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For the rest of 2017 and 2018, the homebuilding outlook is quite compelling given historically low mortgage rates, solid economic growth and tight inventory. Consistent job growth as well as 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. Meanwhile, Hurricane Harvey hit Texas and Louisiana in late August, and Hurricane Irma lashed Florida in early September.

The two devastating storms have created uncertainty for builders. Despite hurricane-related effects and concerns over the chance of a series of interest rate hikes by the Federal Reserve, optimism surrounding the housing market remains unruffled.

Delving Deeper

Existing home sales declined to a one-year low in August, per the latest report from National Association of Realtors or NAHB. Existing-home sales slipped 1.7% last month to a seasonally adjusted annual rate of 5.35 million. This marks the fourth decline in five months, bringing the annual rate to the lowest level in 12 months. Purchases in Houston dropped 25% year over year, and sales would have been flat excluding the Harvey impact.

Economists are of the opinion that diminishing data reflects inventory shortage prevailing in the U.S. real estate market. This has pushed up average home prices nationwide. In fact, median sales price of existing homes rose 5.6% last month from a year earlier.

Moreover, total housing inventory declined 6.5% year over year to 1.88 million, marking the 27th consecutive year-over-year decline. That’s only 4.5 month’s supply. Investors should note that it is preferable to have about six months of supply for a healthy market.

August new-home sales ran at a seasonally adjusted annual pace of 560,000, per the latest report from the Commerce Department — the lowest annual rate since December 2016. This was 3.4% lower than a month ago and 1.2% lower than the August 2016 level. The median sales price of new homes sold in August was $300,200, 0.4% higher than a year ago.

Adding to the woes, housing starts came in at a seasonally adjusted annual rate of 1.18 million last month. This is 0.8% down from a revised July estimate of 1.19 million. Nevertheless, August construction starts were 1.4% higher year over year. Single-family starts were even stronger, growing 17.1% from a year earlier.

Meanwhile, building permits, another economic indicator used to determine the health of the housing sector, increased sharply by 5.7% from the previous month with 1.3 million authorizations. Last month’s permit total was also 8.3% above the August 2016 level of 1.2 million. According to the Census Bureau data, the areas in Texas and Florida that were devastated by the storms accounted for about 13% of permits issued in the country last year.

Investors should note that housing starts, permits and completions dropped 4.8%, 4.1% and 6.2%, respectively, in July. New U.S. single-family home sales also unexpectedly fell 9.4% in July, the lowest level since December 2016.

Reaffirming a Positive Outlook

It goes without saying that the latest July/August housing data has been dismal. Also, the supply situation in the housing sector will remain an issue in the coming months especially in the hurricane-affected areas where focus will be more on rebuilding rather than on constructing new homes.

Nonetheless, homebuilders remain optimistic given strong economic growth and labor market conditions, and expect post-disaster rebuilding efforts to drive demand for new homes next year. Again, demand in the homebuilding industry has been strong and is expected to continue so in the remainder of 2017 and in 2018.
Strong employment, income growth, growing interest from first-time homebuyers, relatively low mortgage interest rates and low inventory of new and existing homes are some of the factors that have been supporting sustained growth in housing demand.

As the economy plays an important role in the industry it is important to note that the U.S. economy grew faster than anticipated in the second quarter (fastest pace in more than two years) and shows a significant jump from the first quarter’s lackluster 1.2% growth. The economy grew at an annual rate of 3.1% in the April-June period, the Commerce Department said in its third estimate on Sep 28. Along with this, solid homebuilders’ confidence (64 in September) raises optimism about the entire construction sector.

This is clearly evident from the Zacks Homebuilding Industry’s year-to-date rally of 40.5% versus the 13.7% gain of the S&P 500.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 19.6% and 36.1%, respectively, year to date.

Let’s take a look at why it’s worth paying more premium for the stocks in the industry.

Homebuilding Industry Offers More Upside

Because of homebuilders’ asset-driven nature, it makes sense to value these 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 1.83. This is quite cheap when compared with the market at large, as the current P/B for the S&P 500 is 3.79. Its lower-than-market positioning calls for upside in the quarters ahead.

Zacks Industry Rank - Positive

Within the Zacks Industry classification, homebuilding companies are broadly grouped in the Construction sector (one of 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 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 #65 (top 25%).

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.

Sector Level Earnings Trend

The Q3 earnings season is gradually gaining steam and investors should be content with the expectation of the broader construction sector. Overall, earnings are on the growth track this quarter and construction seems to be one of the stand-out sectors. Of the construction companies in the S&P 500 cohort, 15.4% have already reported their Q3 results.

The sector saw quarterly earnings growth of 7% on 12.2% revenue growth as of Oct 6, 2017. According to the latest Earnings Preview, 100% of the companies surpassed earnings estimates and 50% beat on revenues.

For 2017, total earnings for the sector are expected to increase 14.6% on the back of 8.8% revenue growth, which looks quite compelling.

Notable homebuilders reported stellar third-quarter results. Among them, earnings and revenues of KB Home (KBH - Free Report) , a Zacks Rank #2 (Buy) company, grew 21.4% and 25.3% year over year, respectively, on strong demand. The company ended the quarter with a double-digit rise in deliveries and housing revenues.

The upside was primarily driven by an ongoing housing market recovery and favorable industry fundamentals. Strong orders in value (up 15.3%) and backlog (up 14.5%) bode well for KB Home in 2017. The company also expects the uptrend to continue to 2018.

Again, Lennar Corporation (LEN - Free Report) surpassed expectations on both counts for the seventh time in a row with its third-quarter fiscal 2017 results. The company’s earnings and revenues rose 5% and 15%, respectively, thanks to the solid demand for homes.

Among the other major homebuilders, PulteGroup, Inc. (PHM - Free Report) is due to report on Oct 24 and D.R. Horton, Inc. (DHI - Free Report) on Nov 9. Toll Brothers, Inc. (TOL - Free Report) is expected to release its financial numbers in December.

KB Home carries a Zacks Rank #2 (Buy), while Lennar, D.R. Horton, PulteGroup and Toll Brothers carry a Zacks Rank #3 (Hold) each.



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