XHB: 3 Negatives And 2 Positives For Home Builders

Some air has started to come out of the home building stocks here in April, after a big move up off the market’s recent lows in late October 2023. The SPDR S&P Homebuilders ETF (NYSEARCA:XHB) is down some 10% for the month to date. Which way will the sector go from here? Let’s take a look at some of the major headwinds facing the industry, as well as a couple of positives.

Negatives:

Mortgage Rates:

Obviously, one of the most important challenges the home building sector faces is the highest mortgage rates the sector has seen since before the Great Financial Crisis. Average 30-year mortgage rates have recently surged above the seven percent level as the ‘higher for longer’ narrative around interest rates has settled upon the market in recent weeks. This is the highest level since November and more than double where mortgage rates were at when the Federal Reserve began its current monetary tightening program back in March 2022.

Higher mortgage rates were the primary factor behind existing home sales posting their lowest levels this century in 2023. They were down nearly 20% from the prior year and a third from the levels of 2021. Home prices have held up quite well, however, largely due to the lack of housing inventory. A good portion of this is the result of the locked-in effect with current homeowners who don’t want to part with their ultra-low current mortgage rate.

Housing Affordability:

High mortgage rates and the rising cost of an average home since the pandemic have both contributed to the historic highs in Housing Unaffordability. Nothing captures how fast housing affordability has deteriorated in recent years than this recent caption. Until mortgage rates and or average home prices fall significantly, housing affordability will remain a major headwind for the housing sector.

Incentives Rising:

Historically, high housing unaffordability is starting to result in increasing incentives given by home builders to move their inventories. These include mortgage buy downs, free or heavily discounted upgrades, assistance with closing costs, etc. This is obviously a negative for home builders’ margins. According to Zonda’s New Home Market Update in January, over 55% of housing communities were now offering significant incentives. A good breakdown of the types of incentives and regions of the country particularly impacted is presented here. Lennar (LEN) was one of many prominent home builders that mentioned increased use of incentives to move inventory on their Q4 earnings conference call.

Solid Balance Sheets:

Unlike at the end of some housing cycles, the balance sheets of the major home builders are for the most part in very solid shape. Let’s take a look at D.R. Horton (DHI), a large well-known home builder, to use as an example.

The company delivered just over $3 billion in free cash flow in FY2023. In addition, this home builder’s debt to capital ratio ended the year at just under 20% which is lower than in 2022 when mortgage rates started the year at just over three percent. PulteGroup, Inc. (PHM), another large home builder, had a debt to capital ratio of just 15.9% at year-end FY2023 as another example.

Lumber Prices Dropping:

Another positive for the sector is that lumber prices have been falling recently. Lumber prices have dropped to around $500 per thousand board feet, which is their lowest levels since November of 2023. This will help margins as a 2,000 square house typically uses 14,000 board feet of lumber to build.

Conclusion:

Home builders moved up more than 50% off their lows in late October before their recent pullback. The rally was primarily based on the belief that the Federal Reserve would start to cut rates significantly in 2024. At the beginning of the year, futures were factoring in 6-7 cuts of 25bps a piece starting in March.

That dynamic has drastically changed in recent months as inflation remains ‘sticky‘ and as the yield of the 10-Year Treasury has moved from under 3.9% in late February to just over 4.6%. Even with the recent pullback in the sector, home builder stocks trade far above their recent lows in October. Until yields start to fall significantly, my guess is the sector will continue to see profit-taking and I would avoid these names for now. If the XHB gives up half their recent gains from October (approximately the $90 level) and mortgage rates hold steady or drop a little, I will probably revisit this space, starting with home building names that see insider buying in their stocks.