Is It Time to Buy Homebuilders Again?

Is It Time to Buy Homebuilders Again?

Higher mortgage rates, combined with rising home prices, have helped slow the housing market during the last few months. Home affordability dropped to a five-year low during August, and new home purchases dropped 1.9% from the previous month. Unfortunately, after several strong months, the United States' housing market has now hit a plateau.

Housing stocks have mirrored the market's weakness. Indeed, the SPDR S&P Homebuilders ETF is down 10% from its highs earlier this year. In addition, PulteGroup , the nation's biggest homebuilder, is down around 30% from its May high, and Lennar Corp is down 25% from its May high.

However, there is some evidence to suggest that this could be a great long-term buying opportunity.

Slow and steady wins the race?
According to the Center for Economic and Policy Research, or CEPR, the slowing housing market is a good thing. In particular, the CEPR highlights that before the rise in mortgage rates, home prices were growing at an unsustainable rate, with nationwide growth in the double digits, and some regional markets reporting annual growth of 20-30%.

What's more, the CEPR reports that if home price growth had continued at this rate for much longer, prices would have been pushed back into bubble territory. That's not good for the long-term economic health of the housing market .

Nonetheless, this evidence indicates that the slowing housing market could actually be a good thing, leading to a slower but more robust recovery.

With the homebuilders now falling back to year-to-date lows, investors are also being offered an interesting opportunity. In particular, homebuilders are now trading at more attractive multiples than they were earlier this year, when a surge of investor cash into the sector sent multiples to five-year highs. Pulte Group for example, now trades at a more respectable forward earnings multiple of 14.4, compared to the multiple of 20.5 reported during May.

But where should you look for deals?
There are numerous ways to value the homebuilders, from the prospect value of their land banks, to the usual financial multiples.

However, I want to look at a different metric: operational gearing. This number describes the relationship between a firm's fixed and variable costs; higher fixed costs mean higher operational gearing.

Why use this metric? Well, high gearing makes a firm highly sensitive to a change in sales, which can happen quickly in the housing market. So we're looking for the company with the lowest level of operational gearing, since companies with high operational gearing are usually forced to make sudden, deep cost cuts when sales start falling.




DR Horton Inc





Variable cost




Contribution margin




Fixed costs




Operating Leverage




Source: Most recent 10-Q. Figures in thousands of dollars.

Now, I should note that these figures are unlikely to be completely accurate, since each company does not provide detailed financial figures for every individual part of its business. What's more, these figures are only related to home sales and the cost of homes built, they do not take into account factors like land sales and financial services, which could distort results. That said, all three companies rely on homebuilding for the majority of their income, so other divisions are unlikely to have a significant distorting effect.

Still, these figures do show us that both DR Horton and Pulte have a high sensitivity to falling sales, or high operational gearing. Actually, these operational gearing really show through within the fiscal third-quarter results the three companies reported.

For example, at the end of the fiscal third quarter, Lennar reported a quarter-on-quarter decline in revenues of 33%; Pulte reported similar declines. However, while Pulte's gross profit decline 30%, Lennar's gross profit slid 22%, highlighting the company's lower operational gearing. DR Horton's revenue, quarter-on-quarter revenue growth and gross profit for the same period remain relatively unchanged.

Foolish summary
All in all, it could be time to consider taking a stake in one of the nation's homebuilders. Slowing home sales are not necessarily a bad thing and lower prices could ignite the market again.

Due to its low operational gearing, Lennar could be your best bet as the company's earnings will suffer less from near-term weaknesses in the housing market. What's more, Lennar is likely to churn out stronger profits when the housing market recovers.

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Fool contributor Rupert Hargreaves 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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