This Boom is Just Getting Started

Call it the gift that keeps on giving. When the Federal Reserve slashed interest rates earlier this year, it led to a sharp drop in mortgage rates. The Federal Home Loan Mortgage Corporation, known as Freddie Mac, says that a 30-year mortgage can now be had for less than 3.0%. That’s near the lowest level in a half-century of record-keeping. Consumers that can handle a 15-year mortgage can now get one for less than 2.5%.

And that has helped light a fire under the housing sector. Consumers suddenly found they could afford a lot more house for the same-sized mortgage payments. Home builders also saw a clear boost as buyers began to pre-qualify for mortgages in droves.

Fed Chair Jerome Powell says this gift to the industry will stay in place for quite some time to come. A recent headline on American Public Media’s MarketPlace website blared, “Fed plans to keep interest rates near zero through 2023.”

As you’d suspect, builders of new homes are now quite bullish. The National Association of Home Builders index of industry sentiment soared to 83 in September, up from 37 this past May and 68 in September 2019. That’s the highest level on record since such surveys began in 1985. (Readings above 50 represent a positive view of industry conditions).

And investors are catching on to this boom. The S&P Homebuilders Select Industry Index has risen 20.2% in the past 12 months to a recent 5,207.

Low interest rates are just one factor in the boom. We’re also seeing a rapid migration out of some of the nation’s largest cities such as New York and San Francisco, creating a surge of home buyers in the suburbs and beyond. Trouble is, there just aren’t that many existing homes for sale. At the end of July, the number of single-family existing homes for sale dropped to a 38-year low of 1.3 million, according to the National Association of Realtors.

A lack of existing homes means that newly built homes will need to fix the imbalance between supply and demand. A lack of new homes was a clear issue well before the pandemic began. A March 2018 article in The Wall Street Journal noted that the supply of new homes failed to keep up with demand ever since the great financial crisis of 2008/2009. According to realtors.com, 17.6 million single-family homes have been built since 2011, while 20.2 million households have been formed. That translates into a cumulative supply shortage of 2.6 million units.

And that, in a nutshell, explains why this rally in home builder stocks is poised to last — for years. Martin Connor, chief financial officer of Toll Brothers (TOL), recently told investors that, “Demand feels really good right now… the longer it goes, the more comfortable we are that it’s got longer legs.”

True enough, the economy is grappling with high unemployment. However, the vast majority of Americans remain gainfully employed.

For investors, it’s important to assess the right home builder stocks to buy. And market positioning is key. Although many Americans remain gainfully employed, the vast majority don’t have the resources to buy higher-end homes, the kind sold by builders like Toll Brothers.

Instead, let’s take a look at home builder D.R. Horton (DHI), which primarily focuses on first-time home buyers (who are more price-sensitive) and those looking to trade up from those starter homes. Just as important, D.R. Horton gets 75% of its revenue from home sales in the U.S. Southeast, South Central and West regions. These are the parts of the country that have been seeing population gains as consumers flee colder climates and (often) higher property taxes.

Second-quarter per share profits of $1.72 were 32% ahead of consensus forecasts, and analysts have now dialed in higher profit forecasts for both 2020 and 2021. For example, the 2021 profit outlook has surged from $4.72 per share in late June to a recent $6.66. Analysts at Bank of America expect D.R. Horton’s operating income to surge to $3.5 billion by 2022, up from $2.3 billion last year.

One of the key long-term drivers for home builders is access to undeveloped yet well-situated land. In late 2017, D.R. Horton bought a majority stake in real estate lot developer Forestar Group (FOR), which enables the homebuilder to buy real estate parcels from Forestar as needed at beneficial prices. At the end of June, Forestar owned more than 50,000 “shovel-ready” lots. Those are the lots that can be developed at a fast pace as key infrastructure is already in place.

With access to large amounts of undeveloped land and an ideal mix of price points and geographic locations, D.R. Horton appears to be the best investment to play the coming extended housing boom.

Action to Take: Consider buying shares of D.R. Horton up to $80 and sell when shares reach $100.