If there was an exploding keg that lit the 2007/8 financial crisis it was the mortgage market. Since March 2022 the US Federal Reserve has hiked rates faster and harder than other central banks to bring inflation under control. The impact for anyone taking out a mortgage is dramatic – the average 30-year fixed-rate mortgage has doubled in two years to 6.39%.
The recession has been widely forecast for some time. If it is to come, you would think that housing might once again play a lead role in the drama. So why am I investing in companies in this sector?
There is no doubt that today’s interest rates are painful. Someone buying an average-priced US home with a 20% deposit, will see their interest payments rise from c.$1,800 a month to c.$2,500. In the first quarter of this year, the average house price fell 9%.
But this is not 2007. Banks have not been lending recklessly and packaging up the debt to hide their folly. Yes, house prices have fallen – but they had risen nearly 50% between the end of the first quarter of 2022 and the end of the year. This looks more like the market taking a breather.
The reason I say this with such confidence is simple – it is the miracle of the 30-year US fixed-rate mortgage. Nine out of 10 mortgages in the US are locked into these ultra-long agreements with rates typically between 3% and 4%. If rates fall homeowners can renegotiate. If rates rise they watch on unperturbed.
Only those moving house or buying a first home will be directly impacted by today’s rates. Tough for them, and that explains why sales of existing and new homes fell over 30% year on year last year. New home sales have recently staged a modest recovery and there are several reasons to be confident that the market has stabilised.
As in other countries, there is a shortage of housing – homebuilders have been more cautious since the Great Financial Crisis so there is pent-up demand. Companies like DR Horton have adapted to the present challenges by offering higher incentives to stimulate demand and by building smaller homes. To counter the impact on profitability management at DR Horton has worked to find efficiencies. The company has shaved 12 days off the construction cycle.
This is encouraging. But we are still wary. We prefer to gain exposure to this sector tangentially, for example through suppliers of materials. Builders FirstSource pre-fabricates lumber roof structures and ships them to construction sites, saving builders both time and money. It manufactures a range of materials required on-site – staircases, doors, windows, and kitchen cabinets.
Suppliers have a big advantage over homebuilders – in a slowdown, they can reduce investment in inventory. This enhances their free cash flow. Consequently, Builders FirstSource has been able to buy back a significant portion of its shares. This means when a recovery comes earnings per share will be boosted. The company also has another source of income – all those people locked into cheap 30-year mortgages who cannot move and so choose to remodel and refurbish. The Covid lockdowns enabled many Americans to build up savings and some of that cash is going on the home.
Builders FirstSource has also been a smart acquirer of competitors, which is helping it to broaden its reach, widen its product offering, and serve more areas. Through acquisitions, it is leveraging its brand and logistics expertise.
Investing in suppliers makes you less reliant on a narrow segment of the market – buyers of new homes. It can also be another way of playing Biden’s huge infrastructure spending plans. Vulcan Materials and Eagle Materials produce aggregates, like gravel, ready-mixed concrete, and sand that will be vital in the construction frenzy we expect to come.
Finally, no building happens without preparation, whether it is a house, a factory, or a road. Ferguson Construction provides pre-construction services like feasibility studies, planning, design, and estimating. This is another company with several income streams.
Have interest rates hit the roof?
Last year was a difficult one for homebuilders in the US. The sector has historically bounced back strongly from such setbacks. There are reasons to be positive – not least that interest rates appear to be nearing their peak, which should help the sector. But there are still risks. Central banks have always struggled to tame inflation – it is like a pernicious weed that keeps reappearing no matter how often you seem to cut it down.
Our approach to tackling the housing sector from the side enables us to have exposure while mitigating some of the risks.