NVR - D.R. Horton: Profiting From Scarcity

2023-09-19 12:15:04 ET

Summary

• Existing home prices in the U.S. have risen sharply due to a shortage of inventory and a decade of low interest rates, prompting more buyers to bid on homes.
• Warren Buffett's Berkshire Hathaway recently invested in homebuilders, with a significant stake in D.R. Horton.
• The housing market is experiencing scarcity, with a shortage of new construction and a widening gap between supply and demand.
• The low premium of new construction over existing homes benefits homebuilders because potential buyers are more likely to buy a new home than an existing one.

Introduction

US home prices are rising again due to a shortage of inventory. The median sales price of a home rose 5% to $380K compared with a year earlier in the four weeks ending Aug. 27.

Current homeowners do not want to give up their mortgages with the low-interest rates, which creates scarcity in the housing supply, leaving more buyers bidding on available homes.

The fact that home prices are rising is quite unique because mortgage rates have risen strongly. Increased mortgage interest rates reduce borrowing capacity, causing house prices to rise less quickly. First-time buyers are putting off buying their first home until mortgage rates become more attractive again. However, there is good news: several FOMC members expect interest rates to fall in 2024.

Homebuilders have benefited greatly from the low interest rate environment, as prices of existing homes have risen strongly as a result. The premium of a newly built home compared to an existing home is now historically low. In addition, the supply of new homes also remains limited.

This piques the interest of Warren Buffett and his investment managers. Berkshire Hathaway recently invested in the following homebuilders:

It is not known whether Warren Buffett, Todd Combs, or Ted Weschler made the purchases. But one thing is clear: They appear to have the most confidence in D.R. Horton ( DHI ).

Scarcity In The Housing Market

Seeking Alpha's Quant rating puts the company high on its list. D.R. Horton is ranked 99 out of 4657 and given a Strong Buy rating . The company scores particularly well in almost all areas, but the valuation rating was given a B-rating. Lennar ( LEN ) and NVR ( NVR ) receive a hold rating and are at 923 and 1054, respectively. House builders are benefiting from the tightness in the housing market.

The cause of the shortage is the lack of new construction. The National Association of Realtors estimates that the housing shortage is currently between 5.5 and 6.8 million units. The gap between supply and demand is widening every year.

The following heat map shows how many new single-family housing permits are issued for each new job in 174 metropolitan areas.

The housing shortage in California is severe. But areas of New York and Pennsylvania are also considered a problem. Both D.R. Horton, Lennar, and NVR do business in these areas. But D.R. Horton and Lennar are much better geographically diversified than NVR.

Home Prices Are Currently Expensive, Which Is Good

Home prices are expensive compared to the consumer price index. This is good for homebuilders.

Shiller describes the Case-Shiller home price-to-CPI ratio (real house price) in his book Irrational Exuberance . In it, this award-winning economist describes the formation of asset bubbles worldwide. Whether we are currently in a housing bubble remains to be seen; often we do not know until after the bubble bursts.

The chart shows real house prices, which are historically expensive. Low mortgage rates over the past decade have contributed to this asset bubble. We may be approaching the end of the bubble now that mortgage rates have risen to as much as 7.18%. Judging by the chart, prices have already fallen slightly.

A consumer now pays only a fraction more for a new construction home. In July, the average sales price of an existing home was $406,700 versus $436,700 for a new construction home (a premium of only 7%). In 2014 , the premium was much higher at 36%, and historically the difference has been between 15% and 20%. The low premium benefits homebuilders because potential buyers are more likely to buy a new home than an existing one.

I think prices of existing homes will return to its average relative to the consumer price index. I believe the housing market has become overheated and will eventually cool down. The catalyst is the sharp rise in mortgage rates. Alternatively, inflation could rise sharply and real house prices will stabilize.

But in either case, the premium of new construction over existing homes will increase. With limited borrowing capacity due to the increased mortgage rates, consumers have to consider a smaller home.

The question remains whether D.R. Horton, Lennar and NVR are interesting investments. A favorable scenario is the ongoing small premium compared to existing homes. But I see some risk of falling home prices, and the catalyst is the sharp rise in mortgage rates. Yet I do not expect it to be significant because banks have tightened their lending standards since the 2007-2008 financial crisis. Also, the unemployment rate remains low and fire sales of homes are non-existent. I am optimistic about the future of these homebuilders since the scarcity of houses will remain.

Growth Drivers

The direction of house prices is always delayed by the rise or fall of interest rates. House prices do not decline instantly when interest rates rise; it may take several years.

The Federal Reserve is showing a favorable scenario about the interest rates. The dot plot chart shows that the federal funds rate is expected to fall next year.

In the long run, the Fed aims for a federal funds rate close to the inflation target. U.S. inflation has already fallen to 3.67% in August. Several FOMC members aim for an interest rate cut in 2024 that will make borrowing cheap again. This will also boost consumer purchasing power and increase borrowing capacity. House prices could therefore rise again from 2024/2025.

Enough Reason To Favor D.R. Horton

Warren Buffett and his investment managers invested heavily in D.R. Horton compared to the other two homebuilders. One reason could be that the geographic risk of D.R. Horton and Lennar is much lower than that of NVR.

D.R. Horton operates in many states in the US, the same goes for Lennar. NVR, on the other hand, operates in the following geographic regions , making it less diversified than the other two:

• Mid Atlantic: Maryland, Virginia, West Virginia, Delaware and Washington, D.C.
• North East: New Jersey and Eastern Pennsylvania.
• Mid East: New York, Ohio, Western Pennsylvania, Indiana and Illinois.
• South East: North Carolina, South Carolina, Tennessee, Florida and Georgia.

Also, D.R. Horton is growing faster in revenue and earnings per share than Lennar and NVR. What further makes D.R. Horton attractive is its low forward P/E ratio. In addition to its strong outlook and attractive valuation, 17 analysts have revised their earnings estimates upward. Plenty of reasons to prefer D.R. Horton over the other two homebuilders.

Still, we need not be pessimistic about the other two companies. They also offer advantages such as a large cash position and a high buyback return. When the company buybacks its shares, its dividends and earnings per share increase. This does not guarantee a rising stock price, but it is a tax-free way to reward shareholders.

Key Takeaway

Increased home prices have favored homebuilders such as D.R. Horton, Lennar and NVR. Despite the sharp rise in mortgage rates, home prices have remained somewhat stable. Several FOMC members expect the federal funds rate to fall next year, which could indicate lower prices. Would home prices get a soft landing after all? We can only know in retrospect. Housing prices are historically expensive relative to the consumer price index. However, the National Association Of Realtors expects scarcity in the housing market to continue. More homes need to be built in these areas and that's where D.R. Horton, Lennar and NVR are strategically located. D.R. Horton is the most diversified and is growing faster in sales and profits than the industry. It is also attractively valued and offers a good dividend and buyback yield. But remember that homebuilders are cyclical companies. We all know what happened in the 2007-2008 credit crisis and beyond. For now, don't panic, but keep a close eye on these stocks during your investment. Right now, they are worth buying.

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