It’s lining up to be another strong year for investors who own homebuilding stocks.
Shares of the 10 builders with the most completed sales in 2016 are up an average of 60.8%. And exchange-traded funds, or ETFs, that invest in homebuilders have also notched gains that eclipse the growth in the broader U.S. stock market.
While many economists expect U.S. housing market growth trends to continue next year, homebuilders that focus on entry-level buyers could be the safest bet for further gains.
“The demand, as we see it, is likely to continue to be pretty good, but the builders that will most benefit will be those who have a focus on the low-end homebuyer,” said BTIG homebuilding analyst Carl Reichardt.
Homes sell quickly
A growing economy, solid job market, low unemployment rate and low mortgage interest rates have helped drive demand for homeownership this year. Sales of new U.S. homes hit the fastest pace in a decade last month.
The trends have also driven gains for some ETFs with exposure to homebuilders. The SPDR S&P Homebuilders ETF is up 27% this year, while the iShares U.S. Home Construction ETF is up 54.9%.
Many economists expect the economic and housing market trends to continue next year, including further increases in sales of new homes and prices.
Realtor.com’s 2018 U.S. housing forecast released this week calls for U.S. home prices to rise 3.2% in 2018, down from a projected gain of 5.5% this year, as the inventory of homes for sale begins to rise. The forecast also sees sales climbing 2.5%.
Still, favorable housing market trends may not be enough to translate into more big gains for homebuilders.
“At these valuations, close to where they’ve traditionally peaked out, you have to believe that something else has changed, something secular, either in how these companies are run or in what demand for housing relative to other consumer goods is going to look like,” Reichardt said. “And I’m not quite ready to conclude that this time it’s different.”
Most of the builders that were in business during the last housing boom have yet to see their share prices return to those high-flying levels. Even so, they are now trading close to the top end of their traditional price-to-book value, which has typically ranged between 1 and 2 times.
For now, Reichardt has “Buy” ratings on only two builders, D.R. Horton and Lennar.
Reichardt has “Neutral” ratings on most of the other builders he tracks. He also has a “Sell” rating on KB Home.
Tax plan may have impact
Through much of the housing rebound that began around 2012, many homebuilders primarily sought to cater to homeowners looking to trade up to bigger or nicer homes, which were typically pricier and translated into better margins for builders. Those buyers were also generally in a better financial position to put down a big down payment or qualify for financing.
The tax overhaul making its way through Congress is likely to have an impact on the housing market, which could affect builder stocks.
The projected corporate tax cut would benefit homebuilders, given that they tend to have high tax rates. The group of builders that BTIG tracks has an average tax rate of 34%. The proposed tax overhaul bills would reduce corporate taxes to 20%.
Other possible changes could be a drag on some builders, including a proposal to limit the mortgage interest deduction on newly purchased homes to the first $500,000 of the loan, instead of the present $1 million limit. That would particularly affect companies building pricier homes on the U.S. coastal metro areas, like Toll Brothers.
Another wild card: mortgage interest rates.
The average rate on a 30-year, fixed mortgage is 3.9% this week, down slightly from a year ago. Mortgage rates often track the yield on 10-year Treasury note, which is also essentially flat from a year ago.
Higher rates tend to be negative for homebuilding stocks because they make home loans more costly for would-be homebuyers. Realtor.com projects that mortgage rates will hit 5% by the end of next year.
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