When interest rates rose sharply from their mid-June lows, investor response was predictable -- home builder stock ratings went from hold to sell. "Home builders have historically shown and continue to show a strong negative correlation with the direction of interest rates," maintains J.P. Morgan Securities home building analyst Michael Rehaut, CFA, in a note published Aug. 13. Counters Fred Cooper, vice president of finance at Huntingdon Valley, Pa.-based Toll Brothers: "Conventional wisdom on Wall Street is that home builder stocks fall when rates rise, but over the past seven years rates have risen three times and we've continued to grow very strongly."
So, given the context, should conventional wisdom still apply or is there more to the story?
First, consider the backdrop for underlying interest rates. When rates began their initial ascent in June, it was from levels that 10-year Treasury note yields and 30-year fixed-rate mortgages had not seen in the past 40 and 30 years, respectively. Those levels reflected a combination of Fed policy, inflation expectations, and extraneous factors that resulted in additional Treasury selling.
While rising rates negatively impacted total mortgage applications, the culprit was significantly curtailed refinancing activity applications, according to the Mortgage Bankers Association of America's (MBA's) Weekly Mortgage Applications Survey. As of the last full week in September, the MBA seasonally adjusted Purchase Index stood at 397.8 -- a decrease of only 5.1 percent from mid-June levels and still at historically high levels.
Part of the continued strength in housing can be attributed to innovations in mortgage finance. Federal Reserve chairman Alan Greenspan said as much during the pre-Labor Day annual Fed conference in Jackson Hole, Wyo. "The emergence of variable rate loans, the growth of the mortgage-backed securities market, and improvements in the efficiency of the credit application process ... appear to have buffered activity in the housing market to some extent from shifts in monetary policy," said Greenspan.
While rising interest rates are traditionally thought of as having a negative impact on demand, equity investors might wonder if they've also begun to hamper home builder access to the capital markets. Hardly, says Gross. "Our credit has strengthened significantly, so we're in a position to take advantage of better rates as a borrower."
That stance is affirmed by a "stable-to-positive" credit ratings outlook for the home building industry from Moody's Investor Service. "Balance sheets are the strongest they've ever been for the industry," says Moody's vice president and senior analyst, Joseph Snider. "In the 1990 [and] 1991 recession, the average debt-to-capital ratio was around 70 percent. Now it is closer to 50 percent and trending down." Toll Brothers' recent $250 million Senior Notes offering represented the "best rate we've ever gotten," says Cooper, who added that there are still "very attractive financing opportunities" for major builders.
With an economic recovery evidently under way, the debate on Wall Street rages on about the implications for home builders going into 2004. The NAHB forecasts a 10-year Treasury yield that "does not deviate far from the current 4.5 percent rage through mid-2004 [on a quarterly average basis]," says chief economist David Seiders. That bodes well for builders. "An increase of 1 percent in mortgage rates, which translates into an after-tax payment increase of roughly $40 per week, is not going to keep our customers from buying their dream home," added Cooper.
Some on Wall Street agree. In the Wachovia Capital Markets "Neighborhood Watch Survey" of home builder sales managers for August, analyst Carl Reichardt says, "With mortgage interest rates still low on a historical basis and speculative inventory tight, public home builders continue to enjoy firm demand conditions with good pricing power and appear posed to post strong earnings growth through 2003 and into the first quarter of 2004."
In addition to earnings growth, others argue that a meaningful opportunity for P/E-multiple expansion continues to exist. According to Jim Wilson, CFA, and senior analyst of business services and housing at San Francisco-based JMP Securities, home builder P/E multiples don't yet reflect the recovery stage in the economy. "We believe that P/E multiples can move into the low double-digit range during an 18-month to two-year recovery phase that may well be under way," wrote Wilson in a recent report titled "Who's Afraid of Higher Interest Rates?"
Among the risks to earning power is decelerating activity in mortgage finance. The recent slowdown in refinancing "could result in incremental operating profit pressure for home builders with above-average EBIT contribution from financial services," says J.P. Morgan's Rehaut. At Lennar, Gross disagrees. "We've been conservative in our guidance with respect to financial services and think that's already reflected in the market." Another overlooked factor softening the impact of the mortgage volume decline is the spread between long- and short-term rates. "Our profit per loan actually rises with a steepening yield curve," points out Larry Angelilli, senior vice president of finance at Dallas-based Centex.
While the impact of moderately higher interest rates on home builder earnings and stock prices continues to be debated, the bottom line is simple, says Gross. "Builders are stronger, the industry is stronger, and the environment in terms of supply and demand positions the sector to continue to experience success going forward," he says.