Lennar and Toll Brothers looks like good bets in a shaky market, even as the housing market deteriorates. Here, a new Lennar home under construction in Montgomery, Ill.
Daniel Acker/Bloomberg
My summer portfolio strategy is to play the old disco hit “Baby Come Back” while slow dancing with my December brokerage statements. If it works, I have a business idea involving Hall, Oates, and a two-and-20 fee structure.
At least there’s real estate. Home equity is said to be hitting record highs. Then again, taking comfort there would be like slipping on a financial toupee—everyone knows that underlying conditions have deteriorated.
The latest reading on nationwide pricing comes from back in March. Since then, 30-year mortgage rates have shot up to nearly 6%, and applications from buyers have slowed. This past week, a pair of online brokers with a good read on house searches, Redfin (ticker: RDFN) and Compass (COMP), announced layoffs.
Meanwhile, Redfin shares are down some 90% from their peak. Builders have gotten clobbered, too. Friends don’t let friends own leveraged exchange-traded funds with names like Direxion Daily Homebuilders & Supplies Bull 3X Shares (NAIL), especially when interest rates are rising, but if you’re curious, that one just lost 45% over five trading days.
Should investors buy shares of home builders here? Brokers? What’s next for house prices? And when will the stock market come back? Let me answer those in order of declining near-term confidence, starting at iffy.
Yes, buy builders. Prefer Lennar (LEN) and Toll Brothers (TOL), says Jade Rahmani, who covers the group for KBW. He points out that builder shares trade at 60% of projected book value, which is where they tend to bottom during recessions, ignoring the 2008 financial crisis. Lennar will benefit from the pending sale of a real estate technology unit, and Toll focuses on affluent buyers, around 30% of whom pay cash, and so aren’t put off by high mortgage rates.
Price/earnings ratios across the group are astonishingly low, but ignore them. They stem from two conditions that won’t repeat soon: land values jumping 30% or more from the time companies bought acres to when they sold houses, and a sharply higher pace of transactions during the pandemic. A builder that trades at four times earnings might really go for eight times assuming normalized conditions—still cheap, but a big difference.
House prices jumped more than 20% in March from a year earlier, but Rahmani expects that rate to plunge to 2% by the end of the year. His baseline view is that next year brings flat prices. His recession scenario, based on a study of past sales volumes, has prices falling 5% next year—perhaps more if mortgage rates rise to 7%. That might not sound like much, but for recent buyers with typical mortgages, a 5% price drop can reduce equity by 25%.
Most homeowners don’t have mortgage rates anywhere near recent ones; some two-thirds are locked in below 4%. These buyers are unlikely to move and take new loans if they don’t have to, which is one reason that supply could stay low for years. Another is that mortgages are much higher quality than they were during the last housing bubble, so there’s unlikely to be a wave of defaults and panic selling.
But something has to give on affordability. Typical payments on new mortgages have topped 23% of disposable income, close to their 26% high during the last bubble. But incomes are growing by 6% a year, so a long pause for house prices could help restore affordability. Anyhow, the pandemic has left people spending more time in their homes, so they should be willing to pay somewhat more on housing as a percentage of their income, reckons Rahmani.
Don’t rush to buy shares of the brokers, says William Blair analyst Stephen Sheldon. He has Market Perform ratings on three of them: Redfin, RE/MAX Holdings (RMAX), and eXp World Holdings (EXPI). In a blog post this past week, Redfin CEO Glenn Kelman wrote that May demand was 17% below expectations, and that the company will lay off 8% of employees. Redfin hires agents directly, whereas many brokers use independent contractors.
Kelman wrote that the sales slump could last years rather than months. More agents could leave on their own. National Association of Realtors membership, a proxy for the number of people selling houses, hit 1.6 million last year, up from about a million in 2012.
Sheldon at William Blair says he’s struck by how far broker valuations have come down, but sentiment is sour, and he’s waiting for signs of stabilization. Redfin goes for less than a tenth of its peak stock market value early last year, even though revenue has roughly doubled. That puts shares at around one-third of revenue. Free cash flow was expected to turn consistently positive starting in 2024. Now, we’ll see.
As for the stock market, I have good news and bad news, neither of which is reliable. The S&P 500 this past week dipped below 15 times projected earnings for next year, which suggests pricing has returned to historical averages. But there’s nothing to say that the market won’t overshoot its average valuation on its way to becoming cheap. And Goldman Sachs says forecasts for 10% earnings growth this year and next look too high.
Expect slower growth, says Goldman, and if there’s a recession, earnings could fall next year to below last year’s level. The bank’s estimates under that scenario leave the S&P 500 today trading at more than 18 times next year’s earnings. Goldman predicts that the index will rise 17% from Thursday’s level by year’s end without a recession, or fall 14% with one. Please accept my congratulations or condolences.
Not to worry, says Credit Suisse. Statistically, individual forecasts for company earnings are tightly clustered. That’s the opposite of what tends to happen before earnings tank.
I’ve heard people refer to the stock market as a “total cluster” before, but I had no idea they were talking about estimate dispersion.
Write to Jack Hough at [email protected]. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.
