In the past 12 months, homebuilding stocks have jumped in anticipation of a rebound in housing prices. So far, the rebound hasn’t even occurred yet! Home prices have stayed roughly flat since 2009.
While I don’t think that I am any good at predicting future home prices, it seems to me that some homebuilders are overvalued. There are some homebuilders trading well above their book value despite being unprofitable.
The fortunes of a home builder depends primarily on three things:
- Land prices. When land prices go up, homebuilders make nice profits. When they do down, they can lose a lot of money. In theory, a homebuilder can gain an edge by predicting fluctuations in land prices. In practice, all of the publicly-traded homebuilders have failed at this. Virtually all of them had large losses when home prices declined across the US around 2005/2006/2007-2009. NVR is an exception as it had very little exposure to land prices. It used options to buy its land and it did not use much debt. However, NVR failed a long time ago as NVR is a company that emerged from bankruptcy.
- How good they are at homebuilding. Because homebuilding is an open-ended problem, there are various areas where a homebuilder can create value and unusual returns. This should be reflected in their operating margins.
- Debt. During the housing bust, debt killed off many homebuilders. In my opinion, you should avoid any homebuilder that takes on too much debt. Currently, some homebuilders are in trouble from debt incurred in the past. However, this debt may not be as dangerous as it first appears since share prices have rallied and homebuilders have been selling stock at high prices.
I don’t think I’m any good at predicting future home prices. But here is what I see:
Reasons for home prices to go up:
- The number of new homes being built is low on a historical basis.
- The supply from foreclosures (shadow inventory) is declining. The US is slowly working off the housing excesses from the past. Corelogic (CLGX) keeps track of the amount of shadow inventory out there.
- Mortgage rates are at record lows.
Reasons for home prices to stay flat:
- So far, the trend has been for the US government to reduce housing subsidies.
- Financing may be harder to get if mortgage standards improve. In the past, home buyers could purchase multiple homes without a job. Then the subprime mania died and the FHA effectively became the lender with the loosest restrictions. In theory, home buyers needed a 3.5% down payment for a home. However, home buyers could borrow against the home buyer’s tax credit and/or use other tricks to effectively avoid a down payment. (I wish I wasn’t making this stuff up.) Currently, home buyers do need a 3.5% down payment as the tax credit program is no longer available to most homeowners.
- Mortgage rates could go up.
I think that homebuilders are overpriced enough right now that there is some margin of safety against rising home prices.
Here are the major accounting issues to watch out for:
- Capitalization of interest. I believe that interest should not be capitalized. A house that was funded with debt does not sell for more money. 10-K filings disclose how much interest is capitalized so you can simply subtract it from book value. You also need to undo the effects of interest capitalization on operating income.
- Deferred tax assets. This is a tricky issue. Because many homebuilders have lost a huge amount of money, they have large net operating losses (NOLs). These NOLs can be used to save taxes in the future, if the company makes a profit. If the company doesn’t make profit, it can’t use these NOLs and they aren’t worth anything. Homebuilders have to record a valuation allowance on their NOLs if it is unlikely that they will be able to use them. But things can change. If they suddenly start making profits again, accounting rules require the companies to reverse the valuation allowances. This will cause the company to record large GAAP profits that have nothing to do with the operating business. This can cause P/E figures to be unreliable. Book value may need to be adjusted for the value of unused NOLs.
- Impairments on land. Land prices fluctuate a lot. However, there is often a delay between changes in market price and when those losses or gains are recognized. When housing prices crashed across the US, the brunt of those losses weren’t realized until a few years later. The accounting policies vary from company to company as some are quicker to record impairments than others. Because housing prices have stayed roughly flat over the past few years, these issues should not distort book value as much as it used to.
Mortgage origination – have investors learned from mistakes in the past?
Many homebuilders have started to get into the mortgage origination business. They give mortgages to buyers. Then the mortgage itself to ultimately sold to investors while the mortgage servicing rights (MSRs) are sold to mortgage servicing companies. I don’t understand this industry that well but it’s possible that some homebuilders may be sitting on some tail risks.
In the past, the subprime crisis revealed problems with the mortgage origination business model. The root of all the problems is bad lending. Mortgage originators were making silly loans that were unlikely to be repaid. A person with no job could lie about their income and buy not just one but several homes. The mortgage originators didn’t care because they would flip these loans to investors. The mortgages were packaged into complex instruments that are now commonly referred to as “toxic assets”. Yield-chasing investors bought these complicated AAA-rated securities and got burned.
Nowadays, investors are STILL buying mortgages. What’s effectively happening is lending by numbers. Mortgage loans are classified by FICO scores and other quantitative measures. Traditionally, banks were the primary mortgage lenders and a human being would sometimes make subjective observations about a borrower’s ability to pay the loan. The banks had an incentive to make good loans because they would get burned if the loans went bad. Now, the alignment of incentives isn’t there. The mortgage originators want to make as many loans as possible; they don’t particularly care about loan quality. Similarly, homebuilders also want to finance as many of their buyers as possible; this is a recipe for low loan quality.
The buyers of mortgages do have some legal safeguards against bad lending. If a mortgage goes bad (this may be several years later), they can have the seller buy it back if there is fraud or improper documentation involved. If the mortgage originator’s employees have been sloppy in their work, the mortgage originator can face liabilities from improper mortgages. Employees may have incentives to issue as many mortgages as possible, which can create a lot of sloppy lending. Overall, I have concerns about the mortgage origination industry. (I also have concerns about the ultimate buyers of these mortgages. Some of them may be retail investors who buy shares in high-yield REITs. They likely have no idea about what they’ve actually bought.)
On the other hand:
- I could be wrong. I don’t understand this industry very well.
- Originating loans could actually be a great business. All of the homebuilders’ mortgage origination units are profitable.
- I don’t think that we will see a repeat of the subprime crisis. Lending standards are far less atrocious.
You do not need these mortgage origination units to blow up to make money on a short position.
Many homebuilders also have a title insurance unit. Title insurance is a wonderful business. Home buyers grossly overpay for title insurance because they don’t know any better. Real estate agents rarely try to save their clients money on title insurance because they just want the deal to close (to be fair, their clients often want to close the deal quickly too).
The best and the worst homebuilders
Screening the American homebuilders by operating margin gives a rough idea as to which ones are operated the best and the worst. See the chart below (generated from finviz.com):
#1 through #5 on the chart above are GAAP unprofitable. As far as I can tell, their profitability is not understated / they really are losing money. None of them have taken unusually large one-time impairments that would cause their GAAP losses to be misleading (the bulk of the impairments occurred a few years ago). Because I like to short unprofitable companies rather than profitable ones, the unprofitable five are the ones I am most interested in.
The homebuilding sector has been pretty heavily shorted in the past few years. The short interest and borrow fees on some of these stocks (high single digits) used to be higher than they are today. I don’t like heavily shorted stocks since I don’t want to pay high borrow fees, get bought-in, or get short squeezed. Here are current borrow rates with Interactive Brokers:
- MDC Holdings -0.22%
- Beazer Homes -1.345%
- M-I Homes -0.5%
- PulteGroup -0.22%
- Comstock Homebuilding -4.72%
- Ryland Group -0.625%
- Toll Brothers -0.22%
- DR Horton -0.4858%
- Standard Pacific -0.47%
- Meritage Homes -0.22%
- AV Homes Inc -0.32%
- KB Home -0.22%
- Hovnanian Enterprises -1.6778%
- Lennar Corp -0.9904%
- NVR Inc -0.22%
The borrow rates for most stocks is reasonable but could easily jump higher. In my opinion, shorting common stock is a high-risk low-reward activity so I would keep common stock short positions very small. None of the five that look interesting have cheap options available.
In future posts, I will try to writeup some thoughts on particular companies. I have written about KBH in the past.
*Disclosure: Short CHCI (short common), KBH (short common+long puts). I may or may not short HOV and BZH in the future. I probably won’t short AVHI.