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Homebuilder stocks are on sale–but investors aren’t buying

May 23, 2022, 5:16 PM UTC
Drawing on the lessons they learned during the 2008 crisis, leading homebuilders have pivoted to a land-light model by buying land options.
Justin Sullivan—Getty Images

Investors have a long memory when it comes to losing money. They vow to not get burned the same way twice.

When it comes to investment pain from the past, homebuilder stocks have done their share of damage. The speculative real estate investment bubble and accompanying overbuilding of homes were major contributors to the financial crisis of 2008. The builders of those homes were duly punished–and their stocks were obliterated.

It has been over a decade since the last housing bust, but it was a memorable one. It left some marks. Many investors have been expecting the next crisis to arrive ever since. And now, they see a sign that the end is near.

The ominous signal? Rising interest rates. The average rate on a 30-year fixed-rate mortgage has surged above 5% this year. That’s a big upward movement from the record low of 2.65% reached back in January 2021.    

Higher rates make housing less affordable. The monthly payment on a $300,000 mortgage with a 2.65% interest rate would be $1,209. That same mortgage at a 5% rate would require a $1,610 monthly payment. For many buyers, an extra $400 a month can make homeownership unobtainable.

In the minds of many investors, the next housing crisis may as well be here. And they’re acting accordingly: Investors have aggressively sold their homebuilder stocks this year.

Plenty of investors got burned during the last housing crash. They are quick to perceive any real estate headwind as the proverbial writing on the wall. But that perception is wrong. Today’s housing market dynamics do not resemble 2008’s. The same applies to homebuilders.

America has a critical housing shortage

Today’s housing market does not resemble the speculative froth that helped drag us into the Financial Crisis.

Instead, there’s strong demand from Millennials making first-time home purchases. A recent study found that millennial buyers accounted for 43% of home purchases in 2021. That’s up from 37% the year prior.

The growing acceptance of remote working is also driving home demand. Many buyers are looking to upgrade to homes with larger office spaces, often in more affordable cities. These trends will continue to drive housing demand in the years ahead.

In terms of supply, homebuilders dramatically slowed their pace of new home construction after the last real estate bust. They’ve only recently begun building at levels resembling the pre-financial crisis average.

A decade of under-building has created an incredibly tight housing market. We’re coming off the lowest inventory levels in recent history.

A report by Realtor.com suggests that America is short over five million homes. With supply chain issues keeping a lid on the pace of new construction and Baby Boomers reluctant to leave their homes, homebuilders should remain busy for many years to come.

In fact, they’re literally turning away business.

“Through our history, to have somebody walk into our models and to tell them, ‘We don’t have a house for you to buy today,’ is something that is foreign to us,” says David Auld, Chief Executive Officer of D.R. Horton, America’s largest homebuilder by volume.

It may be unusual, but that’s exactly what is happening today. With a record-high backlog, many homebuilders are choosing to turn away some potential buyers.

The biggest problem many homebuilders will face over the next 12 months is building fast enough to keep up with demand. Considering the historically cyclical boom and bust nature of these businesses, that’s not the worst problem to have.

The one change that has transformed the homebuilder business

That cycle of boom and bust is surely on the minds of investors that have dumped homebuilder stocks this year.

Homebuilding has historically been an asset-heavy business, with lots of capital tied up in land investments. The value of that land can change quickly. This has helped fuel the typical boom-bust cycle homebuilders experience.

However, homebuilders have solved this problem by shifting to a “land-light” model: Instead of buying up land, homebuilders are increasingly buying land options. They control the land but don’t own it.

When they’re ready to build homes, the homebuilder exercises the option and buys the lot. If the housing market turns south in the meantime, they can renegotiate the land purchase, or walk away with the relatively minor loss of the cost of the land option.

Lennar, America’s second-largest homebuilder by volume, is one of several companies taking the land-light strategy to heart. The company reported its controlled (rather than owned) homesite percentage increased to 58% from 45% the prior year.

“Our extreme focus on a land-lighter model saved us a significant amount of cash spend on land acquisitions during the quarter,” Lennar Co-Chief Executive Officer Rick Beckwitt shared on the company’s recent earnings call. He believes the company can increase its controlled land to 65% by the end of its fiscal year.

The housing market is still red-hot in many cities. Shortages are expected to be the reality for years ahead. Business is so good for homebuilders that they can’t put up homes fast enough. Their balance sheets are strong. Their operations are more resilient. None of these facts are reflected in their current valuations.

Homebuilders are stronger and their future is brighter than what the market is giving them credit for. Yet, fear of another housing bust has detached the price of homebuilder stocks from reality.

Michael Joseph, CFA, is a vice president and deputy chief investment officer at Stansberry Asset Management. Stansberry Asset Management is not currently invested in the specific issuers discussed herein, but may trade in these and additional issuers in this sector in the future. This report should not be construed as investment advice. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

The opinions expressed in Fortune.com Commentary pieces are solely the views of their authors, and do not reflect the opinions and beliefs of Fortune.

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