How to Play the Housing Market Recovery

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

Home-builder stocks soared in 2012 and early this year but have since leveled off their earlier peak. The housing market is sure going to meet a bumpy road before full recovery is achieved; therefore, I believe there is money to be made. But finding good housing stocks is like finding a needle in a haystack.

A bumpy road to recovery

In April, sales of new single-family houses hit a seasonally adjusted annual rate of 454,000, the second-highest level since 2008, and way above last year's estimate of 352,000. Moreover, the National Association of Home Builders issued an upbeat news release on housing starts, which rose 6.8% in May, mainly because of increased construction of multifamily homes.

Thanks to institutional investors, the U.S. housing market has been driven upward. According to Forbes, Blackstone is now the largest owner of individual houses in the United States, with about $3 billion invested in foreclosed houses. Furthermore, Warren Buffett’s Berkshire Hathaway has been building out a residential real estate brand called Berkshire Hathaway Home Services that it plans to franchise with joint-venture partner Brookfield Asset Management.

As a result, the prices of real estate assets went up in more than 30 major cities around the country. Critics of the housing market recovery claim that Wall Street created the bubble, Wall Street burst the bubble in 2008, and now Wall Street is the one inflating a new bubble.

The impact of rising interest rates

Similarly to bonds, housing prices are inversely proportional to interest rates. As rates rise, fewer people qualify for loans and prices normally drop to make the housing market more competitive. This will have a negative impact on both re-sellers and home builders.

One should note that home-builder stocks are particularly sensitive to rising interest rates. Assuming rates will continue to rise, home builders are going to face a dilemma; on one hand, home builders are going to slow building due to diminishing demand, and on the other hand, home builders are going to lower prices, which is going to hurt profit margins.

During the last housing boom, interest rates were markedly higher than today's environment; the 30-year mortgage rates were between 5% and 7%. Therefore, there is no doubt about the negative impact rising rates have on the housing market. But that impact is somewhat limited and other factors, such as the state of the economy, job market, housing starts etc., may drive the housing market.

A needle in a haystack

A large number of companies rode the recent housing recovery wave; to name a few: Pulte Group, D.R. Horton, Standard Pacific, Toll Brothers (NYSE: TOL), Lennar (NYSE: LEN), KB Home (NYSE: KBH), and as well as SPDR Home Builder, the exchange-traded fund for the home-building industry. The mentioned companies demonstrated remarkable gains last year, however, those gains have recently started to slow down. Despite the recent hype over housing stocks, few companies still have upside potential except for KB Home, Toll Brothers and Lennar, which I assume will outperform other home-builder stocks.

The winning trio

Lennar, one of the nation’s leading builders, had big gains in most of its regions and segments. Lennar posted second-quarter earnings of $135 million on a 60% jump in revenue; moreover, Lennar’s earnings per share more-than-doubled. Lennar has consistently reported double-digit revenue growth over the past several quarters.

The Fortune 500 company is a veteran in its field. Lennar's return on equity (ROE) is better than most of its competitors but the company does have higher debt. The company has a debt-to-equity ratio of 1.5, meaning it is highly leveraged and for every $1 in asset value it borrows $1.50. Lennar's P/E ratio is 66, while the average P/E ratio for a stock on the Standard & Poor's 500 index is around 14.

Despite Lennar's high valuation, its CEO Stuart Miller remains positive:  “Against the backdrop of recent investor concerns over mortgage rate increases, we believe that our second-quarter results together with real time feedback from our field associates continue to point towards a solid housing recovery,” he said.

Toll Brothers, one the nation's premier builders of luxury homes and Lennar's most important rival, has experienced most of its recovery before this year while other home builders are just now catching up. Toll reported its fiscal second-quarter profit rose 50%, as the luxury home builder also reported revenue growth well above Wall Street's expectations.

Furthermore, as opposed to other home builders, luxury home builders such as Toll Brothers and KB Home are not as sensitive to rate changes. Moreover, Toll is heavily engaged in five markets showing high price increases, including Atlanta, Las Vegas, Detroit, Dallas and Minneapolis. Lastly, Toll is a highly diversified company utilizing a business strategy that purchase and develops country clubs and golf courses with land attached, which is where it builds its luxury homes.

KB Home, the Los Angeles-based home builder and the largest home builder in the Golden State, has been doing really well during the housing market recovery. Although not competing head-to-head with Toll and Lennar, KB Home had the largest percentage rise in average selling prices among its peers in the past several quarters and it is likely to repeat performance.

KB Home recently announce it is going to include cutting edge technology in new homes, the Wiser home management system, which allow homeowners to track their home’s energy consumption in real time.

The Foolish bottom line

Despite that fact that many analysts believe the housing recovery is unsustainable, I certainly believe the housing recovery is solid and widespread and we are only in its early innings. My favorite housing stocks are KB Home, Toll Brothers and Lennar, out of which Lennar stands out. The companies present strong growth and are not sensitive to rising interest rates. Moreover, assuming the economy will continue its comeback, more people will buy houses, and perhaps this time not only will Wall Street enjoy recovery but the average Joe will be rebuilding America.

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Yaniv Hirsch 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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