Yahoo Finance Will Rising Rates Hurt Builder Stocks?
Homebuilder stocks were among the biggest gainers in 2017, with many of the largest companies gaining more than 50 percent last year, but now the party is over.
Although the economy is strong -- which you'd think would fuel more home buying -- homebuilder stocks are being crushed this year. Toll Brothers (ticker: TOL) stock is down 23 percent year-to-date, Lennar Corp. ( LEN) is down 20 percent, KB Home ( KBH) is down 19 percent, D.R. Horton ( DHI) down 19 percent and PulteGroup ( PHM) is down 13 percent. That's compared to the overall S&P 500 index, which has been volatile but is nevertheless still up 2 percent since the beginning of the year.
What's going on? Although the job market is strong, home prices have risen far faster than wages since they bottomed out in the financial crisis, and that disconnect is expected to widen further, making it harder to afford a new home, especially for first-time homebuyers. Meanwhile, memories of the housing bust in 2007 still linger for existing homeowners, making many Americans more reluctant to upgrade to a bigger, more expensive abode.
[See: 7 Bond Funds to Buy as Rates Rise.]
A survey of 45 analysts shows home prices are expected to gain 5.7 percent in 2018, more than double the 2.8 percent increase in wages expected by a separate Reuters poll of economists. Home price increases are being driven by several factors, including an acute housing shortage, as well as rising prices for construction labor and materials.
Exacerbating the affordability crisis is the Federal Reserve's policy of raising interest rates, which translates into higher mortgage rates. Last week, a day after the Federal Reserve Board raised the federal funds rate by 25 basis points, the average rate on a 30-year fixed-rate mortgage climbed to 4.62 percent, according to Freddie Mac. A year ago, that rate stood at 3.91 percent.
Freddie Mac predicts that mortgage rate will rise to 4.9 percent by the end of the year, and 5.4 percent by the end of 2019.
While those rates remain low by historic standards, they nevertheless come as a shock to young first-time homebuyers who came of age in a low interest rate environment following the financial crisis.
"In our opinion, the red flag in the housing market would be the 30-year fixed mortgage rate crossing 5 percent, which would especially curtail demand for first-time and move-up new home categories," says CFRA analyst Kenneth Leon.
He maintains a "cautious view" on the housing sector this late in the economic cycle, and singles out KB Homes, Taylor Morrison and Toll Brothers as homebuilders that could underperform this year, particularly because of their presence in the West.
[Read: How Rising Interest Rates Affect Your Investments.]
For what it's worth, the CEOs at the largest homebuilders aren't expressing many worries.
Lennar CEO Stuart Miller, in his latest earnings call in April, described interest rates as "kind of a flashpoint for homebuilding, but it's never properly contextualized." Low unemployment will offset the impact of a higher rate, he says.
"Now that raises the question of what amount of acceleration at interest rate increases starts to get to a nosebleed section," he adds. "How far are wages going up and how much additional participation is there in the labor force, and I think we're just going to have to wait and see, but as things sit right now I think we're sitting in a very healthy environment."
Likewise, Pulte CEO Ryan Marshall, speaking in May, pointed to high consumer confidence, growing gross domestic product, wage increases and low unemployment as translating into a favorable environment for the company. As for rising mortgage rates, he said: "At 4.5 percent, that's incredibly cheap money. And we still think in most markets affordability remains very much in check."
There are two other things that could help homebuilders: the makeup of today's mortgages is different than in the past, and the housing supply remains constrained.
"The good news is that the impact of rising rates on consumer budgets will be smaller than past rate hike cycles," notes Freddie Mac. "That is because a much smaller segment of mortgage loans in today's market are pegged to short-term rate movements."
About 8 percent of mortgages are adjustable rate mortgages, or ARMs, compared to 31 percent during the Fed's last round of tightening between 2004 and 2006. At a J.P. Morgan conference in May, Pulte CFO Bob O'Shaughnessy also termed this as a potential opportunity for homebuilders.
"If rates continue to increase from here, the one thing consumers haven't had to do at this point that they could, is go to adjustable rate mortgages," he says. "So if affordability gets stretched based on monthly payment, there's an opportunity to see as people come in shorter on the yield curve."
As for the other bright point: a persistent housing shortage may mean more opportunity for builders, simply because buyers won't have anywhere else to turn for options.
[See: 7 ETFs to Buy as Interest Rates Rise.]
"In the past cycles, when interest rates went up, home sales declined measurably and the builders were very cautious about not building," says Lawrence Yun, chief economist with the National Association of Realtors. "This time around, we're in a different cycle. We're in a significant housing shortage to begin with, and therefore building activity will still increase this year, or next year, even with rising rates."
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