Motley Fool Hidden Gems Investing - A Homebuyer's Dilemma Might Be A Homebuilder's Delight

Episode Date: September 2, 2023

Existing home sales are down around 20% year over year for two reasons: mortgage rates are too high and there aren't enough homes for sale. Matt Argersinger and Deidre Woollard discuss: - The current situation of home sales and what could change it. - Why homebuilders are in a good position right now. - If renting will become permanent for more Americans and which companies might benefit.  Host: Deidre Woollard Guest: Matt Argersinger Producer: Ricky Mulvey Engineer: Rick Engdahl Companies discussed: NVR, INVH, TOL, LEN, MAA, AVB Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. You don't want to let go of that mortgage. I mean, and you can't blame people for that. It's an amazing thing that's happened. And it's just perpetuated this massive supply-demand imbalance that we've been dealing with for, like you mentioned, over a decade or since the global financial crisis. But home builders are filling the vacuum. So while there's no activity happening on the existing home sale side, they are coming in and building new homes. And here's a situation where it is possible to sell a home. I'm Deidre Willard, and that's Matt Argersinger, Motley Fool analyst and my fellow housing nerd. There are two things we know about the current

housing market. Mortgage rates are high and inventory is low. That's bad news if you're looking to buy, but there are opportunities if you are an investor. Matt and I talked about whether or not we're going to become a nation of renters, how home builders are making hay while the sun shines, and where to invest in the future of housing. Every month, I look at the National Association of Realtors' existing home data, and I worry because it's a down year for sales. It's down 17% in July, but the number I watch is inventory, which they measure by month supply. So normal month supply, equal buyers and sellers, six-month supply. We haven't had a normal market, I think, since the great financial crisis. So

we're at 3.3 months based on the July numbers. What does this mean for the market though? Well, first of all, Deidre, thanks so much for having me. It's always a pleasure to get together with you and talk real estate. So I think the really low inventory means it's just highly unlikely we're going to get any kind of meaningful drop in home prices. And I think that's unfortunately what a lot of people, including a lot of would-be homebuyers, have been waiting for. But it's just hard to see that happening when there's such limited inventory. As you mentioned, we've been dealing with this situation for well over a decade now. What's remarkable too, to me, is that we're in a situation now where 30-year mortgage

rates are above 7%. You have to go back to the late 90s for mortgage rates to be at this level. If you had told someone five years ago that mortgage rates were going to rise more than four percentage points, we'd go through this pandemic, this downturn. Everyone, I think the world would have said, well, home prices are probably going to fall. But they haven't. They've held up. And it's because of this low inventory situation. And it's just become really, really hard if you're a first-time homebuyer. Bill McBride, I think who you know, he writes the Calculated Risk blog, hosts great data on the housing market. And he's written about the effect that this rise in rates has had on the cost of finance, the purchase of a

home. If you use July, July 2021, so going back a little over two years ago, the payment on a $500,000 house with a 20% down payment and a mortgage rate of around 3%, would have been about $1,700 a month, principal and interest. That same monthly payment for the same $500,000 house with house prices up 20% over the last two years and mortgage rates now at around 7%, it's a $3,200 monthly payment. That's an increase of 87%. Ouch! Yes. I mean, it's a double whammy if you're trying to finance a home. Think about what it's like right now to be a person in your late 20s or maybe early to mid 30s. You're looking to buy a home. You probably don't have a ton of

savings for a down payment. You might have a student loan that you have to start repaying pretty soon. Your rent is high. I know we'll talk about rents in a bit. You probably have a car payment. Now, just when you think home prices might finally be reversing, mortgage rates are through the roof. And there's still no inventory out there to buy Deidre. So, wow, tough going. Yeah. And there was talk about home prices are going to drop. And they did for maybe a month or so. A little bit in certain markets. A little bit, but nothing like what some people were hoping for. And the reason for that, and this is a stat that is stuck in my head lately, is 91% of people with a mortgage have a mortgage that's under 5%. So, nobody wants to move. Everyone I talk to with

the mortgage says they're not leaving. And it doesn't look like that's going to change. The mortgage rates aren't going to shift for what, maybe a year, maybe two. So, you know, that's not, we can sort of count that out. So then I'm thinking about who or what is going to pick up the slack. And, you know, I think a lot about home builders. They aren't quite building as much as we'd like to see, but the home builder stocks, it went from last year being not a great time to own homebuilder stocks to this year being a much better time. So what's happening here? Yes, the homebuilders are definitely filling a vacuum. But before we talk homebuilders, I just have to say that stat that you brought up, about 91% of people having a mortgage that's under

5%. I mean, it's such a paradox if you think about it, because we have a situation where the Fed has raised the Fed funds rate, what is it, a dozen times now over the past 16 months. the whole idea was to try to slow the economy a little bit, slow down the pace of home prices and rents. But it's had the effect of locking in people, as you mentioned, to their homes. So there's really no existing sales transactions or velocity in the market. And you can't blame people, right? If you're sitting on a 30-year mortgage or a fixed mortgage right now of, say, 3%, even if you wanted to move, even if you saw a house that you wanted out in the market that fits your life better. It might be bigger or in a different location. You don't want to let go of

that mortgage. I mean, and you can't blame people for that. It's an amazing thing that's happened. And it's just perpetuated this massive supply-demand imbalance that we've been dealing with for, like you mentioned, over a decade or since the global financial crisis. But home builders are filling the vacuum. So while there's no activity happening on the existing home sale side, they are coming in and building new homes. And here's a situation where it is possible to sell homes because there can be different kinds of financing via the home builders or they're able to discount certain parts of their inventory to meet demand. So they're doing gangbusters right now. If you look at their margins, for example, the home builders are putting up the best gross

margins, best net income margins they've ever done in their history. And for them, it's almost a perfect situation because they're really the only game in town. And so there's no activity on the existing home side. They can build houses, build a suit, and also build to rent, which I know we're going to talk about. So, there's just a lot of avenues for them right now to fill this big hole in the market that's not being filled by the existing home side. Yeah. So, usually home builders, new homes is about 10% of total homes for sale. It's now around 30% depending on the market, which is just this massive shift. We don't have that. Right. Yeah. Well, and I've been hearing from the home builders, listening to some of their earnings calls, cancellation rates are

going down. And the home builders are trying to be strategic here and trying to be a little cautious. But I was listening to the call for Toll Brothers recently, and they sort of play at the higher end of the new home market. And one of the things the CEO talked about was wealth transfer. So they're seeing first-time homebuyers getting down payments from their parents. And so I'm thinking about these baby boomers, the ones who have that massive amount of equity in their homes. I wonder if they're not going to transfer the homes to the children because the children don't want the homes. They don't want the older homes and they don't want homes in certain areas. Will they sell those homes eventually to fund the down payment for

the children? I'm wondering if we're going to see the wealth transfer turn into a location transfer. That is, you know, before you had mentioned this before the show, it's not something that I had thought a lot about or seen, but it makes a ton of sense. I mean, we should do a whole show at some point on the just the overall massive amounts of wealth transfer that's that's happening now between baby boomers and generation x since baby boomers and millennials or eventually generation x to millennials but there is just a massive amount of of equity and that's that's because who has the equity in this in this country of ours which and it is if you know it's the it's the older professional established population those people that have those lucky three percent

mortgage rates and who have lots of savings. By the way, this is a little bit of a tangent, but bear with me. Talk about wealth transfer. Think about what's happened with the Fed funds rate going up to 5.5%. Now, people are earning, they can invest in a 5% CD or get a 5% high-yield savings account, 5% money market account via their broker maybe. Who has that amount of money to take advantage of that. It's the people with savings, generally the older populations. That itself is a massive wealth transfer. The first time in over a decade that people actually are earning interest on their savings, and people who have these savings are doing really well. Again, all this wealth, you're right, all the wealth is held up here in the

boomer class, the older generations. I see a ton of opportunity for that equity to be transfer down, not just from parents to children, but in a lot of cases, grandparents to children or grandchildren. And the equity is there, so why not do that and enable your son and daughter to actually invest in a home when they otherwise probably couldn't? So, if you're trying to decide between the various home builders, I know you and I are both fans of NVR, and you mentioned margins earlier. What else are you looking at, and are there any other home builders on your radar? Yeah, just one more thing on margins, I would say. That's one way I like to look

at homebuilders, is what kind of gross margins are they getting. That kind of clues you in as to how well they're managing their inventories over time. Then you can look at their net margins as well. Make sure those are consistent over time. Companies like NVR or Toll Brothers have done a fantastic job. The cautionary tale there, though, is that their margins have never been better right now. There is a time when those margins are going to come down, but what you you want to look at is how stable can they be, how far would they fall, and you want to make sure those are staying high if you're investing in homebuilders. I'd also just look at the total return track record for a lot of these companies. Homebuilding is very much a capital allocation

business. In other words, deciding what land to buy or what land to option, when to build homes, when to then take cash flows and either buy more land or return value to shareholders, whether that's buybacks or dividends. Of course, you and I know NVR has done an incredible job of that. The track record for the shareholders has been just astounding. Toll Brothers is also another one. KB Homes, I think, has a pretty good track record. And so, stick to the ones that have delivered value to shareholders over time, and you'll probably do well. Yeah, I think that the thing with margins is that I also think about is, you and I have talked before about the three L's, the land, lumber, and labor. And the lumber part has been pretty good for a while, but I don't

expect that that's going to last. I think that's a factor as well. Yeah. Commodity costs can jump around, but you're right. But the labor one has been the sticky one, right? And it's not just the cost of labor, but it's the availability of labor that has really been, you know, it hasn't affected the homebuilders so much in terms of their business, you know, right now, but boy, is it a bane in other parts of the economy. Well, let's switch to the other side of thinking about mortgages. And for people who, not everybody can buy a home, not everybody wants to own a home. It's sort of interesting because the homeownership rate has stayed pretty steady. It's been between 60% and 65% for decades.

But I'm wondering, is renting going to shift? Is renting going to become more attractive over time? I'd love to know what you think about this as well. I think it almost has to. First, for some of the reasons we've already talked about, which is home buying right now is so cost prohibitive, especially if you're in that late 20s, early to mid 30s. Generally, the first time people tend to buy a home at those ages, it's so hard to do at the moment with the low inventory, high mortgage rates. But I also think there's just other things going on. Especially since the pandemic, I think people are more mobile than ever. Remote work flexibility is enabling that to a certain extent. I know we've seen companies try to claw that back a little bit,

but I think the die has been cast in a lot of ways with a lot of corporations and businesses where, at the very least, employees have more flexibility today than they've ever had, especially white-collar employees. I also get the sense that with younger generations, there's less of a need to put down roots in the town they grew up in or the city that they've lived in the past. I just think people are chasing opportunities and more willing to go different places, not having so much stuff, maybe, that's another topic, which is, I think people just desire less things, which also keeps them more mobile. For those reasons, I think renting, I feel like that proportion has to change. I feel like we might get to a situation,

We won't go as far as Europe, where I know countries like Germany, you look at the home owning population is like 20% and the renting population is 80%. It's a total flip of what we have in the United States. But I do think the trend towards renting will go higher. What do you think? You know, it's sort of a maybe for me. I think we're absolutely already seeing it more on the coastal markets. But I think in the middle of the country, you still see more people that are buying

at what would be the sort of more traditional age. So, you know, I think we're going to see really two trends kind of shaking out. But the other part of this that you and I have been following, too, is the single family rentals, because if you're in a single family rental, you tend to stay in that rental so much longer than an apartment. So for some people, it's just, you know, they get into that house and they just stay. And I think that they don't necessarily think about the monetary aspect as long as their rent remains relatively stable.

Yes. I think that the single-family rental, it's almost a perfect environment for single-family rentals because you mentioned the low turnover rate. That's a big part of it because if you think about once a family moves into a house, say it's two parents and two kids, you're renting, but it's harder to move, especially if kids are going to school and And you have, you know, it's a larger space, you have your furniture, for all those reasons. But I also think it's because of this lock-in effect that we've talked about, that's keeping so much of the existing home inventory out, away from would-be homebuyers, that's creating this environment where people want a larger space.

Again, especially since COVID, right? people want the yard, they want the separate home office, they want the no shared walls or shared ceilings. That makes single-family homes much more appealing than, say, your average apartment, condo, or townhome. At the same time, they want the flexibility of an annual lease, they don't want to worry about maintenance, they want a far more affordable monthly payment. I just feel like it's just this perfect backdrop for the single-family rental industry. Here's a stat that always jumps out to me. If you look at data from John Burns, the housing research firm, it's cheaper to rent one of

Invitations Homes. Invitations Homes is one of the larger single-family rental SFR REITs out there. They own and operate over 80,000 homes. It's cheaper to rent one of Invitation's homes than buy a home in all 16 of the company's markets that they operate in by an average of $900 or 30% per month. So, the average renter of an Invitation home single-family rental is paying $900 less than they otherwise would buying a home in those markets. And so, that is a huge value proposition. I mean, that is, you know, it's over $10,000 a year in savings by renting instead of buying. And, you know, you don't have to deal with the same responsibilities you have as a homeowner, the taxes and maintenance and all those other things.

Yeah. Yeah. I think, yeah, the ease of living is definitely higher. Now, you mentioned invitation. There's a Tricon residential. There's American Homes for Rent. those are all in the single family side. And you've got multifamily at like Mid-America Apartments, MAA, and Avalon Bay. Are you thinking about multifamily different from single family in terms of the investment potential? Right now, I am. I think the tailwinds are much more favorable for the SFR versus the traditional multifamily. But that doesn't say multifamily is experiencing weakness. They're not. I mean, it's just that I think the near-term picture is a bit cloudier. There's a lot of supply coming into the market on the multifamily side.

There was recent data from the St. Louis Fed, the Fred database, which really has some great data on the housing market. New apartment units that are currently under construction are at the highest level they've been going back to the early 70s. Gosh, 50 years, more than 50 years. There's just a ton of supply of new apartments coming in online over the next 6 18 months, especially in a lot of those hot markets. Think your Sunbelt, your Texas, your Florida, maybe Arizona. I think that's going to put pressure on rents. You're already seeing that even in America and Avalon Bay, the two you mentioned, they're still generating rent growth on new and renewal leases, but it's in the low single digits coming way off the double-digit

growth that they were seeing in 2021 and 2022. It's flattening out. It's not a dire situation at all. And in fact, I think MAA in particular looks really compelling from an investment standpoint right now. But I do think as in the near term, you might do better with the SFR side, looking at invitation homes or American Homes for Rent. I just think the momentum there is so much stronger. The rent that those companies are putting up are still in the high single digit in terms of growth. What do you think about location? You and I have been following the Sunbelt trend for like, you know, like four or five years now. There is that little bit of overbuilding in Austin and in Dallas, certainly on the multifamily side, certainly on the office

side, but that's another story. Is the Sunbelt thesis, is it still strong? Is it maybe shifting a little bit? I think shifting might be right, the right verb to use. I mean, it was so strong And it was always bound to face a slowdown. And now it's a situation where there has been some amount of overbuilding. Like I mentioned, all the new supply that's coming available now. And so I do think you're going to see rents probably flatten out, even decline a little bit. You might see landlords have to put larger discounts or offer months of free rent. But gosh, in the long run, it's still the place you want to be.

It's still where the population is trending, where the demographics are the strongest, where corporations are tending to move people and to set up shop. And so, I think it's still the place you want to invest. But I would say, sort of the traditional markets that we kind of poo-pooed over the last five years as well, you know, your New York's, your San Francisco's, Chicago's, Washington, D.C. There wasn't just a ton of overbuilding and rents didn't really go crazy. And yet now you're seeing New York City is having a nice bounce back. I know San Francisco still has some challenges.

Boston is seeing a lot of strength, Philadelphia. And so it never got too hot and it's never got too cold in a lot of those markets. And so those are areas, too, where I think multifamily is going to hold up pretty well. It's just not going to be as volatile as it is in Sunbelt. But I think, you know, yeah, long run, some part of the country is where you want to be. Well, we're talking about the single family rentals, but I want to talk a little bit, you mentioned earlier, build to rent, because that's the idea of building, you know, at times whole communities of single family and townhome for rent rather than sale. It's this, it's sort

of hard to figure out because it's this kind of like emerging class within housing. And, you know, it sort of started during the pandemic when the home builders couldn't sell and then they were sort of, they sold whole communities off. Now it's becoming more purpose-built and you mentioned zoning earlier. I'm seeing already some moratoriums on build to rent. Some, you know, towns are starting to notice this because it's sort of, for a town, it's sort of one thing to have a community come in and, you know, there's the concerns about that. But when it's a rental community, it seems like there's an additional concern, which I feel like is a, I feel like it's a stigma against renters, which I don't like. But how can investors think about built-to-rent? I haven't seen a pure

play. I know some of the home builders are doing it. What do you think about built-to-rent as it starts to grow? Right. Again, we've talked about so many trends that feel so undeniable on this show. And I think built-to-rent is another one where it was always done on a very small scale. But here we are, it's sort of at a point now where, like you mentioned, there's these whole communities now that are being built that are purely designed for rent, the rental market. And it's creating some obvious concerns from communities where maybe there's a proponents of homeowners and all of a sudden now you're introducing another subset of the population that is there for different, maybe there for different economic reasons. But I think it's an undeniable trend, and I think there aren't any pure ways to play it. But one way is the SFRs, the Invitation Homes of the World, because they are sort of, in a way, the customer for a lot of this, the built-to-rent. And so, they're making big moves. Invitation

Homes just recently, in July, bought a huge 1,900-home portfolio. I think a lot of it came from one of their built-to-rent partners. You're seeing that happen. That's just a way for them to really goose their inventory in one big slug. I want to say that Blackstone and Starwood are still involved in this quite a bit. Even a smaller company like Boston Omaha, which I think a lot of listeners might be familiar with, they've got their own built-to-rent vehicle as well. There are some ways to play it right now, not really a direct way, but can get a little bit of it indirectly through the home builders and the single family rental REITs. Well, to wrap up, so we've talked about the current situation with inventory. We've talked

about rentals and what we're seeing there. Is anything going to make this shift over time, other than we know rates will go down, maybe inventory will loosen up, but is there anything, if I'm investing in home builders, which I am, and I'm investing in REITs, which I am, Is there anything I should be looking for? Well, this is going to be too simplistic, but I do think a change in the rate picture, the interest rate picture would have the most meaningful impact. In other words, when the Fed stops raising the rates or when the Fed starts cutting rates, that's something that a lot of analysts are looking at maybe towards the second half of 2024. I think if you're a REIT investor, a home builder investor, that's going to be a

pretty big catalyst, because especially on the REIT side, REIT valuations have just really been beaten down. A lot of it is because they're locked into a situation where they have debt maturing over the next few years, especially on the office side, which we don't need to get into, but it's a really mismatch between liabilities and leases right now. But overall, the whole housing picture, real estate picture is going to change dramatically, I think, rates. Because right now, there's this feeling like, well, the Fed's maybe stopped, but it could go one more and maybe we're at this new, maybe 5.5% or 6% range on the Fed funds rate. That's going to cause yields to go up probably again, but at some point, it'll flatten out. And then

we get to a situation where if rates start coming down next year, because inflation is tame and maybe we get a little bit of a slowdown in the economy, that would be a little bit of a game changer on the REIT side and the housing side. I think that could affect, especially on the existing home side, which we talked a lot about, that could help loosen that up a little bit finally. But we'll have to see. It's not something that's going to happen over the next six months, it might be more of a second half 2024 scenario. We'll have to have another conversation then. Thanks as always for breaking this down with me. Absolutely, Deidre. Thanks so much for having me.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Deidre Willard, thanks for listening, we'll see you tomorrow.