Home sales in the US may be poised for a sustained, but jagged, multiyear recovery, supported by an array of demographic, cyclical and financial factors. With such a favorable backdrop, investors may be looking for ways to add exposure to housing, often starting with homebuilders.
Home sales in the U.S. may be poised for a sustained, but jagged, multiyear recovery, supported by an array of demographic, cyclical and financial factors. With such a favorable backdrop, investors may be looking for ways to add exposure to housing, often starting with homebuilders. But, as Michael K. Arends and Celine E. Demonsang explain, there are compelling opportunities beyond the builders, hidden in the housing transition supply chain.
For the past year, investing in the recovering U.S. housing market has not exactly been a smooth ride. Buoyed by a backdrop of an improving economy and better employment data, many investors followed a traditional path, flocking to homebuilding stocks as a way to participate in the sales recovery.
But that strategy led to broad-based disappointment in 2014, as many housing-related names experienced a sharp selloff. After a modest initial bounce off multiyear lows, new- and existing-home sales reversed lower and remained soft through the rest of the year, as shown in Figure 1. Several factors contributed to this unexpected weakness, including an unusually harsh winter, shrinking inventory, still-tight lending standards and a sharp increase in 30-year fixed mortgage rates.
In recent months, however, the housing recovery resumed and has been steadily improving. At this point, we believe both new- and existing-home sales appear positioned for a sustained, moderate, but jagged, multiyear recovery that should persist for years, supported by a plethora of demographic, cyclical and financial factors. In this paper, we will explore some of those drivers, as well as outline the compelling investment opportunities that may result.
In the 1990 comedy film classic Home Alone, 8-year-old Kevin McCallister (played by actor Macaulay Culkin) is mistakenly left at home as his family leaves for Christmas vacation in Paris. If Kevin, now age 33, has followed the typical path of his generation, he has finished college and returned to live at home. For the past decade, the percentage of young adults living at home has surged to a record high of 28%, as shown in Figure 2.
But this trend may be about to reverse course. As shown in Figure 3, U.S. household formations may be at a significant inflection point. As the Millennials enter their prime household forming years, we could see the release of pent-up housing demand over the next three to five years. This could be spurred by improved job prospects, accumulated savings from living at home — and parents’ growing desire to be home alone!
When Kevin and his peers finally face the decision whether to rent or buy a home, they will most likely find homeownership the more attractive option. After many years of mortgage payments exceeding monthly rents, this ratio changed in 2007, as shown in Figure 4. This was largely because of declining mortgage rates and steadily rising rents.
Right now, mortgage payments are about 60% of rental costs. We believe that accelerating rent increases, the chance to lock in monthly mortgage payments near record-low levels, and growing confidence in building home equity over time will push more people toward homeownership.
As illustrated by Figure 5, rates on 30-year fixed mortgages are near historic lows, which may rekindle demand for housing. When combined with respectable new job creation and rising consumer confidence, prospects for a sustained recovery in new and existing homes sales appear bright.
However, since the financial crisis, mortgage lending standards have tightened substantially, which has posed a significant obstacle to the U.S. housing recovery. Figure 6 contrasts the distribution of borrowers’ FICO credit scores among loans originated in 2001 and 2014. In 2001, 13% of homebuyers who were granted loans had a FICO score below 620, but by 2014, this buyer pool was virtually eliminated. In 2014, about 45% of mortgages were awarded to homebuyers with credit scores above 760.
These tight standards created challenges for first-time buyers and those with impaired credit histories. However, signs of easing credit standards are now emerging. One established gauge of this is the quarterly Federal Reserve Senior Loan Officer survey, which surveys roughly 80 domestic banks and 24 U.S. branches and agencies of foreign banks about changes in the standards and terms of bank loans to businesses and households over the preceding three months.1 As seen in Figure 7, survey respondents have reported two consecutive quarters of modest easing.
In addition, several new initiatives aimed at easing mortgage credit availability have been introduced recently. In late 2014, Fannie Mae and Freddie Mac announced a new option for qualified homebuyers to obtain a mortgage with only a 3% down payment.2 In January, the Federal Housing Administration cut annual insurance premiums for new borrowers by half of a percent, a move expected to prompt a quarter of a million buyers to purchase their first home over the next three years.3
With all of these factors creating a favorable backdrop for a recovery in home sales, investors may be looking more closely at opportunities for additional exposure, naturally beginning with the homebuilders segment. Historically, homebuilders have frequently been valued on a price-to-book basis, as investors are generally most concerned about whether the value of these companies’ assets will grow over time.
Before the stocks of homebuilders plunged in 2007, they traded at lofty price-to-book ratios, as shown in Figure 8. However, throughout the course of 2014, homebuilders’ shares became more reasonably valued, given price declines and growth in book value. Yet, to us, the stocks do not appear to reflect the potential for higher levels of building activity as well as the extended cyclical recovery in new-home sales.
Beyond the builders, the housing transition supply chain, as shown in Figure 9, provides many compelling hidden opportunities. We have found a broad array of less-familiar companies that we believe are well positioned for the U.S. housing recovery. The process of buying a home begins with a real estate broker, followed by a mortgage application, then an appraisal, a credit check, title insurance and, finally, the assumption of a mortgage.
At this point, we believe leading companies involved in real estate brokerage, title insurance, appraisal, credit rating and mortgage lending are worthy of investors’ attention, as we believe unrecognized strength in these industries’ longer-term fundamental prospects will provide attractive investment options over the next three to five years.
While the process of buying a home is well known, the names of major companies involved in the transaction supply chain are not. For example, the leading real estate brokerage firm is a holding company with a somewhat nondescript name. Data used in home appraisals and related statistics are created in the processing systems & products segment of the technology industry. The company with the largest exposure to the technology platform used in mortgage servicing is also one of the biggest title insurance providers for residential real estate.
As shown in Figure 10, title insurance companies and banks with significant exposure to mortgage financing are trading in the middle of their historic 12-month forward price-to-earnings range. Real estate brokers have more limited history as public companies, but they are trading in the lower half of their abbreviated valuation range. These valuations have not discounted a multiyear recovery in new- and existing-home sales, its impact on earnings and cash, or higher levels of operating profitability as dominant franchises in their respective markets.
These types of investments are not without risk, of course. Traditionally, homebuilders and real estate brokers have exhibited above-average volatility. A sharp and sustained increase in mortgage rates could cause a drop in new- and existing-home sales; homebuilders and companies related to housing transactions would likely underperform in such an environment. Plus, the overhang of student-loan debt could delay the growth of first-time homebuyers.
Low mortgage rates, improving credit availability, demographic trends and healthy job creation are converging to strengthen the recovery in new- and existing-home sales, which could persist for longer than the consensus currently expects. Homebuilders will likely receive the most attention from investors, but other, less obvious peripheral areas also appear to offer appealing investment options.
Collectively, we believe the hidden opportunities in housing represent an area where active managers should significantly overweight using a three- to five-year time horizon. Many of the most compelling investment possibilities fall into the small- and mid-cap asset classes and represent very small weights in major benchmarks. We have found select leaders in each respective industry and view the sustainability of free-cash-flow generation, competitive positioning and visibility of fundamental prospects as more attractive than the consensus now does.
1 Senior Loan Officer Opinion Survey on Bank Lending Practices, The Federal Reserve Board. http://www.federalreserve.gov/BoardDocs/snloansurvey/
2 “Fannie Mae Announces 97 Percent LTV Option for First-Time Homebuyers,” Fannie Mae press release, Dec. 8, 2014. “Freddie Mac Home Possible Advantage (SM) Mortgage Makes Home Financing With a 3 Percent Downpayment Possible,” Freddie Mac press release, Dec. 8, 2014.
3 “FHA to reduce annual insurance premiums,” US Department of Housing and Urban Development press release, Jan. 8, 2015.
BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.
The information in this document is not intended to be investment advice, and it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for Professional Clients only. This material is not for onward distribution to, or to be relied upon by, retail investors.
Any statements and opinions expressed in this document are as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon or any of its affiliates. The information contained in this document has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon and its affiliates are not responsible for any subsequent investment advice given based on the information supplied. This document is not investment research or a research recommendation for regulatory purposes as it does not constitute substantive research or analysis. To the extent that these materials contain statements about future performance, such statements are forward looking and are subject to a number of risks and uncertainties. Information and opinions presented in this material have been obtained or derived from sources which BNY Mellon believed to be reliable, but BNY Mellon makes no representation to its accuracy and completeness. BNY Mellon accepts no liability for loss arising from use of this material. If nothing is indicated to the contrary, all figures are unaudited.
Any indication of past performance is not a guide to future performance. The value of investments can fall as well as rise, so you may get back less than you originally invested.
This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value.
This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management.
This document is approved for Global distribution and is issued in the following jurisdictions by the named local entities or divisions: UK and in mainland Europe (excluding Germany): BNYMIM EMEA, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority. • Germany: Meriten Investment Management GmbH which is regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. • Dubai, United Arab Emirates: Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended for Professional Clients only and no other person should act up on it. • Singapore: BNY Mellon Investment Management Singapore Pte. Limited Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. • Hong Kong: BNY Mellon Investment Management Hong Kong Limited. Regulated by the Hong Kong Securities and Futures Commission. • Japan: BNY Mellon Asset Management Japan Limited. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. • Australia: BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865). Authorized and regulated by the Australian Securities & Investments Commission. • United States: BNY Mellon Investment Management. • Canada: Securities are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. • Brazil: this document is issued by ARX Investimentos Ltda., Av. Borges de Medeiros, 633, 4th floor, Rio de Janeiro, RJ, Brazil, CEP 22430-041. Authorized and regulated by the Brazilian Securities and Exchange Commission (CVM).
The issuing entities above are BNY Mellon entities ultimately owned by The Bank of New York Mellon Corporation.
BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. • BNY Mellon Western FMC, Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms’ services or funds to any U.S. investor, or where otherwise unlawful. • BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People’s Republic of China. • BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. • The Newton Group (“Newton”) is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. • BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).
©2015 The Bank of New York Mellon Corporation.
Portfolio Strategist, The Boston Company Asset Management, LLC