheets, manageable debt levels, low exposure to land and experienced management teams that have been through prior downturns.
In short, you’re looking for companies that can survive the rapid, unprecedented recession and get up and running quickly when health fears fade and regular life returns.
“You want to focus on the really high-quality companies that are going to make it through the bottom,” says Kagan.
Homebuilders that Kagan says he “feels comfortable” owning during these difficult times are D.R. Horton, Lennar, NVR and Toll Brothers. “They will all be leaders on the way up,” he says.
NVR, he notes, has the most “extreme asset-light” business model. By obtaining most of their land through options, they’ll have lower land losses if prices fall. They’ll also be able to build on the lower-cost land they have options to buy more quickly than competitors.
Job rebound, bank lending
To buy a house, people need jobs and a source of income. They also must have confidence in the future. Most important, they need banks willing to lend them the money.
The outlook for those conditions to turn positive is promising, given that the finances of most Americans were in better shape heading into this downturn than back in 2008, says Kagan. Banks also have larger capital reserves than they did before the Great Recession.
To make money, homebuilders need buyers to snap up the homes they build. So, keep an eye out for signs that new orders are stable, and buyers are back out shopping.
“Right now, what the stocks are reflecting is an adverse scenario of a significant decline in net new orders,” says CFRA’s Leon.
Investors will want to see teachers go back to school, pilots return to the air, and waiters and bartenders get back to work at restaurants. The coronavirus fear factor must fade as well.
Is it time to buy?
So, when should you dip your toe back in and build your position in homebuilder stocks?
Kagan recommends a gradual, consistent and methodical approach. Put a predetermined amount of money in at preset intervals, such as each month or every quarter, he advises.
“Buy over a period of time, a number of months,” he says. “There’s going to be a lot of turmoil in the market and it’s still going to be messy for a while, so dollar-cost averaging is the way to go.”
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