Options for a Housing Recovery

by Lawrence Meyers | February 5, 2013 11:45 am

Anecdotal evidence is suggesting that a housing recovery might be starting to sprout.

The trouble with housing is that it’s difficult to be certain — it can go in fits and starts, and it’s difficult to determine if it’s for real. Some people are concerned that this is a phantom recovery, as the housing purchases we’re seeing are cash-driven purchases by speculators looking to buy and flip, or to buy and rent.

Another concern is that this particular trend is creating another bubble in the multi-family residential market. California has its own concerns, but there has been a drop in bank-owned foreclosure purchases.

As an investor, it’s can be a dicey game trying to call a bottom. Instead, using options can be a useful way to play a potential bottom and still yield big upside if you’re right, while limiting downside if you’re wrong.

Let’s look at D.R. Horton (NYSE:DHI[1]). As a homebuilder, you’d think it would be hurting, yet the company has seen a decent operating profit each of the past three years, with $333 million in profit coming in FY2012, and $132 million in Q1 of FY2013. You can’t be too careful, though, because D.R. Horton takes write-offs and losses on inventory, so its cash flow position isn’t fantastic. Nevertheless, it’s not going bankrupt, so it’s worth looking at from an options perspective.

I think housing is the kind of thing you need to use LEAPs for, as you are more likely to see a big change in the overall situation over a year or two, not in a month or two. In this case, I would consider buying at-the-money calls, because when we get that clarity, these stocks will move quickly.

As I write, DHI trades at $22.86. The January 2014 $22 Calls are going for $3.50, meaning you will make money if the stock is at or above $25.50 by next January. That being said, I prefer the January 2015 $22 Calls, which are going for $4.85. It’s a slight increase in cost, but it buys you an entire year, and I suspect it will take two years for us to get real clarity.

Like D.R. Horton, Lennar (NYSE:LEN[2]) also can have large inventory write-offs, but both companies have something else in common, which is the ability to carry forward some large tax losses. You have to look at operating income as a result, since the income tax issue increases the company’s net profit. Indeed, Lennar saw a $322 million operating profit last year as well, but it also has a lot more debt than D.R. Horton. I’m not too concerned, though, because that debt is pretty cheap at between 4% and 5%.

In this case, I’d go with the calls again. LEN presently trades at $40.55. The January 2014 $40 Calls are going for $5.70, so they are also being priced at about 16% of the underlying, just like D.R. Horton. Looking another year out, the January 2015 $40 Calls are going for $8.40. Notice that, in this case, the premium is 21% of the underlying, and a bit more for D.R. Horton, so that might be worth looking at on a relative basis.

Of course, if you think the housing recovery is all hype, go ahead and buy puts. Both stocks are offering the puts at a price of about 20% of the underlying for their respective at-the-money options. It might make for a good hedge if you own a home in an area that is still seeing price declines.

As of this writing, Lawrence Meyers[3] did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc.[4], which  brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses. He also has written two books[5] and blogs about public policy, journalistic integrity, popular culture, and world affairs[6]. Contact him at pdlcapital66@gmail.com[7] and follow his tweets @ichabodscranium.

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