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According to data from the National Association of Home Builders, each home built creates an average of three jobs for a year and generates about $90,000 in tax revenue. The Department of Commerce says expenditure on home construction and home improvement has contributed to economic growth for six straight quarters.

But given rising prices and interest rates and lot and labor shortages, will the sector recovery’s momentum remain intact?                                                  

Current Scenario

Three crucial reports on the sector have just been released and each of them indicates that the housing market has improved significantly. The National Association of Home Builders (‘NAHB’) released data on the NAHB/Wells Fargo Housing Market Index which increased marginally to 47 in December, its highest level since April 2006. Even so, it remains below the key figure of 50 and only a rating above this mark means more builders view sales conditions as poor than good.

Next up was Housing Starts, which came in slightly lower than expected at 861,000, an effect ascribed to Hurricane Sandy. This is far higher than the recession low of 478,000 recorded in April 2009. However, it remains well below the annual rate of 1.5 million, the sign of a healthy market.

Lastly, Existing Home Sales which increased sharply, by 5.9%, to 5.04 million units in November, the highest level in three years. Meanwhile, prices have risen 5.6% from last year since the current supply of homes will last only 4.8 months, the lowest level in seven years. Distressed home sales have also fallen by 2%, further pushing up prices.    

Challenges

The picture looks quite rosy at this point, but there are roadblocks that the housing sector could face in the year ahead. The US Economic and Housing Market Outlook for December released by the Federal Home Loan Mortgage Corp (FMCC), or Freddie Mac, claims the market will pick up further in 2013.

Household formation is projected to increase by 1.2 to 1.25 million with housing start-ups only at 1 million by Q4 2013. As household formation exceeds construction, vacancy rates will fall below 2002-03 levels.

Further, long-term mortgage rates will also start rising by the second half of 2013, increasing property value. The major contention of the report is that consumers will take advantage of lower prices. But we are already seeing how rising prices are giving more power to sellers. But this could deter buyers, since lower prices were what were bringing them back in the first place.

Another factor which could affect home affordability is the increase in “guarantee fees” which are fees charged to lenders by Fannie Mae and Freddie Mac. These charges have risen sharply over the last month and have now touched a high of 46 basis points.

These fees are eventually borne by borrowers in the form of higher interest rates. Probably this is why the Freddie Mac report predicts rates to rise by the second half of 2013.

Meanwhile, there has been very little land development since the housing crisis. According to the NAHB’s Chief Economist David Crowe, developers faced with a strong increase in home sales are faced with lot shortages.  

Further, a recent survey by John Burn’s Real Estate Consulting, nine out of ten builders across the country reported a rise in lot prices. Two years ago, only one out of ten had reported an increase. In October, PulteGroup, Inc. (PHM - Analyst Report) said they had raised spending on land purchases from $90 million to $1 billion in 2012.

Shortages in labor could be and even bigger problem according the NAHB’s Chief Economist. A large number of workers had quit the industry during difficult times and joined other sector. Migrant labor had gone back to Mexico. Home constructions jobs have fallen by over 1.4 million since 2008.

An analyst at consulting firm MKM Partners said labor and lot shortages taken together could result in single family home building increasing only 23%, as against the 35% predicted by the NAHB.    

Choices

Thus, the recovery will continue but probably at the same pace as it has done this year. This is why it would be prudent to hold a portfolio with the stocks from both the housing industry and related sectors.

One such pick is MDC Holdings, Inc. (MDC - Snapshot Report). The company is ranked among the top homebuilders by all three rating agencies, with two investment grade ratings. It has a low exposure to land inventory but at the same time its proportion of finished lots is higher.

Further, it is one of only two builders with more cash than debt, which means it has the ability to support future land acquisitions. Moreover, the company has paid regular dividends since 1994. The company currently holds a short-term Zacks #1 Rank (Strong Buy).

PulteGroup is one of the largest homebuilders in the U.S., and its shift towards higher-priced homes for customers wanting to upgrade indicates that overall average selling prices will rise. Its liquidity position is better than its peers and as mentioned earlier it will invest $1 billion for 2012, which would probably stave off shortage issues.

Meanwhile, the company orders for the company have grown consistently by double digits for two consecutive quarters, despite the fact that orders have come from a declining number of communities. The company currently holds a short-term Zacks #2 Rank (Buy).

Coming to related sectors, The Home Depot (HD - Analyst Report) could be a good choice. The housing recovery is still underway which means people will continue to improve their homes and sales for Home Depot will increase. Areas affected by Hurricane Sandy could also push up demand, driving up sales further. The company currently holds a short-term Zacks #2 Rank (Buy).

As housing starts increase further, sales will increase for the paint segment which means Sherwin Williams (SHW - Analyst Report) stands to benefit. Besides, the company sells premium quality paint at higher prices compared to its competitors which includes the likes of Benjamin Moore, BASF and DuPont Fabros Technology, Inc. (DFT - Snapshot Report).

Further, according to an analyst at JPMorgan (JPM - Analyst Report), prices of Titanium Dioxide, a key ingredient of Sherwin William’s paint, fell by 5% in the third quarter. Prices of Titanium Dioxide will probably fall by the same amount in the fourth quarter. The company currently holds a short-term Zacks #2 Rank (Buy).

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