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Last week’s earnings report by Toll Brothers, the nation’s 10th-largest home builder, shook the industry. While profits were solid, new orders in the latest quarter of 2018 fell by 13 percent, the first drop in four years. Compare this to DR Horton, the nation’s largest home builder, where new orders increased by 11 percent.
Data compiled by the AEI Housing Center can shed substantial light on not only recent developments in the housing market, but also how these developments will affect individual home builder performance in the future.
Let’s start with the state of the housing market. Contrary to recent media reports, the housing market remains robust, albeit it appears to have plateaued at a high level and will become more bifurcated between first time and repeat buyers over the coming year. To understand why, one needs to examine the drivers of the housing market recovery that began in 2012. The current house price boom, now entering its seventh year, has been driven by two punch bowls: Fed monetary policy that kept interest rates low, which equally applied to all types of buyers, and an easing of mortgage underwriting standards by government agencies, which almost exclusively applied to first-time buyers.
Because Fed policy is becoming less accommodative, the higher-priced part of the housing market consisting of predominantly repeat buyers will likely see a moderation in home price growth. This trend will be particularly noticeable in higher-priced coastal markets, which will also experience some slowing in mortgage loan transaction volume due to tax law changes and affordability pushing buyers into more affordable markets.
However, due to continued credit easing by the Federal Housing Administration (FHA) and Fannie Mae and Freddie Mac (the GSEs), the lower-priced part of the market consisting predominantly of first-time buyers will likely see continuing strong house price appreciation with loan transaction volume remaining around its current high level.
Therefore, builders largely focused on the repeat buyer at the upper end of the price spectrum, will likely struggle, while builders focused more on the low and middle portions of the new construction price spectrum, particularly first-time buyers, will likely do fine — even with moderately rising mortgage rates.
Let’s consider two examples. On the one end, new orders for luxury builder Toll Brothers, with its homes well in excess of 3,000 square feet and median prices of over $600,000 (about 50 percent higher than the median price of new homes in the areas it builds), have already began to drop. This ought to be expected as about 85 percent of Toll’s financed sales are to well-to do repeat buyers. These buyers rely largely on private sector financing with more conservative lending standards, and hence without access to the leverage punch bowl, will feel the effect of rising mortgage rates more. These buyers may decide to buy existing homes over new one, they may not move, thereby keeping their current low mortgage rates, or they could opt to remodel their current home.
On the other end, sales for entry level builder DR Horton, with its smaller homes at around 2,200 square feet selling at about 90 percent of the median price of new homes in the areas it builds, are still going strong. Expect this to continue as DR Horton’s first-time buyer share of about a third, is double Toll’s share.
After connecting the dots, the takeaways are: Investors need to differentiate builders by the market segments they are serving. And home builders would be prudent to take a page out of DR Horton’s playbook and focus more on entry level homes, where coincidentally the need for more supply is greatest.
AEI’s detailed breakouts for the largest 10 builders by size in 2017 can be found here.
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