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Is Investing In Housing A Good Move?

 The recession which began five years ago was precipitated by a gigantic real estate price bubble . According to the S&P/Case-Shiller Home Price index, the value of homes in the United States prior to that time had been comfortably stable for nearly a century. Beginning at a benchmark of 100 in 1890, prices fluctuated modestly, allowing adjustments for normal inflation, bouncing in between about 65 as a low point and 125 as a high. In the year 2000, this index was at 110. In other words, in an observed period of 110 years, the value of the average U.S. home had gone up just 10% more than the rate of inflation.

And then something totally unprecedented happened. The price of homes began rocketing into the stratosphere. The index soared past 125 in only two years and then passed 200 by 2007. In just seven years, home values roughly doubled. The rocket arrived at its apogee and swiftly headed back down on the same trajectory it took up.  The index is now at around 140.

The Trouble With The Bubble

We might argue about why the bubble happened and whether perhaps it could have been prevented, but there is no argument about the consequences—a deep recession and a lackluster recovery. (My personal view is that the culprits were lax a Federal Reserve monetary policy and excessive political pressure being brought to bear on Fannie Mae and Freddie Mac to underwrite marginal loans.)

Okay, there have been other bubbles. Tech stocks come immediately to mind: The Nasdaq Composite index jumped 170% between July 1998 and January 2000 and then lost three quarters of its value in the following two and a half years. The situation with residential real estate, however, is truly unique. In the first place, it is by far the most valuable and important thing that most families own. As an example, in 2006, United States households held real estate assets worth nearly $23 trillion while owning stocks and mutual fund assets worth only $14 trillion. Second, homes are purchased with a lot of debt. Home mortgages reached a total of $10 trillion in 2006, and they still total about the same today. That can be compared with less than $3 trillion for all other types of consumer credit.

The leverage being used to purchase real estate made sense to lenders because the risk profile of a home was, historically, very modest.  Although the value of a home went up over time, home prices were not especially volatile. Also, because a home was an asset you were living in, you were not likely to dump it, the way you might sell off a faltering tech stock. But then the complete collapse of housing prices, in two short years, rewrote history. Today’s reality is that 22% of homeowners with a mortgage owe more than the property is worth

 

The real problem is that “we are not as wealthy as we thought we were,” as Tyler Cowen, the George Mason University economist who authors the Marginal Revolution blog, so aptly put it. An imaginary wealth, built on the ephemeral value of our homes, allowed us to borrow and consume at a feverish pace, until abruptly, the party came to an abrupt.

All of these things would suggest that the most relevant question for the current U.S. economy is, When will the housing market recover? Nothing is more important.

Unfortunately, it is a question that can not be easily answered. The state of the economy both drives the housing market and is driven by it. If  businesses start to invest more, unemployment significantly decreases and consumers start buying again, then we can expect a rise in home sales and prices. Conversely, however, those economic activities also depend on rising home sales and increasing prices.

A little over a year ago, I wrote a column expressing my conviction that investors were generally being too gloomy about real estate—­and also about the stocks of a dozen or so national companies in the home building industry. Two of the stocks I picked have done very well. PulteGroup (symbol PHM), which at that time was trading at $7, now brings $17 (all current prices are as of the October 4 close). Ryland Group (RYL), then at $17, is now trading at $32. Still, the path to these hefty gains has not been a smooth one, and the sizeable increases have only occurred in recent months. At one point, Pulte was below $4 and Ryland fell below $10.

But these days, sales for both Pulte and Ryland are at last increasing, and the companies have actually begun to show a profit again. For the quarter ending August 31, revenues for another sizeable homebuilder, KB Home (KBH), rose 16% in comparison to the same period a year earlier. Also, the median selling price of one of its homes rose, at $234,100, a rate of 8%. KB did still lose money for the first nine months of its fiscal year, but its deficit was cut by almost two thirds..

news from the homebuilders is good, but it’s still not great. The issue for investors to consider is whether that news is good enough to justify the recent stock moves. Pulte, the largest of the homebuilders, has doubled in price between the first of June and the end of September. So what determines whether $17 is too low, too high, or just right? It’s a tricky call. As in the case of Ryland, KB and many other home builders,  Pulte has not shown an annual profit since the end of 2006—though it may eke out a narrow one this year. For the 12-month period ending June 30, the company’s revenues totaled $4.4 billion, even lower than they were a decade ago and less than a third the level of 2006.

So let’s predict that in three years, Pulte can return to its 2002 revenue level of $7.5 billion (showing an annualized growth rate of around 20%) and profits of $1.80 per share. Even during times when Pulte was in the black, the stock only rarely sported a double-digit price-earnings ratio. So it is hard to imagine how, at current share price, Pulte stock would be worth the risk—that is, of course, unless home sales rise through the roof in the next few years.

And that brings us to the bigger picture: What is happening in today’s residential real estate market?

Numbers Are Improving

New-housing starts have been slowed severely by the recession, and, as time has passed, the supply of new houses has shrunk. Just this August, the industry reached what the National Association of Home Builders called “an historic low” of a mere 141,000 units on the market.  At the current sales pace, that’s a supply of about four and a half months, down from nearly a year’s supply at the close of 2008 and seven months’ supply in 2010. In the meantime, median home prices went up in six of the seven months from February to August, for an average annual rate of 6%.

Home sales are heading in the right direction, but they still have a very long way to go to get anywhere close to normal levels. By close of 2018 the nation’s homebuilders expect to sell 373,000 new houses. That is far below the million-plus annual sales that were the norm as the bubble was still inflating in the middle of the last decade and, more importantly, it is only about half the level that prevailed during the late 1990s.

It’s true, homebuilders have seen benefits from tightened supply, resulting in pent-up demand, but I am not so optimistic that we are on the brink of a boom in new housing construction that will quickly get us back to normal. Therefore, I offer you these investing suggestions:

To begin with, buy home-improvement stocks instead of buying homebuilders. For example, a company such as Home Depot (HD), which sells to contractors as well as average consumers, will definitely benefit from a new housing construction boom, but it will also thrive as homeowners perform maintenance on residences they are unable to sell. Home Depot’s P/E of 18 (as based on estimated earnings for the year ending January 2014) is at its highest level in a dozen years. But what is especially notable is that the company has nearly doubled its profit margin between 2009 and this year with sales nearly flat. Over the coming few years, as the economy returns to more secure footing, sales are sure to rise and profits should show a brisk increase.

Home Depot’s smaller competitor, Lowe’s Companies (LOW), which trades at 15 times its estimated earnings and yields 2.1% is another company I like. Another attractive possibility is Lumber Liquidators (LL), but, at a P/E of 29, it’s a bit too expensive. Keep your eye on it.

In a piece last year, I advised readers to buy iShares Dow Jones U.S. Home Construction Index (ITB) because that exchange-traded fund had twice the concentration in the area of homebuilder stocks as its rival, SPDR S&P Homebuilders (XHB). Since that time, ITB has earned a return of 60%, while XHB has gained 45%. Today I lean toward XHB because it is loaded with companies that support the housing construction sector, such as Lennox International (LII), air conditioning and heating specialists; A.O. Smith (AOS), in water heaters; and Mohawk Industries (MHK), carpet manufacturers; as well as Home Depot and the like.

The SPDR ETF also holds some homebuilders, led by NVR (NVR). This amazing Reston, Va.–based builder has very little debt on its balance sheet and has managed to make profits during each year of the downturn. NVR is expensive (in terms of both its absolute price of $873 per share and its price-earnings ratio), but I still would consider adding it to my portfolio. Otherwise, at least for now, beware of homebuilders.

 

 

 

 

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