Homebuilders Hedge Their Bets for 2013

by Ethan Roberts | January 18, 2013 10:18 am

This has become a very confusing time in the real estate market.

On the one hand are reports of overheated home sales, with sellers receiving multiple offers within a few days of listing. The last time real estate was this hot was in the summer of 2006. Despite soaring prices and interest rates close to 7%, that era will forever be remembered as a parabolic seller’s market.

Today, with prices some 30% to 40% lower and the 30-year mortgage below 3.50%, 2013 is said to be a buyer’s market. Yet, due to tight inventory levels, housing is partying like it’s 2006 all over again.

Ironically, just a few months ago reports showed that homeownership had fallen to about 65%, the lowest level since 1997, and that demand for rental properties was soaring. In many areas of the U.S., rents are now higher than mortgage payments.

The reasons for increasing numbers of renters include tighter lending standards, higher down payments and closing costs, a lack of trust about home prices among younger Americans and condos and apartment complexes providing amenities such as pools, workout rooms and hiking trails that cater to the desires of that youth demographic.

Yet another group to consider is the retiring baby boomers. If home prices rise, older loans are modified and principal is paid down sufficiently, more of the boomers may finally be able to sell their homes and downsize into condos. But is there enough supply to fill that demand?

Given the confusion of the emerging trends for 2013, homebuilders are faced with the dilemma of where to focus their investing dollars. Should they build more single-family homes to feed the rush of buyers, develop new condos for the boomers or build luxury apartments to address the increasing number of long-term renters?

Surprising New Plans

Apparently, the homebuilders have decided to play it safe by hedging their bets. Thus, Lennar (NYSE:LEN[1]) unexpectedly announced this week during an earnings conference call that it will be investing $1 billion for 6,500 new rental apartments over the next three years, with construction to begin in 2013.

Lennar is hoping to capitalize on a large number of families who are now unable to purchase a home because of tight lending standards. It also plans to market its new single-family homes to this group, so that the Lennar renters of 2013 will ultimately become Lennar homebuyers in the future.

Lennar wasn’t the only company with a surprise this week. Toll Brothers (NYSE:TOL[2]), a leading builder of high-price executive homes, announced its intentions to build condos in a diverse group of cities, including Washington, D.C., Miami, Los Angeles, San Francisco, Seattle and Vancouver, B.C. Toll’s City Living division already has 10 condos under construction in New York City.

Toll Brothers’ strategy is to appeal to young urban professionals who don’t want the maintenance of the large suburban home, as well as baby boomers who are looking to downsize. Toll Brothers aims to market the condos to wealthy baby boomers who’ve previously purchased homes from it.

Both companies’ strategies entail some risks. If the rental market weakens, say, from an oversaturation of rental units or because tenants discover it’s cheaper to buy than rent, Lennar could be left with an expensive, underperforming asset. Three years ago was the time to be building apartment houses, and Lennar could be coming late to the party.

Lennar’s assumption that its tenants will also become future Lennar homeowners may be a stretch. Many tenants may opt for less expensive pre-owned homes, especially if a large number of foreclosures and short sales continue to flood the markets.

Likewise, Toll Brothers could be biting off more than it can chew. It’s no easy task to appeal to both 30-year-olds and 65-year-olds in the same condo development. It’s also assuming that boomers who’ve spent their lives in the suburbs will want to make the transition to big city lifestyles.

Nevertheless, so far the upscale condo development niche seems to be working well for Toll Brothers. It sold 21 of 22 units in The Touraine, a Manhattan Upper East Side luxury building, in less than six months. The average sale price was more than $4 million (we’re talking Manhattan). Condo prices and sales are also rising in the Washington, D.C., area, so Toll Brothers is expecting to do very well in that market also.

Looking Ahead

Over the past 12 months, both companies’ stocks have done extremely well, but Lennar has outperformed Toll Brothers by a margin of 90% to 60%. However, given the direction each company is now taking, I would expect a reversal of their comparative performances over the next two years, with Toll Brothers realizing a much higher return on investment on its business model.

This assumes, of course, that we don’t fall back into a recession, which could devastate the luxury condo market, as it did in 2009.

I would, therefore, recommend a purchase of TOL stock on any decent pullback from the somewhat its extended current price of $36.16, with $33 being a more attractive entry point.

In confusing times, sometimes it pays to cover all of your bases.

As of this writing, Ethan Roberts didn’t own any securities mentioned here.

Endnotes:
  1. LEN: http://studio-5.financialcontent.com/investplace/quote?Symbol=LEN
  2. TOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=TOL

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