Barron's Streetwise - The Housing Slowdown is Here

Episode Date: June 17, 2022

Where prices are headed, and what to make of builder and broker stocks. Learn more about your ad choices. Visit megaphone.fm/adchoices

This episode is sponsored by Northern Trust Wealth Management. There is more to being a successful entrepreneur than just good business practices. What is it about an entrepreneur's childhood that helped fuel their entrepreneurial spirit? What are entrepreneurs doing to cultivate this spirit in their own children and build a legacy beyond their business? Tune in each month to the Road to Why podcast by the Northern Trust Institute, where host Eric Chappella dives deeper with leading entrepreneurs on these topics and more. Find the road to why where you listen to your favorite podcasts. Applications for a mortgage to purchase a home, those are down about 15%. April home sales declined 12%. And new home sales, which are more volatile and a smaller share of the housing market

declined by almost 30%. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe. The voice you just heard is Jade Ramani. He's an analyst covering home builders and other real estate stocks for KBW. The housing market is cooling off and related share prices have tumbled. In a moment, we'll hear from Jade about what's next for house prices and where stock buyers can find bargains. And we'll hear from another analyst about publicly traded realtors and layoffs there, and what to make of the shares. Listening in is our audio producer, Jackson. Hi, Jackson.

Hi, Jack. Tell me about an economic indicator I haven't seen yet. Well, I was at the grocery store the other day, and I was looking in the frozen fish section, and I realized that the salmon burgers in my freezer were $3 less expensive than the salmon burgers in the store because they'd raised the price since like, you know, two months ago when I bought them. You're sitting on an embedded capital gain. Don't sell them because I think you'll have to report it. I'm not sure. I'm not sure about the rules for salmon selling.

It's like a 55% annualized return there. It's sweet, but there's no way to cash it unless you sell. And I'm not really sure on the taxation rules for the secondary salmon market. I recommend you eat the profits. Let me say a few words about the stock market. Inflation is the highest in 40 years. There was a hope that the rate had peaked and was starting to ever so slightly decline, but then we got fresh numbers in and they showed that inflation had actually quickened a bit. So the Federal Reserve, which had been expected to raise interest rates by a half point this past week, instead raised them by three quarters of a point.

The prospect of higher interest rates have been sending stocks lower all year. The month of June has so far been lousy for returns. Year to date through Thursday, the S&P 500 index was down 23%. If there's a bright side to this, it's that U.S. corporate earnings are holding up pretty well so far. Wall Street predicts that earnings underlying the S&P 500 index will increase by around 10% both this year and next year. If you believe that, then the index trades below 15 times next year's earnings, which is close to its historical average. In other words, stocks have already gone from being expensive to being fairly priced. Goldman Sachs, however, isn't quite buying it. It thinks that consensus earnings estimates are too high by a smidgen for this year and a larger amount for next year.

If you go by Goldman's lower forecast, the S&P 500 trades at a little over 15 times earnings or a touch more than its average valuation. So maybe stocks have further to fall. Just how much is difficult to say for two reasons. First, stocks spent a long time at above average prices. There's nothing to say they won't now drop to below average prices. And second, although earnings are said to drive stock prices, stock prices can sometimes drive earnings. If prices fall far enough and consumers become concerned about the hit to their net worth, they can become reluctant to spend. That could hurt company results or even trigger a recession.

If we get one of those, Goldman says we'll end up with earnings declining slightly over two years. And if you believe that's going to happen, then the S&P 500 still trades at more than 18 times next year's earnings forecast. Again, that's Goldman's recession scenario, not its baseline view. Price targets are not particularly helpful in this situation, but if you're interested, Goldman's baseline view has the S&P 500 rising about 17% from Thursday's level through the end of this year, and its recession scenario has the index falling 14%. I know which one I'd prefer, but I have no idea which one is more likely. Now let's turn our attention to real estate and

a bizarre combination of record gains for homeowners and outright carnage for housing shares. Our friends at the Wall Street Journal reported this past week that U.S. tappable home equity, or the value of homes that owners could borrow against if they wanted to, rose by $1.2 trillion in the first quarter to a record of more than $11 trillion. That makes sense. Prices have soared more than 20% over the past year. But two big real estate agents, Compass and Redfin, just announced sweeping layoffs. Redfin stock is now down about 90% from its high early last year.

We'll say more about that in a bit. Homebuilder stocks haven't been hit that badly, but they've been hit hard enough. And if you were unlucky enough to own a leveraged exchange-traded fund called Direction Daily Homebuilders and Supplies Bull 3X Shares, the ticker is NAIL. Well, then you got nailed. If you have any young capitalists listening who are sensitive to mentions of extreme market losses, maybe cover their ears for this part. That fund just lost 45% over five trading days. So what's going on?

Well, for one thing, house price data is reported with a lag. So those figures on home equity are as of March. We don't really know where things stand now. What we do know is that home sales volumes have been tumbling, which makes perfect sense because 30-year mortgage rates recently shot up to around 6%, more than double where they were at the start of last year. That combination of high house prices and costly financing has put purchases out of reach for many buyers, to the point where brokers are now downsizing. So what does that mean for house

prices from here, and are any of those beaten down stocks worth buying? To learn about that, I reached out to Jade Ramani, who covers home builders and other real estate stocks for KBW. I asked what he makes of the signals he's seeing. First quarter home sales declined 5%. April home sales declined 12%. That includes about 10% drop in existing home sales and new home sales, which are more volatile and a smaller share of the housing market declined by almost 30%. And over the past five weeks, mortgage purchase applications, so applications for a mortgage to purchase a home,

those are down about 15%. I asked Jay, does that mean that house prices are about to tumble? And he said, not exactly. He thinks price growth will slow sharply from here to a rate of 2% by the end of the year and zero next year. That's not adjusted for inflation. So if inflation is, let's say 3% next year, then houses could lose 3% in real terms if Jade's right. He calls this scenario a soft landing for housing. It involves house prices pausing while incomes catch up. And so when you continue to grow wages at 6%, which is what they're growing at, and there's currently a labor shortage, we expect continued wage growth and a moderation in home prices. That causes the mortgage payment income ratio to have a soft landing.

If house prices stall and incomes keep rising, we could get back to historical average levels of affordability. Although Jay says we might not go all the way back. But when you consider that people are spending more time in their homes now than pre-pandemic, and that there's going to be some percentage of the workforce that probably continues to work in a hybrid format, that means the value and use of residential real estate has increased. So we should be willing to spend slightly more of our income toward housing than historically. And I think we see evidence of that all around us in terms of home remodel spend, in terms of the number of people adding in addition to their homes.

That observation that people's houses now play a more important role in their lives is part of why Jade expects a soft landing for the industry. He also points out that inventory is tight. And although mortgage rates have shot up to around 6%, two-thirds of homeowners with mortgages are locked in at rates below 4%. They're likely to stay put rather than move, so they don't have to take on a new mortgage with a much higher rate. Which means inventories of homes for sale could remain tight.

Also, during that housing bubble more than 15 years ago, household balance sheets were stretched and mortgages got weird. There were loans with no down payments and ones with low teaser rates that jumped up after a short while, and banks played it loosey-goosey on proving that borrowers would be able to make their payments. The result was a wave of defaults and panic selling. Today, household balance sheets appear much stronger and mortgages look much more normal. So that explains why Jay doesn't expect a wave of selling and a sudden drop in prices. But what if things go worse than he expects? He's also modeled a hard landing scenario, and that involves the number of house transactions plunging by 40% through next year. To arrive at that figure, Jade looked at where the bottom was for home sales per capita during

past severe recessions. So under that scenario, instead of house prices staying flat next year, Jade estimates that they would fall by 5%. That seems benign compared with how far house prices have run up and how far stock prices have fallen. But Jade points out that if you have a new mortgage, a 5% drop in your house's price is enough to reduce your equity by 25%. He also says that if mortgage rates keep rising, we might need even more than a 5% price decline to restore affordability. Okay, so maybe house prices will flatten out from here and maybe they'll drop a bit. And of course, it can vary sharply by market. But what does this mean for shares of homebuilders? Jade says it's time to start buying them.

And so we currently estimate that homebuilders today are trading at about a median of 77% of book value. Projecting book value forward, they're at 60%. And historically, the trough during recessions is about 60%. They did go lower than that during the financial crisis. Homebuilders were much more levered than they are today. The home buyer was much more levered. Things were in a totally different state than they are today. You heard Jade mention book value. That's an accounting term for a company's net worth. Jackson, my accounting music, please.

In simplest terms, book value or net worth is equal to a company's assets minus its liabilities. We've all used price to earnings ratios to discuss how expensive stocks are. That's a comparison of the stock price to the amount of money per share a company makes. But with homebuilders, it's more common to compare prices to the value of stuff companies own. Here's Jade on why. It's best to look at book value in my view. Earnings are just a reflection of the current land portfolio. They take those land holdings, they put houses on them, they develop and sell those houses, they take that

cash, they have to buy new land. So most of the land they're sitting on today, they acquired before COVID, before this 30% run up in home prices that we've seen. It makes sense to assume that their redeployment into new land, it's not going to experience the same 30% run-up in home prices. So that's caused their margins to be about 50% above historical levels. That point is important. Homebuilders look incredibly cheap relative to earnings, but earnings also look unusually high. Anyhow, as Jade says, these companies are trading at 60% of his projections for their book values, which has historically been the low point during

recessions. So if a soft landing is coming, it's a good time to buy in his view. And if a hard landing is coming, well, share prices might fall further from here, but long-term investors might also make out just fine. Jade's favorites in the group are Lenar, ticker L-E-N, which plans to spin off some real estate tech investments and could end up with a higher valuation afterwards in Jade's view, and Toll Brothers, which skews toward affluent buyers, including many that pay in cash, so they're not put off by high mortgage rates. Thank you, Jade. So how about Redfin stock down 90% from its high? Is it time to buy?

That's next, after this quick break. Jackson's going to run down to the store and get a price check on those salmon burgers. This episode is sponsored by Northern Trust Wealth Management. There is more to being a successful entrepreneur than just good business practices. What is it about an entrepreneur's childhood that helped fuel their entrepreneurial spirit? What are entrepreneurs doing to cultivate this spirit in their own children and build a legacy beyond their business? Tune in each month to the Road to Why podcast by the Northern Trust Institute, where host Eric Chappella dives deeper with leading entrepreneurs on these topics and more. Find the Road to Why where you listen to your favorite podcasts. Welcome back. There was bad news for some real estate brokers this past week.

Yeah, Redfin announced this week that they're cutting 6% of their headcount. I think Compass also announced they're cutting 10%. That's Steven Sheldon. He covers real estate technology companies at William Blair. Redfin in particular and their CEO, Glenn Kelman, I think has done a great job over the last three to four years calling out the shifts that have happened in the industry, whether things are getting better or worse. And so the fact that they're out there saying that May demand was, I think, 17%, 18% below their expectations, they typically have very good visibility. And part of that visibility is the fact that they have the buyer search portal.

It's one of the three most traffic portals out there along with Zillow and with Realtor.com. So they get, I think, very good insight to what's happening on the buyer behavior. Stephen mentioned Realtor.com in passing. So I'll just note that it and my employer, Barron's, are owned by the same parent company. Now, Stephen also points out

that Redfin hires agents directly, unlike many brokers that use an independent contractor model. If a company like Redfin gets an early read on house demand, and if Redfin is laying agents off, that's not a great sign. But it's more or less what we would expect considering the factors we've been talking about, including sharply higher mortgage rates. talking about, including sharply higher mortgage rates. In a blog post, Redfin's CEO wrote, quote, we could be facing years, not months, of fewer home sales. But he also wrote that Redfin still plans to thrive. Here's another quote. If falling from $97 per share to $8 doesn't put a

company through heck, I don't know what does. Shares actually fell to closer to $7 after the announcement. Think about that for a moment. Redfin's stock market value peaked at close to $10 billion early last year, back when its revenues hadn't yet topped $1 billion. Now revenues are running at around $2 billion a year, and the stock market value is barely three quarters of a billion dollars. In other words, the valuation has fallen from a peak of nearly 10 times revenues to less than half of revenues. Redfin doesn't consistently generate

free cash, but it hadn't been burning much either, and it was expected to swing to positive and rising free cash flow starting in 2024. We'll see. The company's business model is straightforward. Sellers pay lower commissions than they do with traditional brokers. Buyers get plenty of online tools, including the opportunity to tour vacant homes on their own using remote-controlled smart locks. And agents get lots of online referrals. Speaking of agents, Stephen at William Blair points out that membership in the National Association of Realtors had shot up from about a million in 2012 to a record 1.6 million.

I think there are a lot of agents that entered the market that could struggle here in a softening environment where maybe they eventually leave, you know, as we think about the next couple of years. I asked Steve and what he thinks about house prices. He expects conditions to soften, but not collapse. Rents, he points out, have also shot up. So swearing off home ownership altogether isn't necessarily a bargain. Builders are expected to add many lower and mid-priced units, but Stevens says it'll be years until supply rises to meet demand. He covers three brokers, Redfin, Remax, and EXP World Holdings, and he has market perform ratings on all of them, meaning he's neither bullish nor

bearish at the moment. But he is struck by how far valuations have come down. I do think the valuations there have compressed far more than I would have expected. I mean, it's kind of like going back to February 2021. These names were all getting priced like the record levels of activity we were seeing in 2020 and 2021 was going to continue for three to five years. Now it's getting priced like the housing market is going to fall off a cliff and we're never going to see it recover or, you know, that's going to be a weakened demand environment for the next five years or something. So what are the signs then that would cause you? You're a market perform on all these. What are you watching for?

Do the valuations need to become more attractive or are you looking for some kind of signal that the cycle is turning? What are you keeping an eye out for? I think it's more of that. I think the market sentiment, I don't see anything in the next couple of quarters that maybe will change the market sentiment. There's just a bearish view out there, I think, for the housing names. And there's different things you could talk about for each one of those.

But I think the market sentiment is going to be a headwind, at least for the next few quarters. I think what I'm looking for is just more signs of stabilization. One reason that some real estate brokers had traded at such sky-high valuations is that the business seems archaic and ripe for disruption. There's been a lot of talk about that, but the process of buying a house still seems clunky. I'll give you one example. Title insurance. Jackson, I'm feeling pretty fast.

I think I can break the one minute rant barrier. You want to give me 60 seconds on the rant clock? You got it. Banks force borrowers to buy insurance that covers the possibility that somewhere down the road, someone will raise their hand and say, wait a second, I'm the true owner of that house, not the person who sold it to you, so the house is rightfully mine. Now, rules vary by state, but title insurance is generally wildly overpriced, with premiums that bear no resemblance to the actual level of claims, unlike, say, home and auto insurance, which are more competitive. Homebuyers already

pay someone to perform a title search. Why should they have to buy overpriced insurance to cover a mistake that A, isn't their fault, B, is most of the bank's problem, and C, rarely happens? That system needs to change, along with a lot of things about the home buying process. Time? 45. I'm going to need a towel and a cool down. So I suppose that means there's still plenty of room for industry insurgents to make things simpler and win market share. So I think the next leg is really focusing on the consumer

and the consumer experience and making sure that it's, that consumers have more visibility, especially first-time homebuyers. I mean, it's not, it's a pretty complicated and convoluted process. Thank you, Jade and Steven, and thank all of you for listening. Jackson Cantrell is our producer. He has an overweight rating on freezer fish. Subscribe to the podcast, rate it, write us a review, and follow me on Twitter. That's at Jack Howe, H-O-U-G-H.

See you next week. This episode is sponsored by Northern Trust Wealth Management. There is more to being a successful entrepreneur than just good business practices. What is it about an entrepreneur's childhood that helped fuel their entrepreneurial spirit? What are entrepreneurs doing to cultivate the spirit in their own children and build a legacy beyond their business? Tune in each month to the Road to Why podcast by the Northern Trust Institute, where host Eric Chappella dives deeper with leading entrepreneurs on these topics and more. Find the Road to Why where you listen to your favorite podcasts.