Last week the Federal Reserve raised interest rates for the 17th time in a row. This is dire news for the Homebuilder Industry because with every interest rate hike, it gets that much tougher for new home buyers to afford to buy a home. It also introduces an additional negative factor into the equation, in that existing homeowners become worried as to whether they are losing equity in their homes. This may induce them to panic and to put their homes up for sale. These same homeowners, many of whom took out ARMs (Adjustable Rate Mortgages) or “Interest Only” mortgages a few years back, will soon see reality knocking at the door.

Reality will come in the form of higher mortgage payments adjusted to current interest rates. Fortunately, many homeowners have seen their homes appreciate in value significantly over the past 3 years and this signifies higher equity in their homes. As a consequence, some were able to get fixed mortgages, but nevertheless may be concerned about falling house prices in their area, which may induce them to sell as well. With each existing home that goes on the market, it makes it that much harder for the Homebuilder Industry, as existing home sales constitute strong competition.

As an analyst, I like to take theories such as the one presented above and go out and see for myself what is happening on Main Street. Over the past few years I have been driving around the various neighborhoods in the metro Seattle area and have been on the lookout for “For Sale” signs. About three years ago, we were in a “sellers” market and “For Sale” signs were non-existent. This was due to the fact that whenever a home went up for sale, there were a dozen buyers waiting in line to make a bid for it, making the need for a sign superfluous. Exactly the opposite scenario is in place currently. Within a three-mile drive on West Mercer Way on Mercer Island, Washington, the other day, I was able to spot 23 “For Sale” signs. Mercer Island exemplifies a nouveau riche residential area that is located just a few miles from the central Seattle business district. Its residents are good examples for our analysis because they are the type of consumer that the Homebuilder Industry targets when marketing their homes. Perhaps one can argue that this was an isolated event and that it has no bearing on the rest of the country. However, I should mention that I received further verification of this scenario the other day when listening to CNBC commentator Ron Insana. Mr. Insana took a similar drive in Nyack, New York, a suburb of New York City. He reported very similar findings to those that I saw on Mercer Island. Nyack, like Mercer Island, is a key market for the Homebuilder Industry.

The scenario I have just outlined is part of what a qualitative analyst does. A qualitative analyst masters his trade, in part, by studying the works of Philip Fisher (the father of Qualitative Analysis) whose masterpiece, Common Stocks and Uncommon Profits, is a must-read for anyone who is serious about investing. It is a road map of things to look for on “Main Street” which signify just how good a company, its management or the Industry as a whole, is performing. Fisher analysis also works well with macro-economic analysis when trying to predict how the economy will affect a particular industry.

By contrast, quantitative analysis is not instructive in analyzing the Homebuilders at the present time. Quantitative analysis was brought to the forefront in 1934 by Benjamin Graham in his masterpiece Security Analysis which he wrote with David Dodd. Prior to Graham’s work, those who analyzed companies in a quantitative fashion were statisticians and later, were called Security Analysts. A quantitative analyst “crunches the numbers” or analyzes companies in a bottom-up approach by analyzing its financials. Value is then assigned by analyzing each company in an industry, comparing companies with each other within an industry, and then forming a conclusion on the Industry as a whole. This value analysis is micro-economic in nature, and is the basis of Value Investing.

Now it is important to explain why quantitative analysis is not useful in analyzing the Homebuilders. Listed below are the eleven major players in the Homebuilder Industry that are worth noting.

Beazer Homes USA BZH $45.20 $10.46 4.32 23%
Centex Corp. CTX $47.48 $9.67 4.91 23%
Horton D.R. DHI $23.40 $5.03 4.65 23%
Hovnanian Enterpr. ‘A’ HOV $28.65 $7.09 4.04 19%
KB Home KBH $44.09 $10.54 4.18 24%
Lennar Corp. LEN $43.13 $8.60 5.02 21%
M.D.C. Holdings MDC $51.48 $11.24 4.58 21%
Pulte Homes PHM $27.23 $5.65 4.82 19%
Ryland Group RYL $43.04 $9.67 4.45 27%
Standard Pacific Corp. SPF $25.01 $6.51 3.84 20%
Toll Brothers TOL $26.05 $5.15 5.06 22%

SP = Stock Market Price
PE = Price to Earnings Ratio = SP/DEPS
DEPS = Diluted Earnings Per share
ROE = Return on Equity = DEPS/Shareholders Equity

If we were to view the foregoing table solely from a quantitative point of view, these results would be considered excellent. Indeed, as a group, the Homebuilder Industry’s results are superior to any other industry out of the 440 main industries that the federal government tracks for its Standard Industrial Classification (SIC 440) tables. In 2004, I wrote an article and concluded by saying that the Homebuilders as a group should be considered a superior investment and I actually picked it as my “Industry of the Year.” I was justified in saying so because the companies in the foregoing list skyrocketed in value and made some amazing gains.

However, despite the fact that the quantitative figures (“quants”) are excellent, the qualitative analysis is quite dire. Companies in the Homebuilder Industry are required to deal with increased commodity prices (raw materials), increased competition (existing home sellers), and a customer base that is rapidly getting priced out of the market (over-leveraged consumers). On top of this, the Federal Reserve is still uncertain as to whether it will raise interest rates again, and this produces way too much uncertainty to have any confidence in the Homebuilders as a safe investment. Moreover, if the real estate market gets flooded with existing homes, then envision the opposite scenario of what occurred in 2003-2004, and instead of a seller’s market, we will enter a buyer’s market. If this turns out to be the case, then home values will drop sharply and the equity that was accumulated will slowly erode. If the Federal Reserve continues to raise rates, then this process will be accelerated.

As if I have not already painted a picture imbued with sufficient foreboding, there is more. I am concerned that if this pattern were to continue or to accelerate, it could negatively affect the US economy as a whole, for the following reason. Over the past few years, consumers have felt very rich because they have made large equity gains in their homes, with some areas of the country experiencing 100%+ gains. These increases have created a wealth effect that has permitted the same consumers to borrow off this equity, particularly since banks and mortgage lenders have flooded the market with opportunities for second mortgages, home improvement loans, and credit card offers. So now we have consumers who have exploited the strong equity in their homes in order to buy cars, furniture, take trips, or renovate their homes, if not to buy a second home. When lending money, creditors based their decisions on the accumulated equity in the applicant’s home.

If we were to have a few more rate hikes by the Federal Reserve, then the pressures on homeowners will increase and they may panic. When those ARM loans get adjusted to current interest rates, we may see nationwide sticker shock. This will force many to put their homes up for sale immediately in order to avoid bankruptcy. If the number of homes put up for sale grows to the point where there are not enough buyers to purchase them, then the lender community will be forced to start foreclosing on those who can not make their mortgage payments. When this starts to happen, then banks and financial institutions will be required to take what would have been their profits and set that money aside for “reserves for bad loans.” Consumers will begin loading up their credit cards in order to pay their loans and the credit card industry will start to have problems as well. Consumer spending will be anticipated to dry up and other industries such as the retail industry will suffer. Companies that supply these industries will also be forced to slow down operations and thus a spiral effect will take place in the economy. Housing is the backbone of the wealth effect and when people become concerned that they will not be able to pay their bills, then consumer spending all but stops.

In conclusion, it is important that the Federal Reserve stop raising interest rates. With every rate hike comes further increase in the probability of personal bankruptcy or worse, the risk of a recession. Recessions are ugly beasts and everyone suffers. For those interested in the extent of damage caused by a recession to the Real Estate Industry, look at the years 1989-1991. Any way you look at it, the Homebuilder Industry is a dangerous place to invest unless interest rates were to be reduced.

Note: Peter George Psaras is not an Investment Advisor and nothing mentioned above can be construed as investment advice. All Research is written and produced as an information source only, and is not a solicitation to buy or sell securities. Investing in securities is speculative and carries a high degree of risk. All information contained in this research should be independently verified. Investors are reminded to perform their own due diligence with respect to any investment decision. Factual material is obtained from sources believed to be reliable, but Peter George Psaras is not responsible for any errors or omissions. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.