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Hard-hit homebuilders may find refuge in shift to affordable product

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Hard-hit homebuilders may find refuge in shift to affordable product

Homebuilders have experienced a definite deceleration in business in 2018. Whether that weakness devolves into a prolonged downturn is to be determined.

"The stocks right now are in an interesting transition period where they're trying to decide, is the next leg down hard, or stabilization?" Carl Reichardt, a managing director and homebuilder analyst at BTIG, said of the group.

Among economic segments sensitive to rising interest rates, homebuilding is especially delicate. Higher rates translate into steeper construction costs and higher mortgage rates, effectively clipping the business from both the supply side and the demand side. And while the millennial demographic is entering the nesting cycle in droves, the group has an entirely different approach to homeownership. If a young family is in the cohort that actually wants to own instead of rent, and is able to afford a first home, it is very unlikely to "go big" with its purchase.

Homebuilder stocks have taken a particularly deep dive as the stock market has corrected, and Reichardt said lofty home prices across the country have hurt the builders even more than higher rates. Pressured by inflated material costs and emboldened by low inventory, builders in late 2017 and early 2018 became overly aggressive on pricing, pushing beyond what most consumers want or can afford to pay, he said.

"I think the key right now to determining the future of housing is, one, builders are going to have to cut prices," Reichardt said. "That's got to happen."

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Jay McCanless, analyst at Wedbush, said high prices have hurt the California market in particular, and investors are concerned the pronounced weakness there may infect the rest of the country. He said a "buyer strike" in the state and in other high-priced markets in the western U.S. is the way forward.

"[Prospective homebuyers] either want to see some product come onto the market that's closer to their expectations, or the builders need to cut a little in the price," he said.

McCanless named D.R. Horton Inc., a value-oriented builder and one of the better-performing homebuilder stocks year-to-date, one of his "best ideas." He expects other builders will emulate D.R. Horton's focus on affordable and entry-level product, voluntarily or by attrition. The shift in the market could spur more M&A activity like Taylor Morrison Home Corp.'s acquisition of AV Homes Inc., a deal that expanded the former's exposure to the first-time-buyer market.

"That's the calculus that some of the larger builders right now are doing: Does it make sense to go out and acquire one of our competitors who has better entry-level lots than we do, or do we do it organically?" McCanless said.

BTIG's Reichardt is cautiously optimistic on homebuilder names such as LGI Homes Inc. that focus on first-time buyers or on markets where home price appreciation has not been as significant, making them increasingly attractive to downsizing baby boomers and "empty-nesters." Meritage Homes Corp., whose business he estimated is now 35% to 40% focused on first-time buyers, has also benefited from an emphasis on affordable product, he said.

Reichardt framed the overall economic climate as "reasonably positive," and he said there is little evidence that demand for affordable housing product has become "appreciatively softer" this year. Demand from nesting millennials is likely to manifest slow and steady improvement in the market rather than a dramatic upturn, he noted.

"Millennial demand isn't pent up, it's stretched out," Reichardt said.

McCanless expects some softness in the coming months in Southeastern markets impacted by recent hurricane activity, but he is cautiously optimistic on the space as a whole in light of employment and wage growth figures and the limited overall supply in the market.

"I think a lot of people are convinced that we've achieved peak housing, and there's no more growth left from here," he said. "I don't think that's the case."

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