A new home being built in L.A. on Sept. 22.allison dinner/Getty Images
The North American housing market is stumbling badly, as sales decline and prices fall from their recent highs.
That’s not a promising backdrop for U.S. homebuilding stocks, which are now suffering through their worst year since the financial crisis in 2007-08. What will it take to save the sector from its current tailspin?
The iShares U.S. Home Construction ETF, or ITB, an exchange-trade fund that tracks stocks such as D.R. Horton Inc., Lennar Corp. and PulteGroup Inc., has tumbled 38 per cent since mid-December.
While U.S. homebuilders might not be the most popular stocks for Canadian investors, they offer a fascinating window into the outlook for housing. And for those investors willing to bet on this corner of the stock market, the stocks can deliver swift – and impressive – gains during rebounds.
Right now, a turnaround may be hard to see.
Soaring inflation has pushed central banks to raise their key interest rates aggressively, sending borrowing costs to multiyear highs and putting homes out of reach for many prospective buyers.
Canada needs more homes. The problem? Finding people to build them
In Canada, the best five-year fixed mortgage rate has more than doubled this year, to 4.69 per cent, according to Ratehub.ca. In the United States, the 30-year fixed rate mortgage climbed to 6.94 per cent this week, according to U.S. housing finance giant Freddie Mac; that’s a 20-year high and up from 3.09 per cent a year ago.
The impact is showing up in the deteriorating housing markets in both countries.
Sale prices for Canadian existing single-family homes in major markets fell 3.1 per cent in September, from August, according to Teranet–National Bank house price data released this week. That marked the sharpest monthly decline since 1999.
In the United States, home sales activity in September declined for the eighth consecutive month, with sales numbers close to a decade low.
“The relentless surge in mortgage rates to around the 7 per cent mark has caused the sharpest one-year deterioration in affordability on record,” Robert Kavcic, senior economist at Bank of Montreal, said in a note this week, referring to the U.S. housing market.
Given this backdrop, there’s little wonder that building activity is slowing. In September, the number of single-family homes under construction fell 4.7 per cent from August, to a two-year low.
Builder sentiment in October marked its 10th consecutive monthly decline, according to The National Association of Home Builders. Outside of a brief period at the start of the pandemic, sentiment is now sitting at its lowest level since 2012.
Investors expect that homebuilder profits will plummet.
KB Home shares now trade at just 2.8 times estimated earnings, down from a price-to-earnings ratio of 13.6 in May, 2021. That’s not an anomaly within the sector; D.R. Horton’s P/E is 4 and Lennar’s is 4.2.
So far, profits appear to be holding up: In September, Lennar reported a 4-per-cent increase in its fiscal third-quarter profit, compared with a year ago. KB Home reported a 70-per-cent increase in profits over the same period. Clearly, the healthy backlog in orders is helping.
“Order growth was another matter,” Jay McCanless, an analyst at Wedbush Securities, said in a note this week.
He highlighted that KB Home’s orders were 50 per cent lower in the third quarter, year-over-year, which was far worse than his estimate of a 15-per-cent decline.
Things could get even worse for homebuilders if mortgage rates continue to climb and an economic recession raises the unemployment rate and crushes demand for new homes.
Still, there’s a bullish case here.
The United States has been suffering from a shortage of homes, affecting nearly every state. This deficit was recently estimated at 3.8 million homes, according to both Freddie Mac and a 2022 report from Up For Growth, a Washington-based policy group.
The shortage implies that building activity has considerable support over the longer term, providing the basis for a potential rebound in homebuilder stocks if borrowing costs stabilize.
Is that an outlandish bet?
On Friday, the S&P 500 rose 2.4 per cent on reports that the Federal Reserve may slow the pace of rate increases after an expected November hike. Clearly, some investors are already primed for a turnaround.
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