A compelling case for a bet on neglected US real estate

2016 could be the first year since the recession when growth in single-family homes exceeds growth in apartments.

On paper, Toll Bros.' recent earnings report looked like good news. The nation's biggest luxury homebuilder matched Wall Street profit forecasts and boosted its backlog of orders 34 percent from a year ago.

So why is Toll Bros. stock down 15 percent this year?

"The stock market seems to be pricing in a steep decline in the economy and, along with it, our sector," said executive chairman Robert Toll in an earnings conference call. "We, on the other hand, are seeing signs that reflect strength and positive momentum in our business."

A construction worker builds a wall of a home at a Lennar development in Doral, Florida.
Mark Elias | Bloomberg | Getty Images
A construction worker builds a wall of a home at a Lennar development in Doral, Florida.

The whole home-building industry poses the same question for investors now reconsidering whether the economic outlook is as weak as the year's start suggested.

Of all the oddities of the market's 2016 downturn, one of the oddest is the decline in home-building stocks, like Toll Bros., and exchange-traded funds that make broad bets on the Tolls of the residential real estate world, such as the SPDR Homebuilders ETF (XHB) and iShares U.S. Home Construction ETF (ITB), the two largest funds tracking the industry. These two ETFs are down near-10 percent, three times the decline in the S&P 500.

On the face of it, it doesn't make much sense, and it could be an anomaly for aggressive investors to exploit. After all, the average price of a new home is up 2.9 percent in the last year, according to the Census Bureau. Most major builders beat forecasts for fourth-quarter earnings, and new single-family home sales rose 14 percent in 2015, with forecasts calling for a 20 percent gain this year, according to National Association of Home Builders economist Robert Dietz.

"That would make 2016 the first year (since the recession) where the growth in single-family exceeds the growth in apartments," Dietz said.

Investors are worried that the good news can't last, according to MKM Partners analyst Megan McGrath. And some of the short-term data has been troubling.

Wells Fargo's economics team noted this week that sales of new homes started the year on a weak note, existing home sales posted meager gains, housing starts tumbled in January, and homebuilder sentiment fell to a nine-month low on fears that slower global growth and increased financial market volatility will discourage homebuying.

Builders like CalAtlantic Group warned in recent earnings calls that orders weakened in January, raising fears about the crucial spring selling season, especially with the broader market looking shaky: Last fiscal year, the No. 1 builder, D.R. Horton, received 30 percent of its orders for the year between January and March. Industry-wide, an index published by the NAHB and Wells Fargo said builders saw foot traffic at new-home communities fall by five points in January, to a reading of 39 on an index of 100.

But there are reasons to remain optimistic. Wells Fargo noted that job growth has held up relatively well and incomes are rising solidly. U.S. employers added an average of 228,000 jobs per month in 2015, marking the second-strongest pace of growth in 16 years. The breadth of job gains has also improved, across both industries and the nation. Moreover, household finances are also in far better shape, with fairly low debt service ratios and personal income growing solidly.

"While the most recent housing numbers are a bit disappointing, the monthly data tend to be fairly volatile and do not reconcile well with housing demand, which still appears to be strong," the bank's economic team concluded.

Housing sales depend on job gains and consumer confidence, both of which have been strong in recent months, if not as strong as they were in the middle of 2015.

The economy's 4.9 percent unemployment rate is the best since February 2008, but the 151,000 new jobs created in January were well below the fourth-quarter average of 279,000 a month. On Wednesday, the most recent monthly ADP private payroll number totaled 214,000 for February, exceeding estimates. The more closely watched government nonfarm payroll report will be released Friday.

The University of Michigan's consumer confidence index is sitting at 92, well above 2013 levels but below a January 2015 peak of 98.1.

A strong job market could work against builders' efforts to widen profit margins on each home sold, adding to investors' concerns, Morgan Stanley analyst Ryan Gilbert said. In a Morgan Stanley survey, nearly three-fourths of builders reported being affected by labor shortages, with a third saying problems finding enough workers was affecting how quickly they could build homes and their gross margins, or the percentage of a home's price left over after construction costs.

Gross margins actually narrowed in 2015 as labor shortages emerged, and more than half of builders in a Morgan Stanley survey think they'll remain at about the same level in the first half of this year, Gilbert said.

But fundamentally, "good things are still happening in housing," McGrath said. "Most years, there is a hope trend (with stocks rising before spring season). This year investors are too nervous across the board.''

Biggest homebuilder and consumer ETFs

Quarter-to-date return (%)
1-month return (%)
1-year return (%)
Expense ratio (%)
XHB SPDR S&P Homebuilders -9.68 1.15 -14 0.35
ITB iShares US Home Construction -9.63 0.66 -11 0.46
FXD First Trust Consumer Discretionary -3.05 2.48 -9.6 0.7
RCD Guggenheim S&P Equal Weight Consumer Discretionary -1.96 3.12 -8.2 0.4
XLY Cons. Discretionary Select Sector SPDR -4.76 0.45 -0.58 0.16

(Source: XTF.com)

Another problem for some builders is weakness in the oil patch. Texas is one of the largest new-home markets, and cities like Houston are hit hard by the fall in oil prices. Demand in Dallas has held up, but Toll Bros. orders in the Houston market fell 26 percent, and CalAtlantic saw an 8 percent fourth-quarter decline in its Southwest region, which includes Texas. Only about 2 percent of the company's sales are in Houston.

Wells Fargo's economics team released a report this week saying some of the slowing in household growth may be due to the weakening energy patch. Even with this slowdown, the trend in home sales and residential construction is still improving, albeit at a more sluggish pace than was expected a few months ago.

"If you can put a house in Texas in pretty much any market and sell it to make a margin at [$250,000], you're going to sell houses," Horton CEO David Auld said on its earnings call in late January. "I think there's still pent-up demand in Houston; I think that pent- up demand is growing. But it is just not the frenzy that we've seen in the past or is really taking place in some of the other Texas markets."

Select REIT ETFs

Quarter-to-date return (%)
1-year return (%)
Expense ratio (%)
VNQ Vanguard REIT ETF -3.79 -4.27 0.12
IYR iShares US Real Estate -4.82 -6.06 0.46
ICF iShares Cohen& Steers REIT -4.9 -2.15 0.35
REZ iShares Residential Real Estate -4.74 2 0.48
FRI First Trust S&P REIT -3.8 -4.62 0.5

(Source: XTF.com)

Builders themselves are talking confidently.

Horton said on its conference call that it is boosting investment in lots and land by 20 percent this year, though it did not raise its sales guidance. Toll Bros. said it spent $150 million buying back its own shares in the quarter, at an average price 13 percent above where the stock is now.

"We believe the sell-off of homebuilder stocks, including Toll Brothers, over the past few months is not reflective of the fundamentals of our business,'' CFO Martin Connor said during its earnings call.

But expect two reoccurring challenges in the housing market: affordability and low inventories.

Wells Fargo noted that home prices have continued to rise at a faster-than-expected pace across the nation. In particular, cities that have seen meaningful employment gains, such as Portland, San Francisco and Denver, have also seen some of the greatest increases in home prices. Many of these city centers now face a significant affordability hurdle, as home prices are rising at a much faster pace than incomes. Price constraints have shut many potential buyers out of the market. Wells Fargo expects home-price appreciation to moderate in 2016.

What's built into a homebuilder ETF?

Don't let the name fool you. A homebuilder ETF can be, to a significant degree, a consumer stock bet more broadly than a bet on housing, specifically. Take the largest, the SPDR S&P Homebuilders (XHB). Its homebuilder exposure is one-third of the portfolio, and among its top 10 holdings, only two stocks are actually homebuilders: Pulte Group and Lennar. Its No. 1 holding is Whirlpool and other top holdings include both Lowe's and Home Depot, and Bed Bath & Beyond. While it also holds the two building construction big box retailers, the iShares Home Construction ETF (ITB) is closer to a pure-play, with roughly 63 percent exposure to homebuilders and seven of its top 10 holdings actually in the homebuilder niche. Building products is second among sectors, at 15 percent.

Housing affordability is likely to remain an issue in many markets, Wells Fargo wrote in its housing report this week. Available inventory of homes for sale is scarce relative to historical norms. The inventory of new homes for sale has been particularly strong, as the series reported its sixth consecutive gain in January. But most of that increase is homes under construction or not yet started. Completed inventory remains exceptionally low, reflecting sluggish demand for starter homes.

The real tests for the stocks and the ETFs will come over the next few weeks, McGrath said. Builders, like Hovnanian Enterprises, KB Home and Lennar, will report earnings in March, and their order flow and commentary about traffic will set the tone until the spring home-buying season comes into focus, the MKM analyst said.

"To get the builders moving, we need to see proof the spring selling season will be healthy,'' McGrath said.

If the news is good, the bounce over the rest of the year could be fairly substantial. Homebuilding stocks normally make their gains for the year between fall and early spring before flattening out or tailing off. If the skeptics are wrong and the recovery in new-home sales and profits continues, that bounce could come late this year.

By Tim Mullaney, special to CNBC.com