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The U.S. homebuilding industry is in good shape, and still one of the pillars on which the economy rests. The 2017 outlook for homebuilding is quite compelling given historically low mortgage rates, impressive first-quarter 2017 existing home sale data and tight inventory. Consistent job growth, healthy demand-supply balance along with seemingly high homebuilders’ confidence are adding to the momentum.

Yet a tight labor market, limited land availability, higher material costs and a constrained mortgage environment are restricting the ability of homebuilders to respond to growing demand. Despite concerns over the chance of a series of interest rate hikes by the Federal Reserve, optimism surrounding the housing market remains unruffled.

Delving Deeper

As per the latest report from the National Association of Realtors (NAR), total existing home sales, which comprises both single-family and condominiums, rose 1.4% from the preceding quarter to a seasonally adjusted rate of 5.62 million in the first quarter of 2017, marking the highest increase in a decade. This was also 5% higher than the corresponding period last year.

Meanwhile, total existing-home sales decreased 2.3% to a seasonally adjusted annual rate of 5.57 million in April from a downwardly revised 5.70 million in March. Nonetheless, sales were 1.6% higher than the year-ago level, growing at the fourth-highest pace in the last one year.

Even though sales saw a slight decline in April, existing home sales are set for another great year, with prices likely to continue rising at 5% or more. The median existing-home price for all housing types in April was up 6% year over year. This marked the 62nd straight month of year-over-year gains. It is important to note here that existing home sales make up a large part of all U.S. homebuilding activity relative to new home sales.

At the end of the first quarter, there were 1.83 million existing homes available for sale, which was 6.6% lower year over year. The average supply during the first quarter was 3.7 months, down from 4.2 months in the first quarter of last year.

Separately, housing data from the Commerce Department has lately been mixed. New U.S. single-family home sales fell 11.4% in April from the prior month to a seasonally adjusted annual rate of 569,000 units after three straight months of strong gains. On a year-over-year basis, April sales were 0.5% higher.

Although new U.S. single-family home sales toppled from near a nine-and-a-half year high in April, housing recovery remains intact given a tightening labor market. With the unemployment rate at a striking 4.3% in May courtesy of growing employment opportunities for young Americans, demand for housing is building up. The market is also buoying up on historically low mortgage rates, with the 30-year fixed mortgage rate hovering just above 4.0%.

The median price of single-family homes grew nearly 7% to $232,100 year over year in the first quarter, marking the fastest price increase on record since 8.2% growth witnessed in the second quarter of 2015. National median home prices have accelerated in the last three quarters, according to NAR data. However, the median sale price of a new house decreased 3.8% year over year in April 2017 to $309,200.

Again, the inventory of new homes was up 1.5% to 268,000 units in Apr 2017, reflecting the maximum glut since Jul 2009. The stock of new houses is presently below half of the peak scaled during the housing boom. At this pace, it will take 5.7 months to clear the inventory, Also, it was higher than 4.9 months recorded in March.

Meanwhile, construction of new homes, precisely housing starts, dropped 2.6% in Apr 2017 to a seasonally adjusted annual rate of 1.17 million units, per the Commerce Department. This followed a 6.6% decrease in March. Then again, new home sales, which account for a fairly small share of U.S. home buying activity, are expected to pick up over the course of this year as builders step up construction of single-family homes.

That said, the number of building permits — which indicate future construction trends — were down 2.5% in the month of April from the preceding month but 5.7% higher year over year.

Although the drop in U.S. housing starts and permits made be a drag on the homebuilding industry in the coming months, other metrics hint at robust housing demand. Hence, part of the downside in starts and permits could be due to shortage of labor and ready-to-build lots, as well as unusually warm weather that may have accelerated construction activity earlier in 2017. Better finances and the second-highest homebuilder confidence level since the 2005 downturn are likely to propel home purchases in the coming months.

The National Housing Association of Home Builders or NAHB/Wells Fargo Housing Market Index or HMI scaled to 70 in May 2017. This reading mainly reflects builder perceptions of the current single-family home sales and sales expectations for the next six months. HMI rose 2 points month-over-month. Rising prices and tightening inventory are likely to have elevated builder confidence in May. Although U.S. homebuilders have to deal with higher building material costs and shortage of lots and labor, the reading testifies to builders’ untampered optimism in the housing market.

Homebuilding Industry Offers More Upside

Because of homebuilders’ asset-driven nature, it makes sense to value them based on price-to-book ratio. The valuation of the industry looks attractive at present. The industry currently has a trailing 12-month P/B ratio of 1.66. This is quite cheap when compared with the market at large, as the current P/B for the S&P 500 is at 3.62. Its lower-than-market positioning calls for upside in the quarters ahead.

In addition, the housing/homebuilding industry has returned much higher than the S&P 500 Index in the 12-month period. The industry grew almost 23% in the said period compared with the S&P 500 Index’s gain of 17.3%.

SPDR S&P Homebuilders ETF (XHB - Free Report) and iShares U.S. Home Construction ETF (ITB - Free Report) , the two largest exchange traded funds focusing on homebuilders and related fare, have rallied 15.5% and 22.7%, respectively, in the last one year.

Zacks Industry Rank - Positive

Within the Zacks Industry classification, homebuilding companies are broadly grouped in the Construction sector (one of the 16 Zacks sectors).

We rank 256 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Our back-testing shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1.

The Zacks Industry Rank for homebuilding is currently at #57 (top 22%).

Though the industry picked up pace, equity market volatility, labor shortage and land availability issues along with higher building material costs are marring its prospects. The odds of a hike in interest rate is an added dampener.

The ranking is available on the Zacks Industry Rank page.

Earnings Review & Outlook

The Q1 earnings season is over and investors should be content with the performance of the broader construction sector. The constructer sector saw quarterly earnings growth of 9% on 6.8% revenue growth. According to the latest Earnings Preview, 76.9% of the companies surpassed earnings estimates and 69.2% beat on revenues.

For 2017, total earnings for the sector are expected to increase 13.8% on the back of 7% revenue growth, which looks quite compelling.

Notable homebuilders reported stellar first-quarter results. Among them, KB Home (KBH - Free Report) , a Zacks Rank #2 (Buy) company, reported solid first-quarter results wherein earnings and revenues grew 7.1% and 20.7% year over year, respectively, on strong demand. The company started 2017 with a double-digit rise in deliveries and housing revenues. Strong orders in value (up 32%) and backlog (up 25%) bode well for KB Home in 2017. KB Homes raised its housing revenue guidance for the year.

Toll Brothers Inc. (TOL - Free Report) gave a stellar show in the recently reported second quarter of fiscal 2017, with both earnings and revenues surpassing analysts’ expectations. Adjusted earnings rose 43.1%, while revenues were up 21.4% year over year. Second-quarter net income grew 40%, deliveries increased 26% in units, and contracts rose 23% in dollars and 26% in units from the prior-year quarter, defining the best spring selling season for this Zacks Rank #3 (Hold) company in more than 10 years.

Another Texas-based homebuilder, D.R. Horton, Inc. (DHI - Free Report) remains committed toward achieving continued double-digit annual growth in both revenues and pre-tax profits while generating positive cash flow and improved returns. The Zacks Rank #3 company came up with yet another stellar show in the second quarter of fiscal 2017, with both earnings and revenues beating the Zacks Consensus Estimate given the solid housing market scenario. D.R. Horton lifted its fiscal 2017 projections given the positive momentum.

PulteGroup Inc. (PHM - Free Report) also reported solid first-quarter 2017 results, beating the Zacks Consensus Estimate by 7.9% and 10.7% on top and bottom lies, respectively. Its earnings grew 29.2% on 13.9% revenue growth year over year. PulteGroup, a Zacks Rank #3 stock, will continue to benefit from its value-creation strategy as it focuses on generating solid returns, with a balanced approach in its portfolio and capital allocation plans.

Bottom Line

Despite concerns regarding the health of the economy, homebuilders are becoming increasingly optimistic about their opportunities. However, labor shortage, a slight slowdown in sales, intensifying competition, and rising land and construction costs are concerns.

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