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Uncertainty Clouds Real Estate Development Industry Outlook

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The Zacks Real Estate – Development industry includes companies that are mainly engaged in owning, developing and managing a variety of real estate properties, including commercial, residential and mixed-use parcels. While some developers undertake construction on their land holdings to eventually sell the properties to homebuilders, retaining the same for conducting operations is also a common practice. Operations of these properties provide recurring revenue sources for companies.

Moreover, some industry participants actively undertake strategic activities such as infrastructure improvement along with land planning and development to promote economic development, attract quality job creators and diversify the regions in which the companies operate. These firms also provide real estate leasing, stewardship, underwriting, planning and entitlement services.

Before we delve into the details of the industry, it is worth noting that real estate development companies are primarily classified as financial companies, not construction companies.

Here are the three major themes in the industry:

  • Lending and Underwriting Activities to Stall: The economic repercussions from the current pandemic have rendered volatility to the commercial mortgage market. In fact, commercial mortgage spreads are significantly up, while commercial mortgage closings declined in second-quarter 2020. This is expected to have a ripple effect on development lending and underwriting. In fact, given the larger-perceived risks and uncertainties about construction schedules, lending activity is anticipated to be constrained in the near term. In fact, lenders are likely to be highly conservative in their underwriting and selective in property type selections. Lending in sectors such as hotel and retail, which have been hit hard by the pandemic, is likely to be difficult to secure. Hence, it may be challenging for the industry players to secure loans at favorable terms.
     
  • Declining Investment Volume: Uncertainty over economic recovery and investor’s cautious approach amid the pandemic has impacted developers’ ability to sell properties. In fact, investment volumes for commercial and residential real estate have fallen. Going by a CBRE Group (CBRE - Free Report) report, which cited Real Capital Analytics, second-quarter commercial real estate investment volume plunged 69.9% year over year to $40.2 billion. Moreover, Fannie Mae projects a year-over-year home sales decline of 6.9% in 2020, driven primarily by a 7.5% slowdown in existing home sales. With such a slump in deals, companies will have to hold land and properties in inventory for a longer-than-anticipated period. Such inventory carrying costs are likely to result in losses and can impact returns.
     
  • Opportunity Zone Incentives to be a Bright Spot: The Opportunity Zone program was created by passing the Tax Cuts and Jobs Act, aimed at incentivizing private investment in under-served and low-income areas across the United States, in exchange of a hefty tax break. In response to this, trillions of dollar investments are anticipated to be deployed in these zones over the next several years, as developers keep hunting for assets and investment opportunities with solid upside potential. Given the investor demand for real estate investments under the program, capital invested in this will likely emerge as an attractive financing source for real estate developers. Moreover, it might compel developers to shift their focus from high-income regions to the otherwise-blighted neighborhoods.


Zacks Industry Rank Indicates Gloomy Prospects

The Zacks Real Estate Development industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #170, which places it at the bottom 33% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of the bleak earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are gradually losing confidence in this group’s earnings growth potential. Since August 2019, the industry’s earnings estimates for the current year have been revised 54.7% downward.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.


Industry Lags Sector, S&P 500

The Zacks Real Estate – Development industry has lagged the broader Finance Sector as well as the S&P 500 composite over the past year.

The industry has lost 23.2% during this period compared with the broader Finance sector’s decline of 6.7%. During the same time frame, the S&P 500 Index has moved up 16.6%.

One-Year Price Performance

 


Industry’s Current Valuation

On the basis of the forward 12-month price-to-earnings (P/E) ratio, which is a commonly used multiple for valuing real estate development companies, we see that the industry is currently trading at 12.76X compared with the S&P 500’s 22.77X. The industry is trading below the Finance sector’s forward 12-month P/E of 16.67X.

Over the past five years, the industry has traded as high as 33.73X and as low as 9.37X, with a median of 19.13X. This is shown in the chart below.

Forward 12-Month Price-to-Earnings (P/E) Ratio

 

 

Bottom Line

We note that the real estate development industry is slower moving as compared with the stock market. Moreover, leasing fundamentals and demand for property do not vary wildly on a day-to-day basis. Hence, if the health crisis has a sustained and significant impact on the broader economy, its repercussions on the real estate development market will be far-reaching.

Nonetheless, the recovery and expansion of sales activity is influenced by numerous factors, including low mortgage interest rates that are currently at historical lows, higher participation in property ownership and the relative strength of the markets. Notably, residential and industrial deals are expected to be a bright spot in the near term.

Hence, it would be wise to bet on a few real estate development stocks that have stellar growth potential. We are presenting a stock sporting a Zacks Rank #1 (Strong Buy) and two stocks carrying a Zacks Rank of 2 (Buy) that investors may consider betting on.

You can see the complete list of today’s Zacks #1 Rank stocks here.

LGI Homes, Inc. (LGIH - Free Report) : The company is the 10th largest residential builder in the nation and closed more than 40,000 homes over 17 years of homebuilding operations. It currently flaunts a Zacks Rank of 1. The current-year consensus estimate for EPS has moved 22.4% north to $9.17 in a week. Further, it is likely to register earnings growth of 13.1% in the next year.

Price and Consensus: LGIH

 

 

Green Brick Partners, Inc. (GRBK - Free Report) : This publicly-traded company operates as a homebuilding and land-development provider. It currently carries a Zacks Rank of 2. The 2020 consensus estimate for its EPS has been revised 9.8% upward to $1.79 over the past week. The figure denotes 54.3% year-over-year growth for the ongoing year.

Price and Consensus: GRBK

 

 

Forestar Group Inc. (FOR - Free Report) : The company operates in two business segments — real estate and natural resources. The real estate segment owns real estate directly or through ventures. The natural resources segment manages acres of oil and gas mineral interests. It carries a Zacks Rank of 2 at present. The Zacks Consensus Estimate for fiscal 2020 EPS suggests a 23.5% year-over-year increase to $1.05. Further, it is expected to register earnings growth of 11.9% in fiscal 2021.

Price and Consensus: FOR

 

 

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