AS WE MOVE FORWARD TO 2006, we are optimistic that the third “soft landing” since 1994 and 1995 is currently unfolding in the U.S. housing market. Increased mortgage liquidity means that consumers are less reliant upon low fixed rates to provide the catalyst toward homeownership. Though demand appears to be moderating slightly in some markets, it continues to outpace supply, leading to home price appreciation, albeit at a slower pace. In the event of a consumer slowdown, market equilibrium could be achieved by building slightly smaller homes, offering fewer features, and by utilizing higher density per acre. These modifications are typically minimal enough to continue to deliver significant value, while at the same time reducing overall home prices and still providing considerable profit for builders.
MITIGATED RISK Demonstrating increasing financial sophistication, builders have improved their business models to better withstand cyclical downturns. To mitigate risk, sales exposure has been diversified into a wider variety of geographic markets, price points, and product types. At the same time, the use of options to control land has increased meaningfully, to 63 percent of the total currently, up from 50 percent in 1995. With broader exposure to more geographic regions and market segments, builders are managing their supply to local market dynamics, which has driven another compelling statistic. The rate of speculative building by the nation's builders has dropped to 23 percent of the total today, from 40 percent in 1970. With limited supply in demand, home price appreciation has been robust. Looking forward, we expect the builders to focus on capturing market share opportunities in existing markets through broader product breadth and strategic land purchases. We anticipate that geographic expansion will be driven by leveraging the existing infrastructure to grow into contiguous markets, which is a low-risk strategy.
In the past decade, annual unit sales growth for the top 10 builders has averaged 15 percent, compared with industry growth of 5 percent, suggesting that consolidation will be another positive driver contributing to the growth rate of public builders. The average market share position of a top 10 builder is just more than 2 percent, and the top 10 builders control less than 25 percent of the single-family market and less than 40 percent of the metro markets. As such, market share gains or small acquisitions can drive significant growth, before the top builders start to compete head-on. Moreover, the biggest markets are concentrated, with starts in the top 15 states representing 70 percent of the total. This suggests that there is also significant opportunity for scale advantages and geographic expansion, without undue attendant risk. Acquisition activity typically accelerates when demand slows; as such, we expect an increase in M&A over the next two years.
EFFICIENCY OPPORTUNITY Over the past decade, the building industry has enjoyed unprecedented growth and lower cyclicality than in any prior period. Larger builders have taken advantage of the growth period to raise home prices, but the opportunities to remove permanent costs through aggressive cost cutting have yet to be realized. Examples of remaining opportunities for improvement include process simplification, national purchasing, quality control, supply chain management, value engineering, vertical integration, and training, both internally and of the subcontractor base. We will drill down on these opportunities in a future edition of BIG BUILDER.
DRIVERS WANTED Since 1994, U.S. household growth has eclipsed growth in the housing stock, generating a supply shortage. The key demographic segments contributing to this increase include:
The chart above compares the housing stock to both household formation and job growth since 1965. Although the undersupply of homes in the past decade relative to household formation is clearly visible, of equal importance is the trend of lower cyclical troughs and peaks in comparing the housing stock to new job formation. This demonstrates increased builder restraint in good markets and the general shift to a “build-to-order” operating model.
THIRD SOFT LANDING UNFOLDING Mortgage liquidity has increased significantly since the early 1990s. This, combined with favorable demographic trends, has muted the cyclicality of housing demand. As a result, the housing market has survived two “soft landings” in 1994-95 and again in 1998-2000. We believe a third soft landing is unfolding currently, as mortgage rates are starting to inch higher.
SOFT LANDINGS EXAMINED 1994-95. In 1994-95, new home sales dropped 24 percent from peak levels due to a sharp 240 basis point increase in mortgage rates to 9.2 percent. In this period, year-over-year earnings growth (per a selected peer group) remained above 20 percent, but stocks declined 40 percent.
1998-2000. Again in 1998-2000, new home sales fell 17 percent from peak to trough over a 19-month period, as mortgage rates jumped 160 basis points to 8.4 percent. Earnings per share growth remained robust, with the lowest rate at 31 percent. However, this did not offset a 26 percent decline in the average stock price, from peak to trough. We note that this was largely due to a sector rotation into technology stocks, which we believe is unlikely to reoccur.
2004-2005. Since June 2004, the Fed has executed a typical tightening, with 11 increases of 25 basis points each in the fed funds rates to 3.75 percent currently. The yield curve has inverted, however, and mortgage rates have decoupled from their typical relationship with short-term rates. As such, the 30-year fixed rate is at 5.8 percent, up just 60 basis points from its low in June 2003. Lower rates along with steady job increases and consumer confidence are driving robust housing demand, which in turn is driving record earnings power for the home builders.