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Industry Analysis: Homebuilding
The Homebuilding Industry is comprised of several of the nation's largest publicly traded residential construction companies. From a strategic standpoint, all of the builders generally adhere to a similar operating model that centers primarily on land purchases and construction activity. Homebuilders predominately operate in six regions in the U.S.: the Sun Belt, Central, Southeast, mid-Atlantic, Midwest, and West. Only a few large builders have operations in the Northeast. That region, which is densely populated, is where small privately financed builders dominate. Building opportunities there are fairly limited.
The top ten homebuilders tend to focus on certain categories. Some of the companies under our review cater to the affluent market, providing luxury homes. Others focus strictly on the entry-level category, in which buyers heavily base their purchase decision on their ability to secure affordable financing. A majority of homebuilders, though, concentrates on the "first-time" segment. Here, the average home price is modestly higher than that of an entry-level model. This segment includes another appealing business venue, the first-time move-up market.
The industry is highly fragmented. At the peak of the last housing cycle (in 2006), the ten biggest domestic homebuilders accounted for only about 35% of housing starts. There are hundreds of small, privately financed builders that operate solely at the regional level, pursuing niche market opportunities. One major advantage big industry players have over their smaller counterparts is the ability to easily obtain debt and equity financing for large land purchases and construction projects. They have the clout to secure access to the nation's most desirable living locations.
In good economic times, when funding is widely available, it is common for large companies to expand their operations (essentially, land positions) by buying up small regional builders. Historically, this has been an inexpensive way for builders to penetrate new markets.
Land and Home Inventories
Investors considering a commitment to Homebuilding stocks should pay close attention to land and home inventories. When consumer demand outweighs supply, builders typically increase both their land holdings (owned and optioned positions) and home inventories. It's best to focus on those companies that have a lengthy track record of steady, year-to-year, increases in these assets.
We caution, however, that inventories on builders' balance sheets can, at times, become excessive, hitting record levels, suggesting that the housing market is overheated and a correction is in the offing. An oversupply situation often leads to falling prices, increased builder incentives, and writedowns of land and home inventories to fair market prices.
Homebuilders that carry mostly a short-term supply of land on their balance sheets (typically lasting two years or less) are not overly exposed to sizable asset impairments when difficult market conditions arise. Such companies pose limited risk for investors.
Two important indicators that can aid an investor in gauging the health of the industry are housing starts and building permits. The U.S. government releases these figures on a monthly basis. Housing starts are the number of new private homes coming under construction. Building permits indicate the prevailing trend in home construction. During strong housing markets these two measures tend to rise at a healthy clip, conversely they fall when the economy weakens.
From a company-specific perspective, investors should review new home orders and construction backlogs. The lag time from when a contract is signed to when a new home is delivered is typically six months. These figures tend to be strong indicators of a builder's near-term revenue and earnings prospects. Both are reported on a quarterly basis.
The performance of Homebuilding stocks can be highly influenced by funding cost and mortgage rate levels. Share prices often receive a positive boost when the Federal Open Market Committee cuts borrowing rates, or even just hints at a reduction. Of course, cheaper financing spurs demand for new and existing homes. When the Fed tightens its monetary policy, the cost of funding rises, in turn, hurting housing demand. Fed decisions to raise or lower borrowing rates have the greatest impact on builders that cater to the entry-level and first-time, move-up markets. Naturally, buyers in these two categories are very sensitive to mortgage costs.
The Pool of Buyers
The population of able buyers in the market is closely tied to the health of the domestic economy. In prosperous times, housing sales will pick up. One figure that should be watched closely, though, is the nation's unemployment rate. Increases in jobless claims usually remove buyers from the market. Not surprising, if an individual doesn't have a job, his/her ability to buy a home is compromised. Thus, we don't expect homebuilders to be at their peak performance when unemployment is on the rise.
This industry is highly cyclical, and the operating performance of each Homebuilding company typically moves in sync with the fortunes of its peers. Therefore, those looking to invest in the Homebuilding sector should take a broad economic view, focusing on some of the aforementioned market metrics. Generally, all sectors, from entry-level to luxury, and Homebuilding companies, prosper in an economic upswing. These stocks notably suffer in periods of recession.