Investors were quick to begin selling shares in the homebuilding segment once interest rates began rising. Despite these companies’ record profits, and strong demand for homes nationwide, investors have sent homebuilders as a group — as measured by the S&P Homebuilders Select Industry Index (NYSEMKT: SPSIHO) down nearly 40% since the start of the year. That’s given the group some of the lowest P/E ratios in the S&P 500, with some homebuilders even trading near book value. Those low price-to-book numbers could offer investors an opportunity to snap up these companies on sale.
Why this housing market is different from 2008
The drop in the homebuilders is a response to mortgage rates reaching nearly 6%, which has many believing that the red-hot housing market is due to cool. And while that might be true, the selling has assumed things will get as bad as they did in the 2008 subprime mortgage crisis. However, this time things are different.
For example, the 2008 crisis was just that — a crisis caused by demand for mortgage derivative products that fueled lending to unqualified buyers. This time around, any softness in the housing market comes directly from the Federal Reserve’s plan to raise interest rates methodically and cool inflation. One side effect is the rise in mortgage rates, but unlike in 2008, demand for housing remains strong.
Look at the June data from Realtor.com:[https://www.realtor.com/research/june-2022-data/]
- Listing prices are still rising (up 16.9% year over year)
- Homes are still selling quickly (average 32 days on market, down four days year over year)
- Housing inventory levels remain near historic lows (active listings down 34.1% compared to June 2020)
This highlights the continuing pent-up demand from consumers and investors; a depressed supply amid homebuilders’ inability to keep up with that demand; and a group of existing homeowners who have significant equity in their homes, all of which has kept housing prices from crashing as they did in 2008.
Deep stock discounts in the homebuilding sector
The price-to-book ratio compares a company’s market cap against the net assets on its balance sheet. It’s long been accepted by value investors as one good metric for uncovering undervalued stocks that the market has mispriced. Typically, it works best when evaluating industries that invest large amounts of capital in fixed assets like homes or properties.
The chart below shows the price-to-book ratio of homebuilders Lennar Corporation (NYSE: LEN), and KB Home (NYSE: KBH) over the past 10 years. Clearly, P/B’s have fallen from recent highs and are approaching levels last seen at the end of the 2008 sub-prime mortgage crisis. But is the situation for the homebuilders as dire as it was in 2008? If it’s not, then investors could be staring at a good value proposition in the industry.
Right now, Lennar trades at 1.02 book value and KB Home at 0.77. In short, Lennar is selling at roughly the same value as its total net assets, while KB Home is actually selling for less than the entire net assets of the company. This could make the latter company a potentially good target for value investors looking for a bargain.
Even though P/B’s are depressed, these companies continue to post strong results. In its most recent quarter, KB Home’s total revenue increased 19%, and its diluted earnings per share grew by 55%. In addition, the average selling price of its homes rose 21%, and gross profit margins expanded to 25.3%.
KB Home is also projecting that its return on equity (RoE) will exceed 27% in 2022. Return on equity measures how much money a company is making from its assets — and how well the company’s managing investors’ money. The 27% figure means KB Home expects to generate more than $0.27 in equity for every dollar of assets held. To put that in perspective, the RoE at KB Home in the beginning of 2021 was just 12.7%. Financials at the other homebuilders show similar strength.
Investors seem to be pricing in a doomsday scenario for the housing market, but given the tight supplies and continued strong demand for housing in the U.S., this seems overblown. Homebuilder profits remain at record levels, and while industry experts expect some softening, they don’t foresee crash like in 2008. In the long term, the homebuilder stocks look attractive thanks to shifting dynamics in the housing market. Prices this low don’t come about often, and they represent an excellent risk/reward picture, given that any economic downturn is not likely to be as steep and prolonged as that seen in 2008.
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Fool contributor Steve Walters holds no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Lennar Corporation. The Motley Fool recommends KB Home. The Motley Fool has a disclosure policy.
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