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Housing data for the July-August period indeed showed dismal growth. Two devastating hurricanes, Harvey and Irma, along with the ongoing higher labor and material costs have been hitting the homebuilding industry hard of late. Also, inventory shortages have started taking their toll on sales pacing.

Nevertheless, overall housing got off to a good start this year and the trend is expected to continue through next year, courtesy of healthy demand, strong economic growth, historically low mortgage rates, escalating rent costs and easy availability of loans. Again, there are signs of increased inclination of home purchases among millennials, a generation that had, to some extent, refrained some from entering the market.

For that matter, there are plenty of reasons to be optimistic about the broader housing sector for both the short and the long term.

Below we discuss some of the key factors driving the sector and what investors can expect going ahead.

Robust Economic Growth

Gross Domestic Product (GDP) surged in the second quarter, more than doubling the growth seen in the first quarter this year. GDP increased at a 3.1% annual rate in the April-June period, the Commerce Department said in its third and the final estimate on Sep 28. This is the quickest growth since the first quarter of 2015.

President Trump aims to double economic growth through an ambitious stimulus program featuring tax cuts, deregulation and higher infrastructure spending. Although this may face varied obstacles, we expect the plan to help the economy grow at a faster clip in 2017.

Along with strong economic growth, the labor market helped the industry to maintain its stature. Although the unemployment rate was weak in September in the aftermath of hurricanes Harvey and Irma, economists are expecting the numbers to rebound in the coming months and the economy to continue growing.

Average hourly wages rose 2.9% from a year ago. Improving economic growth supported by a better employment picture generally boosts housing activity and provides the basis for stronger demand.

Higher Demand, Low Inventory to Boost Price

Steady economic growth along with favorable demographics, historically low interest rates and the attractiveness of owning versus rent are driving demand. The July/August housing data may have been weak due to Hurricane Harvey or Irma and the sales pace is expected to remain subdued through 2017 in the Houston area, as well as in parts of Florida.

Nevertheless, re-building efforts and lost activity are expected to show up in 2018. As the hurricane-ravaged communities rebuild, activity could pick up, giving way to improving demand later this year and into the next.

Per the National Association of Realtors or NAR, total existing home sales, which include both single-family and condos, fell 1.7% sequentially to a seasonally adjusted rate of 5.35 million in August. That said, total existing home sales increased 0.2% year over year.

On the other hand, a shortage in buildable lots, skilled labor and available capital for smaller builders are limiting home production, thereby lowering the inventory of homes, both new and existing. The convergence of healthy demand and low inventory levels is boosting prices and is expected to continue doing so for some time.

At the end of August, there were 1.88 million existing homes available for sale, which was down 6.5% year over year, as per data released by the NAR. The reported figure has fallen for 27 consecutive months. The average supply during the month was 4.2 months, showing a decrease from 4.5 months a year ago.

Thanks to low inventory and high demand, median sales price of existing homes rose 5.6% in August from a year earlier. We believe prices will continue to scale despite recent decelerating sales growth as demand for homes is likely to grow on high consumer confidence and low unemployment. Improving labor markets, declining unemployment rates, low mortgage rates and limited home supplies are driving home prices, thereby boosting homebuilders’ top line.

Millennials Take Interest

Millennials -- those born after 1980 -- are anticipated to continue to make up a large and growing portion of the buyer section, although many disagree with this view. This is due to the fact that millennials occupy the largest adult generation and make up the greatest percentage of the workforce.

According to the 2017 National Association of Realtors Home Buyer and Seller Generational Trends study, millennials account for 34% of all buyers and make up for the largest share of home buyers.

Boosting Land Bank Amid Rising Costs

U.S. homebuilders have been seeking various ways to increase their land holding amid rising land acquisition costs and a tight labor market that hinder efforts to tap the recovery in the housing market. Again, limited capital for land development has left entitled lands in short supply while growing demand drives land prices. The labor market has also tightened with limited availability of labor, arresting the rapid growth in housing production.

Land development and homebuilding are correlated but fundamentally different operations. Prominent homebuilders are buying out major land developers that will help them to address the ongoing issues. In Oct 2017, D.R. Horton, Inc. (DHI - Free Report) acquired 75% share of Forestar Group Inc. (FOR), a residential and mixed-use real estate development company, for about $520 million in cash.

This buyout will give a meaningful percentage boost to D.R. Horton’s current holdings of 252,000 lots (owned and under control), as of June 2017. The company is on track to close 45,800 to 46,200 homes in fiscal 2017. The deal would add to D.R. Horton's fiscal 2018 earnings.

The Forestar integration is in sync with D.R. Horton’s long-term strategy of developing strong relationship with land developers across the country and growing the optioned portion of its land and lot position to enhance both operational efficiency and returns.

Another homebuilding company, Lennar Corp. (LEN - Free Report) , acquired Florida-based homebuilder WCI Communities Inc., a premier lifestyle community developer and luxury homebuilder of single and multi-family homes, in February 2017 to enhance its land holdings.

Low Mortgage Rates Make Homes Affordable

High mortgage rates dilute demand for new homes as mortgage loans become expensive. This lowers buyers’ purchasing power and hurts volumes, revenues and profits of homebuilders.

According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate ticked up to 3.85% for the week ending Oct 5, 2017 from 3.83% a week ago. Nonetheless, that was below the roughly 4% rate seen at the start of 2017. Although the upsurge in rates has stalled refinance activity for the time being, mortgage rates are likely to be lower in the coming weeks.

Even if mortgage/interest rates rise with the Fed probably announcing further federal fund rate hikes later this year and the next, the rates should remain reasonable, in our view, keeping housing affordable. Modest hikes in interest rates in the context of an improving economic environment can be a net positive for the housing sector.

How to Play the Industry

Major homebuilders, like Lennar, D.R. Horton, PulteGroup, Inc. (PHM - Free Report) , KB Home (KBH - Free Report) , Toll Brothers Inc. (TOL - Free Report) , to name a few, are well poised on the positive fundamentals of the housing market. Particularly, given the cheap valuation compared with the broader market, this is perhaps the right time to pick a few stocks from the Zacks Homebuilding Industry. We recommend those that are witnessing positive estimate revisions and carry a Zacks Rank #1 (Strong Buy) or 2 (Buy):

One such company is Persimmon Plc (PSMMY - Free Report) . The company sports a Zacks Rank #1 and advanced 62.1% year to date. The stock has seen a 16.8% upward revision in the Zacks Consensus Estimate for the current year, over the last 90 days.

KB Home, a Zacks Rank #2 stock, has gained 64% in the period. Its earnings estimate has improved by 2.4% and 2.9% for 2017 and 2018, respectively, in the last 30 days. The company has solid expected earnings growth of 54.9% for the current year and 21.9% for the next. Also, the stock surpassed earnings estimates by an average 12.67% over the trailing four quarters.

M.D.C. Holdings, Inc.’s (MDC - Free Report) shares have climbed 45% so far this year and carries a Zacks Rank #2. Although, the stock has seen the Zacks Consensus Estimate for the current year being marginally revised downward in the last 30 days, 2018 earnings estimate revisions have been trending upward (5.6% over the last 30 days). The company has solid expected earnings growth of 67.3% for 2018.

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

Conclusion

Though homebuilders admit to rising labor shortage and land/labor costs, they remain optimistic about a measured recovery this year in tandem with steady economic growth.

The housing industry is cyclical and is affected by consumer confidence levels, prevailing economic conditions and interest rates. Although rising interest and mortgage rates, land and labor shortages, and rising material prices raise concerns, the 2017 outlook for homebuilding seems to be solid given strong economic growth and labor market. Investors could also take advantage of the homebuilding-sector opportunities in the near term.

Check out our latest “Housing Industry Outlook” here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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