Watching for a Downturn in the Home Market

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The National Association of Realtors recently warned that home prices are moving to far too fast. The only thing that can help solve the problem is more construction. That will be good news for home builders, until it isn't anymore.

The housing market was pummeled by the 2007 to 2009 recession, which had its roots in the finance and housing markets. Banks were lending too easily and home buyers were rushing to buy before prices got even higher. The end result was a massive housing market crash and years of stagnant home sales and moribund home prices.

The carnage, however, has started to clear as institutional investors like BlackStone (NYSE: BX) stepped in to build institutional single-family home businesses. That removed much of the cheap existing inventory from the market. New home sales from builders like Lennar (NYSE: LEN), DR Horton (NYSE: DHI), and Toll Brothers (NYSE: TOL) have increased to pick up the slack in supply.

The good news

For now, the builders look to have solid businesses. However, the National Association of Realtors has come out to warn about the swift rise in home prices. The group was late to highlight the risks on the way up before the housing crash, which may be making them hyper sensitive the second time around. That said, there are increasing similarities between the two periods.

For example, investors are being pushed to act. While the boom years' drive was to get in before home prices went up, now the impetus is to get in while prices and mortgage rates are still low. Seeing this, banks have become more accommodating by loosening their lending standards. The combination of these events could be pulling demand forward and setting up a downturn.

There is a distinct possibility of interest rates passing a tipping point where buyers can no longer afford homes and the market corrects again. Investors need to monitor this closely.

Looking for clues

The clues to a downturn at the publicly traded home builders can be found in home builders' backlogs.

Lennar reported second quarter results in late June. It delivered 4,464 homes, an increase of 39% year over year. In the first quarter, the company delivered 3,186 homes. Clearly things are getting better. New orders in the second quarter totaled 5,705 homes, up 27%. The first quarter saw orders of 4,055 homes.

The company's second quarter backlog stood at 6,163 homes, amounting to $1.9 billion. The first quarter's backlog was 4,922 homes with a value of $1.5 billion.

These are the numbers to watch. As long as the trends here are positive, the company should continue to reward investors. Earnings went from $0.26 a share in the first quarter to $0.61, showing the leverage on the way up. However, earnings fell from over $3.50 a share in 2006 to a loss of more than $12 in 2007, showing that leverage can be a double edged sword.

DR Horton reported its second quarter results in late April and is next up to report. It closed on 33% more homes on a year over year basis last quarter, with a total value 47% higher than the prior year. New orders were up 34% based on the number of homes and 52% based on the value of the homes. The home count in the backlog increased 54% with the value advancing 76%.

The magnitude of the improvement on a year over year basis is astounding. “With $250 million in pre-tax income through the first six months of the year, we have already exceeded our pre-tax profits for all of fiscal 2012,” the company noted recently. A turn for the worse, however, could have an equally large effect in the opposite direction.

Toll Brothers' late May second quarter earnings release related a similar story. Deliveries advanced 38% year over year. New sales were up 36% based on home count, but advanced 57% in dollar terms. The average price was $678,000 in the second quarter, up from $631,000 in the first quarter and $585,000 in the second quarter of 2012. Backlog was up 52% to 3,655 homes, but advanced 69% in dollar terms. The average price of a home in backlog was $693,000. The company should report again in August.

Follow the numbers

Luckily for investors, these three home builders report in a sequential pattern. Lennar just reported, DR Horton should report in late July, and Toll should report in August. Keeping tabs on the backlogs and sales of the publicly traded home builders, then, is easier than you might expect.

Although this trio's shares have come down a little of late, they all remain well above their recessionary lows. Essentially, the homebuilders are most appropriate for momentum investors as their core businesses ramp up again. But, you need to watch closely for slowing sales trends and be particularly watchful for a reversal. 

Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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