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Rising Mortgage Rates Spell Trouble for Homebuilders

Zachary is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors were just getting used to the idea of a rebound in the housing market; and now, a sustained rise in mortgage rates may lead to disappointment once again.
 
At risk are the domestic homebuilders, a group of stocks that have advanced significantly over the past few years, but may now be vulnerable to a lapse in demand for housing.
 
The most well known home builders are now trading at valuations that fully account for the recent rebound in the housing market. These stocks are vulnerable to a significant decline as mortgage rates pressure the industry. I would recommend locking in any gains in the sector today, and selling these stocks before they sustain further declines.
 
Mortgage rates are moving higher 
 
On Wednesday of this week, Freddie Mac announced that mortgage rates moved higher for the sixth straight week. 30-year fixed rates hit a 14-month high at 3.98% as benchmark treasury bonds continue to soften.
 
The underlying issue at stake is the uncertainty surrounding exactly how and when the Fed will taper its bond buying program. Artificially low interest rates -- fueled by massive asset purchase programs from the Fed -- have helped drive demand for new as well as existing homes.
 
But as the Fed winds down its operations and interest rates begin to rise, the fear is that higher funding costs for home purchases will dampen long-term demand for new homes.
 
Today, I will take a look at some of the most vulnerable homebuilders, in order to avoid losses as capital rotates out of this industry.
 
Premium homes, premium stock price 
 
Shares of Toll Brothers (NYSE: TOL) have the highest price to earnings multiple of the group. That's fitting, because the company builds the highest priced houses of the group as well. Shares are currently trading for about 20 times next year's expected earnings.
 
Toll Brothers currently has a debt level of $2.48 billion, which is reasonable given the company's cash balance of $936 million and a healthy level of real estate assets as well. The majority of the company's debt will not mature for well over five years, so there is no pressing need for capital.
 
Toll Brothers will likely face less pressure from interest rates than competitors because the company's typical client is much more financially secure. The average selling price is $573,000 versus most other public home builders who are in the mid to upper $200,000 range.
 
Still, with the stock trading at 20 times forward earnings, and the overall housing market likely to endure a decline in demand, the stock should have a hard time advancing much farther.
 
Aggressive growth, potential risk 
 
The management team at KB Home (NYSE: KBH) has worked hard to structure the company for aggressive growth. The group currently has nearly $2 billion in debt and is actively buying up land.
 
If the market for new homes continues to expand rapidly, KB Home will likely be one of the biggest winners. But, if higher mortgage rates cause more slack in home buying demand, KB Home definitely has more to lose.
 
Analysts expect the company to earn $1.14 per share next year (fiscal year end November, 2014), which is up more than 300% from the current year estimates of $0.26. But, although a 300% growth rate is very attractive, it is unlikely that the company can sustain growth anywhere close to this level past 2014.
 
KB Home is growing earnings after a severe slump, and is vulnerable to any decline in demand for new homes. It would not be unreasonable for investors to place a price-earnings multiple of 10 or 12 times forward estimates, given the uncertainty in the market. And that would represent a stock price between $11.40 and $13.70 -- quite a drop from the current price.
 
Reasonably priced, most to lose 
 
While Lennar (NYSE: LEN) sells some of the most reasonably priced new homes, this also means that the company's future growth may be much more affected by interest rates.
 
While luxury homebuilders such as Toll Brothers market their homes to affluent buyers with plenty of capital, Lennar pitches its homes to potential first-time home buyers based on the cost savings of buying versus renting.
 
As interest rates rise, this potential savings becomes less distinguishable. Lennar's customers don't typically look at the overall price of the house as much as the monthly cost of the mortgage (plus insurance, utilities, HOA fees etc.).
 
Shares of Lennar are currently trading near 16 times next year's expected earnings (fiscal year end November, 2014). While this is lower than both KB Home and Toll Brothers, the discounted valuation is justified given the company's risk to mortgage rates as well as the overall employment environment.
 
Too much risk to justify 
 
Home builders have been a tremendous investment as the housing market rebounded from a severe recession. But now that interest rates are on the rise, these stocks could wind up being stagnant investments for a significant amount of time, or they could decline materially as investors account for new risks.
 
Rather than waiting to see exactly how the Fed will proceed, I recommend selling out of home building stocks and looking for more attractive growth opportunities. The key here is managing risk before a decline in these stocks adversely affects the value of your portfolio.
 

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Zachary Scheidt 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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