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Investing in a Transitioning Housing Market

Written By Briton Ryle

Posted January 6, 2015

The U.S. housing market is right on the cusp of a hefty transition from one phase of its recovery to another. Are you ready for it?

Since the economy began recovering in early 2009, the housing market has recovered right alongside it. As graphed below, new home construction has increased from a multi-decade low of 500,000 units annually in early 2009 to around the 1 million new units level today. New home sales have also increased from the 275,000 units per year level in mid-2010 to the 425,000 units per year mark today.

transitioning housing market chart one


However, the above graphs point to a major problem for housing sector stocks which investors should be prepared for. And it all hinges on the imbalance between new home construction and new home sales.

This imbalance means that not all housing stocks which performed well during the housing recovery can be expected to fair well in the future.

But just as the old saying goes: “When Hell closes a door, Heaven opens a window.” Although some segments of the housing market are expected to slow soon, other segments will be picking up the slack and will be growing rather robustly. In fact, over the past six months we have already begun to witness this transition from one housing segment to the other.

What is this shift in the housing market that is already taking place? And more importantly, how can investors capitalize on it?

Out With the Old, In With the New

The state of new home construction and new home sales in the U.S. shows a disconcerting imbalance which has already begun playing out in a number of home related stocks.

As graphed above, if new homes are being constructed at a rate of just over 1 million units annually, but are being sold at a rate of just over 400,000 units annually, that leaves some 600,000 surplus new homes being added to the market every year, which ultimately end up sitting vacant. This means there will have to be a slow down in new home construction until the surplus of freshly built homes is all bought up.

Another bad sign for home construction stocks is the upcoming phase of rising interest rates, which will likely stretch out across the next 5 years or so until they reach their normal levels near 5 or 6%. As interest rates rise, home buying will cool.

Add the two together – a surplus of new homes sitting vacant and an expected slowing demand for new homes as interest rates rise – and we get a strong signal that home construction stocks are not the place in which to be invested.

However, that does not mean all housing related stocks will suffer. It merely means there is going to be a shift from one housing market to another. Where will this shift be moving to? Home renovation and home improvement stocks.

As interest rates rise, more and more potential home buyers will opt for the cheaper alternative of staying in their existing homes and simply renovating them. This shift from home building stocks to home renovation stocks has already begun playing out since the beginning of last summer.

From the first half of July, 2014, we have been witnessing a stark divergence in home related stocks, with the home renovation segment greatly outperforming the home construction segment, as graphed below.

transitioning housing market chart two


It should not surprise us that the top three performing stocks on the graph should be home renovator stocks, including:

• Lowe’s (NYSE: LOW), up 43%,

• Home Depot (NYSE: HD), up 30%, and

• Lumber Liquidators (NYSE: LL), up 15%.

Nor should it surprise us that the home construction stocks are grossly underperforming by comparison:

• Lennar Corp. (NYSE: LEN), up 9%,

• PulteGroup, Inc. (NYSE: PHM), up 7%,

• DR Horton Inc. (NYSE: DHI), up 3%,

• Beazer Homes USA Inc. (NYSE: BZH), down 1%,

• Toll Brothers Inc. (NYSE: TOL), down 5%,

• KB Home (NYSE: KBH), down 8%, and

• Hovnanian Enterprises Inc. (NYSE: HOV), down 9%.

Only the Beginning

Yet investors still need to be prepared for a slow transition out of the home construction segment toward the home renovation segment, as two housing reports last week indicated there is still a little bit of impetus remaining on the construction side.

Pending home sales for November released last Wednesday showed a 0.8% increase in pending home purchases over October. “The consistent economic growth and steady hiring we’ve seen the second half of this year is giving buyers enough assurance to consider purchasing a home before year’s end,” Lawrence Yun, chief economist of the National Association of Realtors noted. “With rents now rising at a seven-year high, historically low rates and moderating price growth are likely to entice more buyers to enter the market in upcoming months.”

Another spurt of home buying is likely to surge in the first half of 2015 just before interest rates begin rising, as buyers rush to lock in current multi-decade low rates before they’re gone forever. This should reduce the glut of excess housing on the market a little, and could trigger another mini-wave of new home construction in 2015 and 2016.

In fact, the second housing report released last Friday already shows a slight increase in construction spending of 0.9% in residential projects over October’s spending levels.

Even so, it is only a matter of time before the home construction market runs out of steam. New home construction has already been flatlining for over a year. The new home buying rate is less than half the new home construction rate, leaving more than half of new homes unsold. And interest rates are due to begin rising in the coming few quarters, which will continue for a few years at least.

Add them all together and we get a gradual shift out of home construction toward home renovation as home owners chose to revamp their current residences rather than upgrade to newer ones.

This gives investors an opportunity to revamp their portfolios, exiting the already slowing home construction stocks and picking up some home renovators which are just at the beginning stage of a nice upward run which is destined to last for years to come.

Joseph Cafariello