Cherry-Picking California's Best Homebuilders


The housing market seems to have been nurtured back to health. Sales of newly built homes across the U.S have risen by 12.6% over the last 12 months, with California's housing sector -- now one of the fastest-growing real estate hotspots in the U.S. -- leading the way. If this stellar run continues in 2014, homebuilders with significant exposure to California could end up selling a lot more houses, and getting even higher prices for them.

Why homebuilders want a piece of California

New home sales in California have reached their highest levels since 2006. The Zillow Home Value Index suggests that average property prices in the state have appreciated by 25% year over year. Furthermore, the California Association of Realtors (C.A.R) estimates that home sales in the state can grow by 3.2% in 2014.

KB Home is one of the largest developers in California, with about 49% of its FY 2012 revenues emanating from the state. The homebuilder was severely hit when property prices in the state plummeted between 2006 and 2009, and its shares began to tumble.

California House Price Index Chart
California House Price Index Chart

However, the recent boom in the California real estate has also boosted KB Home's financial performance. Its revenues and gross profits have expanded by nearly 177% and 293% since 2011, respectively. But the homebuilder isn't just sitting back and enjoying the ride.

KB Home plans to develop 120 luxurious communities by the end of the 2013 fiscal year, located in some of the fastest growing metropolitan areas in California. The move will increase its community count by 15% year over year. Management also plans to invest $1.2 billion in land acquisitions during the 2013 fiscal year, up from a previously earmarked $1 billion.

It's worth noting that the size of these investments is comparable to KB Home's current market capitalization of nearly $1.5 billion. This move wagers even more of the company's future on California's housing sector, thereby amplifying its risks and rewards. But since new homes sales and property prices in California are on the rise, KB Home's huge investments seem to offer significant gains with limited risks.

Gigantic Presence

Another enterprise to consider is Lennar , one of the largest homebuilders in the U.S., with a market cap in excess of $6.3 billion. The company enjoys a hefty gross margin of 24.9%, as opposed to the industry average of 20%. Its closest peers, KB Home and PulteGroup , operate with a gross margin of 18.2% and 23.9%, respectively.


Average Selling Price (ASP)

ASP Change YoY

Unit Net Order Change YoY

KB Home












Source: Company earnings call transcripts.

It's important to note that all the mentioned homebuilders recorded comparable ASPs during the recent quarter. But despite having similar price points, Lennar posted the highest gain in its net orders. This spectacular growth came on the back of 77 community openings during its most recent quarter.

"Today, we are fortunate to have land in hand to meet our projected deliveries through 2014 and much of 2015 as well," said Stuart. A. Miller, CEO of Lennar. "And as a result, we're pursuing land opportunities for 2015 and beyond."

Speaking of exposure to California, Lennar owns a majority stake in FivePoint Communities, the state's largest residential developer, which has ambitious plans to develop 50,000 residential units in California's metropolitan areas. Needless to say, FivePoint's ambitious expansion plans in California are one of the key growth drivers for Lennar.

Avoid the Behemoth

When it comes to homebuilders, it's hard to overlook Pulte Group. It's the largest homebuilder in the U.S (by revenues), with a significant exposure to California's real estate sector. But despite having a diversified and huge portfolio, the homebuilder has disappointed Wall Street.

Pulte Group is gradually shifting toward high-margin projects, to improve its profitability and reduce its risk exposure. To attain better ASPs, the homebuilder deliberately held off on selling about 50% of its inventory in Arizona, Nevada, and Southern California in the recent quarter. On a year-over-year basis, this move boosted its ASP by 10.76%. But its net orders took a deep plunge, as you can see in the table above.

With interest rates on the rise, homebuilders should strive to sell their inventory before the demand for residential units slows down. In case of a slowdown, PulteGroup might not be able to offload its inventory at the desired average price. Furthermore, hoarding its own inventory makes it prone to asset devaluation, should property pricing suddenly retreat from its current heights.

PulteGroup is placing itself in a dangerous position here, and risk-averse investors might want to avoid it.

Bottom Line

Interest rates are on the rise, and their continued increase could hamper the demand for new homes over the longer run. But over the shorter term, homebuyers and retail investors might still want to buy residential real estate in some of the fastest-growing areas (like California), before those interest rates become unaffordable. If it pans out, this rationale will most likely continue to fuel the growth of KB Home and Lennar over the coming quarters.

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Piyush Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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