Description

Current environment will be more favorable for the homebuilders than what the market appreciates, even today. Unique combination of supply demand dynamics in the housing market will serve the homebuilders well and allow them to ride the housing cycle relatively unscathed. The structural supply constraint for existing homes driven by existing mortgages and relative undersupplying of housing stock will result in 1) new home sales taking share and 2) soft landing on home prices. Homebuilders' benefit from both relatively stable demand for new homes and home prices holding up is still being underappreciated in the market. Furthermore, the consolidation that will likely take place in current environment will lead to a number of homebuilders, including DHI, to grow stronger.

Existing home inventory is near a historic low as existing mortgages are the lowest it's ever been. Of the mortgages currently outstanding, 90% are <5%, 80% are <4%, and 50% are <3%. With almost the entire homeowners' mortgages much lower than current mortgage rates, existing homeowners' incentives to move is significantly depressed as trading-up will significantly increase housing payments and trading-down will require a significant trade-down. This has resulted in new listings to continue its significant decline (exhibit A) and existing home inventory being near all-time low with new home inventory filling in the gap (exhibit B). As EHS accounted for the large majority of housing turnover (exhibit C), the supply bottleneck from historic low existing home inventories will lead to significant slowdown in housing turnover and freeze the housing market. This is further aggravated by the relative lack of housing starts since the last housing cycle (exhibit D), leading to total housing inventory running at <50% of pre-COVID levels and available for sale MOS remaining below pre-COVID levels (exhibit E) despite significant slowdown of sales.

On the demand side, unprecedented increase in mortgage rate has undoubtedly destroyed demand with total housing turnover down nearly 40% from recent peak. However, the demand destruction today is an interest rate induced slowdown as economy still remains hot and we are still in early innings of generational demographic tailwind of millennials reaching peak home buying age. Historical housing cycles suggest that interest rate induced slowdown tend to be more short lived as homebuyers jump back into the market after adjusting to the new normal (exhibit F). It's also evident that first-time homebuyer demand is more resilient than repeat-buyer demand, even more so when there is a demographic tailwind (exhibit G). Despite the housing affordability deterioration, first-time homebuyer demand should stay relatively resilient and rebound from interest-rate induced slowdown should further help housing demand recover, which is near historic low on a per capita basis (exhibit H).

The first-time homebuyers, whose number will only grow due to a generational demographic tailwind, has the smallest inventory of existing home to consider for its first home purchase. Combined with the seismic shift in living patterns caused by COVID, new homes will be a great, and sometimes, the only option available for the millennials reaching peak homebuying age. Existing home historically filled a significant portion (70+%) of first-time homebuyer needs over the recent decades (exhibit I), and this will swing the other way significantly. Combine this phenomenon with the fact that new homes were supply constrained during COVID due to labor challenges/supply disruptions, which are easing today, homebuilders will have a significant offsetting force, perhaps even a tailwind, to volume during this cycle. Furthermore, the supply bottleneck with relatively okay overall housing demand has created a frozen market, in which 1) home prices will take longer to find its new equilibrium and 2) settle at a level that is higher than what you would expect in a normal equilibrium. With soft landing on home prices and "favorable" new home volume dynamics, homebuilders will be much more resilient than currently priced.

While most homebuilders will reap the benefit of the aforementioned dynamics, a subset of homebuilders, including DHI, are even better positioned. As homebuilders will play a much bigger role in providing the much needed liquidity, those that can execute on bringing new home supply to the market will benefit the most. Those that are best positioned are homebuilders that can self-fund growth and have proven scale advantage to source the supply/labor. I believe these subset of homebuilders will outperform homebuilders that relied on debt-funded growth (who will have a tougher time finding the new equilibrium for self-sustainable growth) and benefit the most from smaller homebuilders that could be casualties of the current environment.

To summarize, the tailwinds for homebuilders like DHI are 1) soft landing on home prices (slow drift down + incentives likely leveling off/trending down as buyers adjust to new normal), 2) input cost deflation and construction time normalization, 3) much better volume dynamic for new homes, and 4) significant consolidation of market share. This should lead to both top line and bottom line significantly outperforming market expectations.

Hard Landing?

What could possibly go wrong with buying homebuilders near all-time-highs in possibly a peak market? The permit trends are already starting to look nasty*! Even if they are fine in higher for longer regime, what if there's a hard landing? Will it look like the last housing cycle? No (read CalculatedRisk's post, which I think does a good job explaining link). While '78-'82 cycle will be the most similar, current cycle should fare better as 1) peak demographic tailwind is taking place today, where as '78-'82 arguably was slightly before the peak demographic tailwind (exhibit J) and 2) supply constraints, albeit less than higher for longer, on existing home inventory should persist and existing home inventory is already significantly lower (~75% estimated) vs. '78-'82 cycle (exhibit K). Thus, even if there's a hard landing, homebuilders won't be an absolute disaster + hard landing likely leads to significant consolidation that helps offset overall market weakness for homebuilders like DHI (+ some homebuilder stocks actually appreciated during '78-'82 cycle as they grew despite the terrible market backdrop).

*I think this is more so a function of many homebuilders' growth, particularly the smaller ones, in recent history having been debt funded, whose growth can no longer be funded with debt and are having to pause in order to find a new normal that they can self-fund. I believe that permits will recover as self-funding homebuilders continue to grow and historically debt-funded homebuilders find its new normal.

This is an investment best suited for higher for longer regime, which I still assign a decent probability to. While not as compelling as they were back in mid-2022, I've added to my position on the long side recently as I've built back some short positions related R&R.

Exhibit A - New Listing

Exhibit B - Home Inventory

Exhibit C - Home Sales Mix

Exhibit D - Housing Starts

Exhibit E - Total Housing Inventory Available for Sale MOS

Exhibit F - New Home Sales Historical Trends (from CalculatedRisk)

Exhibit G - First-time vs. Repeat Buyer Peak to Trough

*Baby boomers reached peak homebuying age during '86-'91 (median homebuying age during '85-'94 was 31 y.o.)

Exhibit H - Homes sold per 1,000 people

Exhibit I - EHS Absorption of First-Time Homebuyer Demand

Exhibit J - Average First-Time Homebuyer Profile

Exhibit K - Inventory Estimate

Catalyst

Market realizing and seeing existing home market is structurally losing share and subset of homebuilders gaining share