RKT - Best Housing Plays Very Different Stories By Sector
2023-06-12 12:56:32 ET
Summary
- Housing sector valuations and trends suggest holding Pulte, selling Rocket and Redfin, and buying MGIC and AGNC.
- Factors affecting the housing industry include a housing shortage, low affordability, excellent mortgage credit quality, low interest rates, and a wide spread between mortgage and 10-year Treasury interest rates.
- Investment opportunities depend on the specific sector within the housing industry and the impact of these trends on each company.
Sentiment towards housing shifted sharply this year. The aggressive Federal Reserve since last year created fear that housing was going to blow up due to affordability challenges. But home prices and home sales stabilized this year, eliciting this comment from S&P Corelogic Case-Shiller :
“March’s results suggest that the decline in home prices that began in June 2022 may have come to an end.”
Does this new view create an investment opportunity for you? That depends on which sector within the housing industry you are looking at. This article reviews five sectors and a representative company within each sector:
- Homebuilders – Pulte Homes ( PHM )
- Mortgage lenders – Rocket Companies ( RKT )
- Realtors – Redfin ( RDFN )
- Mortgage insurers – MGIC ( MTG )
- Mortgage investors – AGNC ( AGNC )
Current housing sector valuations – Hope over hard numbers
Check out the valuation data:
Sources – Company reports and Seeking Alpha
Based on the information below and these valuations, my investment recommendations are:
Pulte – Hold
Rocket – Sell
Redfin – Sell
MGIC – Buy
AGNC – Buy
The big picture housing stories
Yes, each of these companies has its individual story. But these five industry trends will largely determine their fate over the next few years:
- A housing shortage
- Historically very low housing affordability
- Excellent home mortgage credit quality
- Low interest rates on existing home mortgage debt
- A historically wide spread between mortgage and 10-year Treasury interest rates.
I’ll quickly review each trend, with a picture.
A. The housing shortage
The supply/demand balance for single-family housing is well summarized by its vacancy rate. This chart clearly shows that single-family housing is in record shortage:
Source: The Census Bureau
B. Housing affordability is historically very low
You are all likely familiar with the fact that single-family housing is about as unaffordable as it has ever been, due to the ‘20/’21 home price surge and the ’22 mortgage rate surge:
Yardeni Research, from National Association of Realtors data
Source: Yardeni Research, from National Association of Realtors data
C. Mortgage credit quality is excellent
Home mortgage lending standards have been remarkably conservative for nearly 15 years now:
Source: The Urban Institute
D. Interest rates on existing home mortgage debt are very low
Here is a recent quote:
“According to Goldman Sachs, 99% of borrowers have a mortgage rate lower than 6% (or the current market rate). Of those, 28% locked in rates at or below 3% and 72% locked in rates at or below 4%.” ( Yahoo Finance, March 13, 2023 )
E. The spread between mortgage and 10-year Treasury interest rates is historically very high
We can think of home mortgage interest rates as the sum of (1) the market rate of interest, denoted by the 10-year Treasury bond yield, and (2) a spread over the market rate. That spread is near its record level at present, as this chart shows:
Sources: FRED
The next step in this housing industry analysis is to link these trends to the housing sectors to which they are relevant, throwing in the valuation data as well. Here goes.
Homebuilders – Pulte
The good news – The housing shortage. The business of Pulte is to reduce the housing shortage by building new homes.
The bad news – Low housing affordability. This means that it will take many years to fix the housing shortage.
Net/net – New home sales will remain well below the ’20 peak, but sales appear to have stabilized and according to Fannie Mae should remain stable, as this chart shows:
Sources: Census Bureau and Fannie Mae
Valuation summary – Hold Pulte . Wall Street expects the company to earn about $9 per share this year and next year. Stable home sales suggests that EPS beyond ’24 will be in that $9 range, probably with an upward bias as Pulte continues buying back stock. A 10 P/E seems reasonable for this story, making Pulte modestly cheap.
Realtors – Redfin
The bad news – Low affordability. The fewer the households that can afford to buy a home, the fewer the home sales. Not a brilliant deduction on my part.
The bad news – Low mortgage rates. The fact that a majority of homeowners with low-rate mortgages have little incentive to move and sharply increase its housing costs.
Net/net – Existing home sales should remain well below their pre-COVID pace for an extended period, as this Fannie Mae forecast suggests:
Source: Fannie Mae
Valuation summary – Sell Redfin. Redfin ’s stock price reflects a whole bunch of hope. Let’s focus first on its $0.19 book value. Why so low? Because it has managed to lose $754 million of the $775 million investors have given it over its lifespan. Now EPS. Wall Street expects $0.68 per share of further losses this year and another $1.23 next year. In its struggle to survive, market share growth – its big selling point – has stopped. Market share today is the same as it was two years ago.
There is no reason in my mind to own this stock today.
Mortgage lenders – Rocket Companies
The bad news – Low mortgage rates. Rocket is in the business of originating mortgages for home sales and for refinancing existing mortgages. The large share of homeowners with mortgage rates well below the current rate is of course a killer for refinancing. For example, refinancing volume this year will be less than 10% of ‘20/’21 refi activity. And Rocket’s total origination volume for Q1 ’23 was only 17% of what it was two years earlier.
More bad news – Low affordability. It is very unlikely that a big rise in home sales will replace much of the lost refi business.
Net/net – Mortgage origination volume will remain very weak for the foreseeable future, as this chart of unit volume (the number of mortgages originated, not the dollar volume) shows:
Source: Fannie Mae
Valuation summary – Sell Rocket. Again, a lot of hope is factored into Rocket’s current valuation. Mortgage banking is far from a growth business, with many tough years ahead due to weak refinancing opportunities. Rocket has been trying to reposition itself as a fintech, but it is up against a multitude of fintechs, not to mention the many traditional competitors. I suggest buying only on a significant dip, to the $6-$7 range.
Mortgage insurers – MGIC
The good news – Excellent home mortgage credit quality. The loan underwriting discipline of the mortgage industries’ credit managers, particularly Fannie Mae and Freddie Mac and the mortgage insurers, has drastically reduced the potential for rising home foreclosures. Check out this history of MGIC’s claims payments due to foreclosures:
Source – MGIC financial reports
Claims payments as a percent of mortgage insurance in force are 2-basis points at present, only one-quarter of the previous low.
More good news – Low interest rates. About two-thirds of MGIC’s loans insured have well below market mortgage rates, meaning these highly profitable policies will stay around for a long time.
Even more good news – The housing shortage. It gives an upward bias to home prices, which further reduces home foreclosure risk.
Net/net – MGIC should continue to moderately grow earnings, especially because it is using its substantial excess capital to buy back lots of stock.
Valuation summary – Buy MGIC. Its 7.0 P/E ratio translates into a 14% earnings yield, most of which is free cash flow. A 14% return with growth? I love this stock and its peers Radian and National Mortgage.
Mortgage investor – AGNC
For those of you that don’t know it, AGNC is a REIT that invests in MBS on a leveraged basis.
The potential good news – The wide mortgage spread. As I reviewed in my recent Seeking Alpha article on AGNC , a wide mortgage spread both:
- Creates very profitable new MBS investment opportunities.
- Lowers book value and requires AGNC to reduce its earning assets.
The sweet spot for investors is when a period of wide spreads (high profit margins) shifts into a period of narrowing spreads (rising book value). This is illustrated in this chart, which compares AGNC’s historic stock price to mortgage spreads, inverted:
Sources - FRED and Yahoo Finance
Mortgage spreads widened sharply in the wake of the Great Financial Crisis. As the recovery developed beginning in 2009, the spread narrowed and AGNC’s stock price doubled.
Valuation summary – Buy AGNC, noting the risk. When investors are fully convinced that the Fed is done raising rates, more and more investors will look to lock in the current high bond yields. And MBSs generate high yields with no credit risk. In this scenario, not only would AGNC’s current 15% dividend yield look safe, but a dividend increase is possible. Note that if the Fed tightening still has a while to go, AGNC becomes a riskier investment.
For further details see:
Best Housing Plays, Very Different Stories By Sector