US homebuilder set to see 15% earnings growth as demand up

The US economy is the envy of the world in 2017. Business and consumer confidence has soared after the election of the most pro-capitalist Republican President since Ronald Reagan. The unemployment rate is a mere 4.7 per cent. Wage growth has begun to accelerate. Millennials, who have lived in their parent’s basement since 2008, have now accumulated the cash and the bank credit to qualify for a home mortgage for a starter home.

Home prices rose five per cent and I am exploring “flipping” opportunities in Philadelphia, the city where I spent six wonderful years of my youth (it was called South Philly then). Inventory growth is limited. Land prices have still not pressured homebuilder operating margins, though construction costs (steel, cement, labour) have begun to rise. Banks have begun to relax mortgage lending criteria (lower credit scores, higher debt to income levels).

True, mortgage rates have also soared after the 100 basis point rise in the 10-year US Treasury note yield. President Trump’s Tweets and policy agenda have raised tensions in international relations, a scenario that would mean higher risk free rates (Fed tightening), inflation risk and risk premia on homes, all components of rental yields. There are vast regional differences in America — Greenwich, Connecticut is in a different universe than Detroit, Michigan and Palm Beach County is not Miami Dade in Florida.

I have no problem finding homebuilders with 10-12 per cent demand order growth and at least 15 per cent earnings — growth. The supply/demand trends are hugely bullish for homebuilder profits in 2017, even if mortgage rates have now begun to move higher. After all, if Trump’s fiscal stimulus is green lighted by a Republican Congress (it will be), the Yellen Fed has promised to raise the Fed Funds rate (overnight borrowing rate for bank reserves) at least three times in 2017. (She will, she must.

The logic of the Fed’s dual mandate makes monetary tightening certain). Yet it is significant that existing home inventories in America’s top 25 cities are only 3.4 months, offsetting the impact of higher mortgage rates. My conclusion? Existing homes (at least two thirds of transaction volumes) will rise 5–8 per cent in 2017. This means it is time to print money in mass market homebuilder shares on Wall Street.

Will demand for new homes be hit by the 70 basis point rise in the 30 year US mortgage rate to 4.45 per cent? Not if recent data from homebuilders Toll Brothers and Lennar is any guide. The “animal spirits of Joe and Jame Sixpack in Middle America are itching to go long brick and mortar. Victor Hugo said nothing can stop an idea whose time has come — just as nothing can stop the momentum of a residential US home builder rally whose times lines come. The housing Humpty Dumpty had a great fall in 2016 but all the king’s horses and all the kings men (the central banking gnomes of the Federal Reserve) have finally managed to put together Humpty Dumpty again. So flippin in Philly is white hot. Reminds me of a 2007 property flipper tagline from New Dubai — cruisin’ gently in his Bentley.

I believe the highest demand, easier bank credit, most compelling demand, most resilient operating margins, most compelling demographics and most mortgage rate insensitive segment is homebuilders who specialise in entry level homes.

While I am vowed by Lennar’s backlog absorption ratio, my real interest in fallen angel D.R. Horton, the largest homebuilder in the US. As interest rates soared in the bond market after July, D.R. Horton shares fell from 35 to 28. In 2017, DR Horton will build 45,000 homes, making it a potential money machine if my analysis of mass market “starter homes” is correct. This is the only major US homebuilder that has positive free cash flow. Its three bedroom homes (iconic villas in Dubai property speak) sell for 300,000 (they would cost at least 1.2 million USD in Ranchistan or other wannabe ritzy expat enclaves).

If prices rise, this puppy earns $14 billion topline with a 15 per cent gross margin. Horton trades at 10 times earnings and 1.4 times price to book value. This is a compelling value metric for me, though Dr Ben Carson as Housing/Urban Development Secretary (HUD) and significantly higher mortgage rates mean the shares could fall to 25. Horton buys lots/builds homes in 78 cities in 26 major American urban markets. Horton has reduced net debt to 22 per cent, thanks to its cash flow tsunami. Its land bank is a cash cow from sea to shining sea. Oh say, can you see by dawn’s early light.