Separating the West from the Rest Shows Opportunity in Housing

Dan Oppenheim
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SEE LAST PAGE OF THIS REPORT Dan Oppenheim , CFA

FOR IMPORTANT DISCLOSURES (415) 889-5617

doppenheim@ssrllc.com

December 12th 2018

Separating the West from the Rest Shows Opportunity in Housing

  • Housing statistics heavily influenced by deterioration in the west; healthier trends elsewhere. Recent housing news has been decidedly negative, based on a slower pace of home sales, higher inventory, worsening affordability, and slowing home price appreciation. However, much of the lower sales, rising inventory, and modest pricing has been in the west, where there’s been a sharp deceleration from San Diego to Seattle. In other regions, we’ve seen some easing of activity, but generally not close to the magnitude of the slowdown in the west. In addition, the recent decline in interest and mortgage rates (if sustained) will limit the decline in turnover that we otherwise expected to continue into 2019, as declining rates with a slowing economy can serve spur a shift to home ownership.
  • Opportunities in homebuilders, preference for LOW over HD and INVH over AMH; beginning to look at building products. We believe the valuations of larger homebuilders with lower west coast exposure (DHI, LEN, and PHM have 30-35% west coast exposure and NVR has none) are attractive, with many trading at 1.1-1.3x estimated 2019 tangible book value. Our more positive view is based on the reasonable trends in non-western markets, rather than simply being a function of valuation, which rarely works in the homebuilding sector. Those homebuilders with greater west coast exposure (KBH, TOL, and WLH) are trading well-below estimated 2019 tangible book value, but we remain concerned about additional slowing and risk to book value in the west. Among the home centers, the potential for less of a decline in turnover due to the falling mortgage rates, may limit the risk to home improvement spending. We believe that LOW’s lower west coast exposure represents a relative strength as compared with HD, and also see the potential for operational improvement for LOW following the recent management changes and initial actions. For the single-family REITs, we continue to expect a benefit from modestly lower turnover, which would drive higher occupancy and rent growth with less pressure on expenses. However, further declines in mortgage rates would potentially lead to higher turnover, with greater impact on AMH (more affordable markets) than INVH. For multifamily REITs, we favor AVB, CPT, and EQR. Within building products we have concern about slowing big-ticket remodeling and favor Masco (MAS) (Exhibit 1).
  • Deterioration in the west impacting overall housing trends. Real estate trends always vary across markets, but we believe that the current differences – healthy conditions in the Southeast, Texas, Southwest, and less impactful Northeastern and Midwestern regions, but severe slowing in the West – are greater than the regional variations typically seen. For example, our analysis suggests that slower sales in the west have accounted for approximately 70% of the national slowing of sales in recent months, despite the west representing just 22% of total annual existing home sales (Exhibit 2). Similarly, we’ve seen inventory levels increase meaningfully in the west, with inventory up sharply in markets such as San Francisco (up 63% year/year), Seattle (up 78% year/year), Southern California (up 32% year/year), with these areas accounting for more than the increase in inventory nationally (Exhibit 3).
Exhibit 1: SSR’s Preferences Among Housing-Related Sectors
Source: SSR Analysis
Recent trends show declining sales in the west influencing the national housing stats. Existing home sales have slowed on a national basis, but the driver has been weakness in the west, rather than consistent weakness across markets. That is, in October, existing home sales nationally would have declined just 0.9% year/year (not seasonally adjusted) without the impact of slowing in the west. Most regions continued to see generally healthy sales, with a 2.9% year/year decline in Atlanta, a 4% increase in Austin, a 3.7% decrease in Dallas, a 2.4% increase in Houston, and essentially flat in Orlando (down 0.4%) and Phoenix (down 1.2%). However, there was significantly more weakness in west coast markets. Sales in California are now back to levels more commonly seen in the early recovery in 2011 and the slowing in 2014. In addition, we have seen worsening trends continue through November with both closed and pending sales falling 10-20% year/year in key west coast markets.

Exhibit 2: Slowing Sales in the West Impacting National Trends

Source: SSR Analysis of MLS trends

Rising inventory indicates the shifting balance of the market. The slower sales activity has led homes to stay on the market longer, with higher inventory levels overall. Nationally, the increase has been slight, with just a 0.9% year/year increase, but west coast markets have seen inventory increase sharply, with a 28% increase in California in October (and higher still in November, we believe). Some markets such as the SF Bay Area and Seattle say large increase in inventory in percentage terms, but inventory remains modest in months of supply. However, inventory levels are higher in Southern California, where we have greater concerns about pressure on home prices. Consistent with that, 44% of homes on the market in California in October had seen price reductions, well above the 31% nationally, which was impacted by the high level of reductions in the west.

Exhibit 3: Rising Inventory Far More Concerning in the West than Elsewhere
Source: SSR Analysis

West coast to show further deterioration, potentially creating opportunity. We expect to see national housing statistics negatively impacted by further erosion of west coast trends in the coming months, both due to fundamental weakness driven by affordability issues, but also by temporary issues. That is, we believe that the combination of 1) higher home prices, 2) mortgage rates (even with the recent easing) along with 3) the impact of the effective elimination of deductibility of real estate taxes in high-coast west coast markets due the tax changes has hurt severely impacted affordability in the west and limited the pool of buyers. In addition, we expect added (temporary) weakness in home sales in California in November and December, as the fires and poor air quality impacted contract activity in November. However, we believe that this weakness in the west and the impact on national statistics may present an opportunity for homebuilders with less west coast exposure and would begin to look at home centers, should the stocks see further weakness.

Attractive valuations for many homebuilders given solid trends in non-western markets. We see opportunity in many homebuilders, given the reasonably healthy trends in markets away from the west coast and valuations near book value, which we believe reflect concern about housing across the country. We believe that homebuilders such as D. R. Horton (DHI), Lennar (LEN), NVR (NVR), and Pulte (PHM) are well-positioned, given that they generate either no profits from the west in the case of NVR, or approximately one-third of profits from the west for DHI, LEN, and PHM.

Exhibit 4: Attractive Valuations for Homebuilders
Source: SSR Analysis

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