2023-03-10 19:04:18 ET
Summary
- Lennar is trading near its all-time-high price despite many growing headwinds in the housing market.
- Lennar's strong profits in 2022 were greatly driven by market momentum from 2020-2021, when construction costs were lower and prices were rising quickly.
- With pending sales at extreme lows and household financial stability declining, existing and new home inventories appear likely to rise this summer at the expense of prices.
- The company's huge inventory level suggests it is overextended going into a weakening macroeconomic environment.
- I believe LEN may be a solid short opportunity due to its high price despite weakening market conditions.
The rise in mortgage rates has led to a substantial decline in home affordability. Due to low inventory levels, home prices rose last year, excluding a few high-cost areas where people are moving from. Inventory levels are beginning to rise (seasonally adjusted), indicating home sales and price challenges may grow in 2023. Despite these challenges, many homebuilder stocks, such as Lennar ( LEN ), continue to trade near their all-time high valuation. With this in mind, homebuilders may be at increased risk of experiencing a significant correction this year; however, it is also possible that low inventory levels or rising rent costs may maintain the homebuilder bull market.
Lennar has had a tremendous record over recent years. The company's sales and profits have risen dramatically as low existing home inventory levels promote new builds. While building costs have risen, home prices nationally remain much higher than in 2019-2020. That said, the company is pushing its luck, with inventory levels rising at a staggering pace that suggests it is highly exposed to a home-demand reversal this year.
Overall, I believe LEN's valuation today is based primarily on backward-looking performance and does not accurately account for the rapid slowdown in the housing market. Home prices considerably lag financial market factors, potentially causing many investors and analysts to underweight its risk factors today. With this in mind, I believe LEN may be a decent short opportunity at its current price.
Homebuilder Macroeconomics Are Shifting
Homebuilders like Lennar are highly exposed to macroeconomic headwinds facing the property market. One key issue is that the real estate market has gone from "goldilocks" conditions in 2021 to very challenging situations today. In 2021, homebuilders benefited from ultra-low rates, a considerable stimulus-laden economic rebound, and rising home prices. Today, mortgage rates are the highest in decades, household financial and economic stability is waning, and home prices are stagnating amid a slight rise in inventories.
Since the property market usually lags behind economic conditions, Lennar's lofty EPS projections appear to be based on 2021 conditions that do not account for recent changes. Although some geographies appear more robust than others (with the Southeast strong and the West weaker), Lennar is well-diversified across geographies. As such, Lennar is highly exposed to national trends impacting the housing market and is unlikely to benefit from population movement patterns.
Mortgage rates appear unlikely to decline from today's high levels and have risen materially in recent weeks. Affordability remains extremely low, although urban home prices are beginning to fall. See below:
Changes in home prices are ultimately tied to inventory levels more than affordability. Abysmal affordability causes buyer demand to decline, but it takes a long time to translate to lower prices due to low inventory levels. In other words, many homebuyers will pay far too much if there are not enough homes on the market. Pending home sales remain extremely low today despite the surprise increase last month. One factor benefiting home sales may be the sharp increase in rental costs. That said, inventory levels are rising YoY, implying home prices may decline more quickly (nationally). See below:
US housing starts and building permit levels have declined dramatically over recent months due to the sharp decline in sales. Still, housing starts remain above pre-COVID levels, indicating builders are still expanding despite the strong signs of a property market contraction. Housing completed levels were well-below starts for most of the past two years but are now above starts - indicating significant new home inventory is likely to come to the market this summer. See below:
Over recent years, the property market has benefited from the strong inertia set by ultra-low interest rates and lower construction levels. However, I expect its momentum will fade faster over the coming months as low sales levels are met with a large increase in new home inventory. The continued elevation in mortgage rates and high home prices may likely exacerbate the issue. Of course, rising rent costs could somewhat offset this risk factor since it encourages home ownership.
That said, fewer Americans are likely able to buy homes today than they were in 2020-2021 and before. Due to rising living costs, real hourly wages have declined dramatically over the past two years. Similarly, consumer sentiment and personal savings levels have collapsed. See below:
Lennar faces two large hurdles in 2023 that could last for a few years. One, poor home affordability and immense new competition are likely to cause inventory levels to rise this year at the expense of home prices. Second, economic factors and inflation have led to deterioration in the financial stability of average US homebuyers, likely making them more price sensitive and less likely to find credit approval. Together, I believe these factors will greatly limit Lennar's profitability as it may sell its new builds at lower-than-expected prices, likely taking a longer-than-expected time to sell.
Rising Costs Escalate Lennar's Risks
Lennar has deployed immense capital since 2020 to take advantage of the previously strong market dynamic. The company's inventory level is extremely high today, while its profit margin is beginning to slip. Given the seemingly high likelihood of weakening conditions going into the 2023 home selling season, Lennar may be forced to cut prices dramatically to offload inventory. See below:
Lennar is entering the year with an inventory-per-share of ~$75, or around 80% of its market capitalization. This is a very high historical level for Lennar's overall inventory, indicating immense exposure to changes in home prices. The company's margins were well-above average again last quarter, likely due to the price momentum and low inventories. However, as inventory levels rise, Lennar may get stuck in a price-cutting cycle later this year.
Unfortunately, the labor and supplies shortage has dramatically caused construction costs to grow, implying greater margin exposure to price cuts. Construction commodity costs remain very high, but construction labor costs may finally slow amid the recent decline in construction job openings. See below:
Factors influencing construction costs are no longer rising at the pace they were, but they are still far higher than they were two years ago. We should keep in mind that Lennar's true profit margins today were likely well below its levels last year. Last year, Lennar was selling homes that were built during periods where construction costs were lower (2019-2021) at peak prices. Today, construction costs are likely 20-30% higher than they were in 2019, meaning Lennar's expected profit margin on its new builds is likely near its normal range since home prices are no longer rising. However, if home prices decline, as I suspect, then its margins could easily fall toward or below zero due to its immense inventory level.
The Bottom Line
Overall, I do not believe LEN stock should trade near its peak valuation amid a substantial shift in macroeconomic headwinds facing the company. Many investors may state that "the company had a strong 2022 despite headwinds, so macroeconomic challenges don't matter". While it is true that Lennar's 2022 performance was stellar, it was still benefiting from strong housing market momentum last year due to low inventory levels.
Additionally, many people decide to buy homes well in advance, so buyer demand may have been elevated due to momentum from 2020-2021. At the end of the day, today's national home prices are likely unsustainable in light of weakening household financial stability, an extreme decline in family formation over the past decade, and high prices & mortgage rates.
In light of the situation, I suspect the property market will take a larger turn this summer as new home inventories rise (due to completions), with sales remaining extremely low. Lennar is walking into this changing environment extremely extended, with inventories accounting for around 80% of its equity valuation. The company's profitability appears strong because it was selling properties at peak prices that were built during periods of lower construction costs. However, over the next year, the company will be selling homes, likely at flat or falling prices, built during a peak construction cost period. In my opinion, this situation makes it very likely the firm will face a substantial decline in profitability this year, with losses not unlikely.
A Short Opportunity
Lennar's downside is tough to assess because it is unclear how home prices will change over the coming year. That said, I fundamentally do not believe Lennar is any stronger today than it was prior to 2020. Indeed, I suspect the firm is in a weaker position due to its substantial inventory level and rising costs. With that in mind, I have a price target of $70 on the stock, equating to its tangible book value per share today. The stock may decline further than that if price conditions deteriorate at a faster pace.
In my view, LEN is a decent short opportunity today. Despite its high price, LEN has attracted few short-sellers, at only ~3% of outstanding shares. As such, the stock has a near-zero borrowing cost . LEN's option implied volatility level is below its median level, suggesting put options may be cheaper to bet against the stock with defined risk. Of course, if pending home sales continue to rise, then my view may not pan out as the market returns to stability. Other positive factors may include increasing rental costs, low inventories, a potential slide in construction costs, and a possible reversal in mortgage rates. Of those factors, the most likely seems to be rising rental costs, but issues in home affordability still seem to offset that factor.
For further details see:
Lennar: 'Perfect Storm' Amid Falling Home Prices And High Inventories