The Housing Hangover

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Is this a cold open? Have I cold opened just now?

I think you just cold opened. I mean, we can't do the welcome to the Streetwise Podcast thing because we're going to do it again.

It's a rerun. We're not being rude. We will welcome people in the rerun. We don't want to welcome them twice because we don't want them to think we're weird.

That's weird. Yeah. You just can be more casual.

Yeah.

Hey, how's it going?

Yeah, cool. Hey, cool, man.

Your neighborhood podcast.

This is an episode we did back in June. This is the second of two reruns we're doing for the holidays. We'll be back with new episodes next week. People have asked for an update on the housing market. We will come to that soon. But for right now, conditions are not much changed between where we are today and where we were at the time of this episode. Right. Mortgage rates, the level of the stock market, even housing stocks. One thing that is different is Redfin stock, which we talk about in this episode. That's down quite a bit from where we were. And our colleague Andrew Barry was just on this podcast recently to present his top 10 stock picks for the year ahead. And one of them was a homebuilder, Toll Brothers. We can come back to homebuilders in coming weeks. Anything else to say for our cold open, or have we— have we nailed it?

I think it's time for a cold close.

How do you do that? Stop talking, or do you just kind of, you know, you just let your voice kind of wander off? All right, cool. Good. Hey, good seeing you guys. All right.

Applications for a mortgage to purchase a home, those are down about 15%. April home sales declined 12%, and new home sales, which are more volatile and a smaller share of the housing market, declined by almost 30%.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe. The voice you just heard is Jade Rahmani. He's an analyst covering homebuilders and other real estate stocks for KBW. The housing market is cooling off and related share prices have tumbled. In a moment, we'll hear from Jade about what's next for house prices and where stock buyers can find bargains. And we'll hear from another analyst about publicly traded realtors and layoffs there and what to make of the shares. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

Tell me about an economic indicator I haven't seen yet.

Well, I was at the grocery store the other day and I was looking in the frozen fish section and I realized that the salmon burgers in my freezer were $3 less expensive than the salmon burgers in the store because they'd raised the price since like, you know, 2 months ago when I bought them.

You're sitting on an embedded capital gain. Don't sell them because you're— because I think you'll have to report it. I'm not sure. I'm not sure about the rules for salmon selling.

It's like a 55% annualized return there.

It's sweet, but there's nowhere to cash in unless you sell. And I'm not really sure on the taxation rules for the secondary salmon market. I recommend you eat the profits. Now let's turn our attention to real estate and a bizarre combination of record gains for homeowners and outright carnage for housing shares. Our friends at the Wall Street Journal reported this past week that US tappable home equity, or the value of homes that owners could borrow against if they wanted to, rose by $1.2 trillion in the first quarter to a record of more than $11 trillion. That makes sense. Prices have soared more than 20% over the past year. But two big real estate agents, Compass and Redfin, just announced sweeping layoffs. Redfin stock is now down about 90% from its high early last year. We'll say more about that in a bit. Homebuilder stocks haven't been hit that badly, but they've been hit hard enough. And if you were unlucky enough to own a leveraged exchange-traded fund called Direxion Daily Homebuilders and Supplies Bull 3x Shares, the ticker is NAIL, Well, then you got nailed. If you have any young capitalists listening who are sensitive to mentions of extreme market losses, maybe cover their ears for this part. That fund just lost 45% over 5 trading days. So what's going on? Well, for one thing, house price data is reported with a lag, so those figures on home equity or as of March. We don't really know where things stand now. What we do know is that home sales volumes have been tumbling, which makes perfect sense because 30-year mortgage rates recently shot up to around 6%, more than double where they were at the start of last year. That combination of high house prices and costly financing has put purchases out of reach for many buyers, to the point where brokers are now downsizing. So what does that mean for house prices from here? And are any of those beaten-down stocks worth buying? To learn about that, I reached out to Jade Rahmani, who covers homebuilders and other real estate stocks for KBW. I asked what he makes of the signals he's seeing.

First quarter home sales declined 5%. April home sales declined 12%. That includes about 10% drop in existing home sales and new home sales, which are more volatile and a smaller share of the housing market declined by almost 30%. And over the past 5 weeks, mortgage purchase applications— so applications for a mortgage to purchase a home— those are down about 15%.

I asked Jay, does that mean that house prices are about to tumble? And he said not exactly. He thinks price growth will slow sharply from here to a rate of 2% by the end of the year and zero next year. That's not adjusted for inflation, so if inflation is, let's say, 3% next year, then houses could lose 3% in real terms if Jade's right. He calls this scenario a soft landing for housing. It involves house prices pausing while incomes catch up.

And so when you continue to grow wages at 6%, which is what they're growing at, and there's currently a labor shortage We expect continued wage growth and a moderation in home prices that causes the mortgage payment income ratio to have a soft landing.

If house prices stall and incomes keep rising, we could get back to historical average levels of affordability, although Jay says we might not go all the way back.

But when you consider that people are spending more time in their homes now than pre-pandemic, and that there's going to be some percentage of the workforce that probably continues to work in a hybrid format, that means the value and use of residential real estate has increased. So we should be willing to spend slightly more of our incomes toward housing than historically. And I think we see evidence of that all around us in terms of home remodel spend, in terms of the number of people adding an addition to their homes, That observation that people's houses now play a more important role in their lives is part of why Jade expects a soft landing for the industry.

He also points out that inventory is tight, and although mortgage rates have shot up to around 6%, two-thirds of homeowners with mortgages are locked in at rates below 4%. They're likely to stay put rather than move so they don't have to take on a new mortgage with a much higher rate. Which means inventories of homes for sale could remain tight. Also, during that housing bubble more than 15 years ago, household balance sheets were stretched and mortgages got weird. There were loans with no down payments and ones with low teaser rates that jumped up after a short while, and banks played it loosey-goosey on proving that borrowers would be able to make their payments. The result was a wave of defaults and panic selling. Today, household balance sheets appear much stronger and mortgages look much more normal. So that explains why Jay doesn't expect a wave of selling and a sudden drop in prices. But what if things go worse than he expects? He's also modeled a hard landing scenario, and that involves the number of house transactions plunging by 40% through next year. To arrive at that figure, Jade looked at where the bottom was for home sales per capita during past severe recessions. So under that scenario, instead of house prices staying flat next year, Jade estimates that they would fall by 5%. That seems benign compared with how far house prices have run up and how far stock prices have fallen. But Jade points out that if you have a new mortgage, A 5% drop in your house's price is enough to reduce your equity by 25%. He also says that if mortgage rates keep rising, we might need even more than a 5% price decline to restore affordability. Okay, so maybe house prices will flatten out from here and maybe they'll drop a bit. And of course, it can vary sharply by market. But what does this mean for shares of homebuilders? Jade says it's time to start buying them.

And so we currently estimate that homebuilders today are trading at about a median of 77% of book value. Projecting book value forward, they're at 60%. And historically, the trough during recessions is about 60%. They did go lower than that during the financial crisis. Homebuilders were much more levered than they are today. The home buyer was much more levered Things were in a totally different state than they are today.

You heard Jade mention book value. That's an accounting term for a company's net worth. Jackson, my accounting music, please. In simplest terms, book value, or net worth, is equal to a company's assets minus its liabilities. We've all used price-to-earnings ratios to discuss how expensive stocks are. That's a comparison of the stock price to the amount of money per share a company makes. But with homebuilders, it's more common to compare prices to the value of stuff companies own. Here's Jade on why.

It's best to look at book value. In my view, earnings are just a reflection of the current land portfolio. They take those land holdings, they put houses on them, They develop and sell those houses. They take that cash, they have to buy new land. So most of the land they're sitting on today, they acquired before COVID before this 30% run-up in home prices that we've seen. It makes sense to assume that their redeployment into new land, it's not going to experience the same 30% run-up in home prices. So that's caused their margins to be about 50% above historical levels.

That point is important. Home builders look incredibly cheap relative to earnings, but earnings also look unusually high. Anyhow, as Jade says, these companies are trading at 60% of his projections for their book values, which has historically been the low point during recessions. So if a soft landing is coming, it's a good time to buy in his view. And if a hard landing is coming, well, Share prices might fall further from here, but long-term investors might also make out just fine. Jade's favorites in the group are Lennar, ticker LEN, which plans to spin off some real estate tech investments and could end up with a higher valuation afterwards in Jade's view, and Toll Brothers, which skews toward affluent buyers including many that pay in cash, so they're not put off by high mortgage rates. Thank you, Jade. So how about Redfin stock, down 90% from its high? Is it time to buy? That's next after this quick break. Jackson's gonna run down to the store and get a price check on those salmon burgers.

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Welcome back. There was bad news for some real estate brokers this past week.

You know, Redfin announced this week that they're cutting 6% of their headcount. I think Compass also announced they're cutting 10%.

That's Steven Sheldon. He covers real estate technology companies at William Blair.

Redfin in particular, and their CEO, Glenn Kelman, I think has done a great job over the last 3 to 4 years calling out the shifts that have happened in the industry, whether things are getting better or worse. And so the fact that they're out there saying that May demand was, I think, 17%, 18% below their expectations, you know, they typically have very good visibility. And part of that visibility is the fact that they have the buyer search portal. It's one of the 3 most trafficked portals out there along with Zillow and with Realtor.com. So they get I think very good insight to what's happening on the buyer behavior.

Steven mentioned realtor.com in passing, so I'll just note that it and my employer Barron's are owned by the same parent company. Now, Steven also points out that Redfin hires agents directly, unlike many brokers that use an independent contractor model. If a company like Redfin gets an early read on house demand, and if Redfin is laying agents off, That's not a great sign, but it's more or less what we would expect considering the factors we've been talking about, including sharply higher mortgage rates. In a blog post, Redfin CEO wrote, quote, we could be facing years, not months, of fewer home sales. But he also wrote that Redfin still plans to thrive. Here's another quote: if falling from $97 per share to $8 doesn't put a company through heck, I don't know what does. Shares actually fell to closer to $7 after the announcement. Think about that for a moment. Redfin's stock market value peaked at close to $10 billion early last year, back when its revenues hadn't yet topped $1 billion. Now revenues are running at around $2 billion a year, and the stock market value is barely three-quarters of a billion dollars. In other words, the valuation has fallen from a peak of nearly 10 times revenues to less than half of revenues. Redfin doesn't consistently generate free cash, but it hadn't been burning much either, and it was expected to swing to positive and rising free cash flow starting in 2024. We'll see. The company's business model is straightforward. Sellers pay lower commissions than they do with traditional brokers Buyers get plenty of online tools, including the opportunity to tour vacant homes on their own using remote-controlled smart locks. And agents get lots of online referrals. Speaking of agents, Steven at William Blair points out that membership in the National Association of Realtors had shot up from about 1 million in 2012 to a record 1.6 million.

I think there are a lot of agents that entered the market that could struggle here in a softening environment where maybe they eventually leave, you know, as they think about the next couple years.

I asked Steven what he thinks about house prices. He expects conditions to soften but not collapse. Rents, he points out, have also shot up, so swearing off homeownership altogether isn't necessarily a bargain. Builders are expected to add many lower- and mid-price units, but Steven says it'll be years until supply rises to meet demand. He covers 3 brokers, Redfin, RE/MAX, and eXp World Holdings, and he has market perform ratings on all of them, meaning he's neither bullish nor bearish at the moment, but he is struck by how far valuations have come down.

I do think the valuations there have compressed far more than I would've expected. I mean, it is kind of like going back to February 2021. These names were all getting priced like the record levels of activity we, we were seeing in 2020 and 2021 was gonna continue for 3 to 5 years. Now it's getting priced like the housing market is going to fall off a cliff and we're never gonna see it recover or, you know, that it's gonna be a weakened demand environment for the next 5 years or something.

[Speaker] So what are the signs then that would cause you, you're at Market Perform on all these, what are you watching for? Do the valuations need to become more attractive or are you looking for some kind of signal that the cycle is turning? What are you keeping an eye out for?

I think it's more of that. I think the market sentiment— I don't see anything in the next couple quarters that maybe will change the market sentiment. You know, there's just a bearish view out there, I think, for the housing names. And there's different things you could talk about for each one of those. But I think the market sentiment is going to be a headwind, at least for the next few quarters. I think what I'm looking for is just more signs of stabilization.

One reason that some real estate brokers had traded at such sky-high valuations is that the business seems archaic. And ripe for disruption. There's been a lot of talk about that, but the process of buying a house still seems clunky. I'll give you one example. Title insurance. Jackson, I'm feeling pretty fast. I think I can break the 1-minute rant barrier. You want to give me 60 seconds on the rant clock?

You got it.

Banks force borrowers to buy insurance that covers the possibility that somewhere down the road someone will raise their hand and say, wait a second, I'm the true owner of that house, not the person who sold it to you, so the house is rightfully mine. Now, rules vary by state, but title insurance is generally wildly overpriced, with premiums that bear no resemblance to the actual level of claims, unlike, say, home and auto insurance, which are more competitive. Home buyers already pay someone to perform a title search. Why should they have to buy overpriced insurance to cover a mistake that A, A, isn't their fault. B, is most of the bank's problem. And C, rarely happens. That system needs to change along with a lot of things about the home buying process. Time?

45.

I'm going to need a towel and a cool down. So I suppose that means there's still plenty of room for industry insurgents to make things simpler and win market share.

So I think the next leg is really focusing on the consumer and the consumer experience and making sure that it's that consumers have more visibility, especially first-time homebuyers. I mean, it's not— it's a, it's a pretty complicated and convoluted process.

Thank you, Jade and Steven, and thank all of you for listening. Jackson Cantrell is our producer. He has an overweight rating on freezer fish. Subscribe to the podcast, rate it, write us a review, and follow me on Twitter. That's @JackHowgh. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.