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Housing market needs to 'get back into pace' amid interest rates

With the spring homebuying season around the corner, and mortgage rates rising after a two-week decline, investors may be wondering where a good entry point would be to add homebuilder stocks to their portfolios.

UBS US Homebuilders & Building Products Equity Research Analyst John Lovallo joins Yahoo Finance to discuss the housing market and what investors should keep an eye on when considering some of the top homebuilding stocks.

Lovallo affirms: "KB (KBH) and Lennar (LEN) are two homebuilders that we have buy ratings on and we have a favorable opinion on. For DR Horton (DHI) though... it's a couple things: One, it's the largest builder by volume, by call it 10 or 11 percent. There are a lot of advantages to the size and scale. They also attack what we believe is the hottest part of the market, which is that first-time entry-level buyer, where frankly you're looking at a need-based, event-driven, life-event driven — meaning children or marriage, things of that nature — type buyer... I think it checks a lot of boxes."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

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Editor's note: This article was written by Nicholas Jacobino

Video transcript

[MUSIC PLAYING]

JOSH LIPTON: Mortgage rates ticked up after two weeks of declines and today we're looking at how to navigate the big picture in homebuilders stocks. With the Yahoo Finance playbook, we're joined now by John Lovallo, UBS equity research analyst covering US homebuilders building products. John, it is good to see you. I'm looking at the XHB John. So the homebuilders ETF, it's up about 15% this year.

It's up about 70% over the past 12 months. That seems to be pricing in a lot of good news John.

JOHN LOVALLO: Well, thanks for having me, Josh, first of all. Yes and no, we've certainly had a nice run over the past year or so. But if you look at valuation across our group, we're still looking at a group that's trading at 9 and 1/2 times earnings just over 1 and 1/2 times book. You compare that to the S&P 500, which is trading closer to 21 times next year's earnings and close to four times book.

And I think you can make a real argument that these stocks are incredibly compelling at these levels. So yes, the stocks have run. But they're still not pricing in that much frankly.

JULIE HYMAN: And John, I think we all know this seems to be a lot of demand out there. But we have seen some gross margin compression for some of these companies because they keep offering incentives because of affordability issues because of still high mortgage rates, et cetera. Where are we in that gross margin cycle, if you will and are things getting better?

JOHN LOVALLO: That's a great question, Julie. It's interesting. I would tell you as a starting point, this industry has evolved tremendously over the past decade where this was a business that historically was call it 20% gross margin, 10% and as a percentage of sales, 10% operating margin. We're now looking at a business that's probably 23% ish gross margin. Maybe 8% or 9% SGA. Probably closer to 14% or 15% operating margins.

There's been a lot of structural changes that have occurred. Some of it forced through efficiencies driven by COVID. Some of it just from a more simplified building process, if you will. The gross margins to your point, have come down off of the COVID peaks. But are leveling off at levels that are a good two to 300 basis points above historical average. And frankly, I think we've reached a point where we've troughed if you will.

And according to our model, you'll see a little bit of degradation this year. But then we'll start to see a gradual improvement as we move into 2025 and 2026.

JOSH LIPTON: John, one question I had. And it just helped me think through this, is if the Fed is telling you three cuts are coming this year. They start cutting, John. Let's say existing homeowners. OK. Now they start getting more comfortable. They feel more comfortable selling. It's time to move to Boca. Supply ramps. What would that-- what would the impact of that be on your coverage universe John?

JOHN LOVALLO: Yeah. Josh, it's a highly debated question right now. Here's how we shake out on it. First of all, as a starting point, I would tell you that 80% of mortgages are below 5%, 60% are below 4%. On top of that the homebuilders would tell you that 5 to 5.5% is the sweet spot where they're buying down rates too. So what does that mean, it tells me that rates would have to fall pretty meaningfully from current levels of around 7% on the 30 year fixed before we would see significant supply come back to the market.

So that's as a starting point. But maybe more importantly, what I would tell you is that the largest part of the housing market, which is the existing home market historically has constituted 80% to 90% of sales is essentially frozen. We're looking at $4.3 million units was the print today on existing home sales. We were just over 4 million units for the full year last year. That should be closer to 5 million, maybe even 5.5 million units.

So we need that market to recover because at the end of-- on the other side of a transaction on an existing home sale, there's generally a home that's purchased, many times that's a new home. And we just need that churn to come back. So look, we would take lower rates all day long for housing, whether it's new homes existing policies. I think the market just needs to get back into a pace.

JULIE HYMAN: John, so clearly you seem relatively optimistic on the sector writ large. I understand your top two names are what KB and Lennar if I'm not mistaken, what stands out about those two?

JOHN LOVALLO: Our top pick Julie honestly is DR Horton. KB-- but but no, you're right. KB and Laura are two home builders that we have buy ratings on and we have favorable opinion on. For DR Horton though, the reason we are-- it is our top pick in the group a couple of things. One it's the largest builder by volume, by call it 10% or 11%. There are a lot of advantages to size and scale.

They also attack, what we believe is the hottest part of the market, which is that first time entry level buyer. Or frankly, you're looking at a need based event driven-- life event driven, meaning children or marriage things of that nature type buyer. And also what I would say is among the best executers within our group. So I think it checks a lot of boxes and that is our top pick.

JOSH LIPTON: John, thank you so much for joining the show today. It was great having you.

JOHN LOVALLO: I appreciate it guys. Take care.