Description

Overview

NVR is one of the largest homebuilders in the US and builds single-family residences, townhomes, and condominiums. Its primary areas of geographic focus are the Washington DC and Baltimore metro areas, which accounted for 22% and 9% of settlements and 27% and 11% of 2019 homebuilding revenue. The company operates under the trade names Ryan Homes, NVHomes, and Heartland Homes and sells primarily to move-up buyers but also builds starter and luxury homes. NVR is currently developing 563 communities in 14 states and the District of Columbia. In addition to DC and Baltimore, it builds in the suburbs around Philadelphia, Pittsburg, Cleveland, Cincinnati, Indianapolis, Chicago, Charlotte, Raleigh, Nashville, Greenville/Spartanburg, Orlando, and Tampa. NVR sold nearly 20,000 homes in 2019 at an average price of $367,000.

NVR is different from other homebuilders primarily in that it does not engage in land development. It has long procured building sites using options which allow it to acquire finished building sites from developers at a fixed price. This requires NVR to pay the developer an up-front payment of up to 10% of the finished value of the lot. This way NVR can control the supply of needed lots without having to invest a huge amount of capital and gives them the ability to not exercise the option with only the initial premium at risk. Typically, the company has controlled enough lots for five years’ worth of building. NVR currently controls over 100,000 lots. In the past the company has purchased raw land on occasion but this has typically involved unique circumstances and the company utilizes JVs with developers to develop the land.

NVR typically sells homes on a pre-sold basis rather than engage in speculative building. This approach, plus its lot acquisition strategy showcase the conservative nature of its operations. This conservative way of doing business is also reflected in the company’s capital structure. Currently NVR has net cash on the balance sheet of over $800 million. In years past the company has often been in a net cash position. When it has used debt, it has used it sparingly. After being founded by Dwight Schar in 1980, NVR filed for Chapter-11 bankruptcy protection during the real estate slump of the early 1990s. It had heavily used bank lines of credit and issued high-yield debt to buy Ryan Homes in 1987. NVR owned a significant amount of land heading into the downturn which declined in value. Interestingly, in the late 1970s, after leaving his job with Ryan Homes (the same Ryan he bought a decade later), Schar started NVRLand which purchased and developed raw land for homebuilders in the DC area. I would imagine that the difficulty of bankruptcy plus the experience of being a pure land developer greatly informed Schar’s view of the business and led to NVR being run in a more conservative manner after the bankruptcy. Schar is currently a large shareholder in NVR and its Chairman.

Financials

The most noteworthy aspect of NVR’s financial position is how it operates with a relatively small amount of capital and it manages to generate very high returns on incremental capital. For example, the company generated homebuilding revenue of $7.22 billion and NOPAT of $830 million while employing only $2.7 billion of capital in the business, including cash. Over the past three years, capital invested has increased by $1.1 billion and NOPAT has increased by $386 million for an incremental ROIC of 35%. Over five years, the incremental ROIC has been 40%. Even more incredible, the company has produced positive free cash flow every year going back 15 years! Even during the depths of the real-estate downturn, free cash flow was negligible in 2011, but still positive.

The company has managed this feat using the policies previously mentioned: it does not tie up capital in land development but rather purchases options on finished lots. Instead of speculative building, it pre-sells homes so it receives an upfront payment from consumers and is less likely to be stuck holding real-estate for long periods of time. Thirdly, it outsources most aspects of construction to contractors based on fixed price contracts. As a result, NVR’s gross margin has been stable as has the gross profit per settlement. As homebuilding volume has increased in recent years, there has been some SG&A leverage with SG&A/settlement declining from $31,100 in 2011 to $22,800 in 2019. As a result, operating margins have increased in recent years. Over the past five years, gross profit/settlement has increased at a CAGR of 0.5% whereas SG&A/settlement has declined at an annual rate of 5.5% which results in operating profits/settlement growing by 5% over the past five years. This is noteworthy because the average settlement price for an NVR home over the past five years has been flattish. Over the past three, five, and seven years, settlements have increased at a CAGR of 10% as volume has recovered in the wake of the financial crisis. The company has shown that it can maintain profits as it builds more low-priced homes and homes in areas of the country with lower price points. One of the largest impediments to household formation and home ownership has been high prices, so going forward it will be crucial for builders who wish to grow to provide affordable housing. In fact, several NVR communities in places like Florida, Ohio, and South Carolina, homes start at under $200,000.

Given the company’s streamlined operating model and the competitive pricing environment, the company’s future profits will depend in large part on the volume of future builds. For that reason, the next section discusses the potential for home sales in the US over the coming decade.

Housing Industry Shortage

The primary component of the thesis on NVR is that home building will remain strong and even strengthen in the years ahead. In the aftermath of the real estate bubble, housing completions have vastly fallen short of what is needed to the point that the excess inventory built up during the bubble has been absorbed and then some. Given the underbuilding of recent years, we are now in a supply deficit. In data going back to 1968, approximately 1.4 million privately-owned housing units have been completed in the US per year. However, the number of completed units has fallen below that total annually for the past twelve years.

The Updated Household Growth Projections from the Joint Center for Housing Studies of Harvard University estimate that from 2018 through 2028, there will be over 1.2 million households formed per year, which is 20% higher than the previous five years. These estimates include a reduced level of foreign immigration and a slight decline in the rate of household formation amongst younger households. Overall, the study forecasts an annual need of 1.5 million new housing units over the next decade. The study concludes: “In fact, current additions to the housing stock are falling short of the needed rate given current levels of household formation. The reasons for this shortfall are not entirely clear but suggest that some form of supply constraint may limit the market’s ability to meet demand for housing. If that shortfall persists, the expected result would be rising housing prices and rents that would result in lower rates of household formation.” In other words, because not enough housing is being built, rents and prices will continue to rise and household formation will be negatively impacted. Of course, the flip side of this is that perhaps more homes being built and low mortgage rates stimulate an increase in the rate of household formation which in turn will lead to more units being built.

NAREIT estimates the current shortage is around 4 million housing units given underbuilding over the past decade, especially of single-family units.

Research published by Freddie Mac in December 2018 estimates that the US housing shortage at that time was approximately 2.5 million units. Freddie estimates the current rate of annual demand is approximately 1.62 million housing units based on a growing population, need to replenish the existing stock and need for more vacant units to improve housing market dynamics.

The research points out that in 2016, almost 90 million US residents were between the ages of 15 and 34, which is 6 million more individuals than the population aged 35 to 54. As the median age of the first home purchaser is early 30s, demand for homes will increase as this cohort ages into prime homebuying years. Freddie estimates formation of 20 million households from young adults over the next decade. This of course will be offset by declines in households from older residents yet net growth will be healthy. In addition, older residents have shown a greater preference than past generations for staying in their residences longer. This is enabled by improvements in health and greater home healthcare options.

The following table reflects Freddie’s estimates for annual housing needs based on growth in households, replacement of existing units, demand for second homes, and a necessary increase in housing inventory available for sale or rent due to the very low level of current inventory.

Note the current completion rate of privately owned units of around 1.2 million is below the low estimate of 1.3 million and significantly below the high estimate of 1.8 million. Using either of the baseline estimates from Harvard or Freddie, the US will need completion of between 300,000 and 400,000 additional housing units (as compared to current production) annually going forward, or an annual increase of nearly 30% based on completion levels in 2019.

Obviously, the need for homes can vary greatly by geography with certain areas of the country being adequately supplied while others face shortages. Research from Freddie Mac published in February 2020 looked at housing supply on a state by state basis and found that there are 29 states facing a housing shortage, and looking just at these states, the overall housing shortage increases from 2.5 million to 3.3 million units. For each state Freddie looked at the vacancy rate in 2018 compared to historical vacancy rates for that state. The research showed that the vacancy rate in 2018 was low relative to the past for Maryland, Washington DC, Virginia, North Carolina, and Florida. These states combined represent a large portion of NVR’s sales which likely indicate sustained demand in these markets, particularly Washington DC, Florida, and North Carolina due to a combination of population gains and low current vacancy rates.

The numbers previously discussed obviously include owned homes and rentals, so change in the home ownership rate are relevant for homebuilders. The home ownership rate bottomed in Q2 2016 63.1% and had rebounded to 65.1% as of Q1 2020. Peak home ownership was 69.4% in 2004. I think it is unlikely that the home ownership rate declines significantly from here, mostly due to the favorably cost of financing for mortgages as compared to rental rates and the aging millennial cohort. A combination of strong demographic-driven growth and insufficient supply will lead to a powerful tailwind to the homebuilding industry for years to come.

Recent Events

While it is difficult to gauge the long-term implications from COVID-19, the impacts of the pandemic are likely to increase people’s desire to both own a home and potentially own a home outside of large urban areas. Probably the biggest impact of the pandemic has been millions more employees working from home (WFH) for extended period of time. During the period of peak quarantine in May, over 50% of employed Americans worked from home full-time and an additional 18% worked from home part-time. These employees total more than 100 million workers in the US. Likely many of these employees will continue WFH after the pandemic passes. Many companies have already announced plans for at least a portion of their workforces to WFH permanently, with other allowing for WFH part-time.

The ability to WFH plus the stress of being forced to quarantine in small apartments has led to an increase in households either looking for second homes or moving to suburban areas with more space and lower living costs. For some, space and cost now trump proximity to an office. If this is in fact a durable trend, NVR will benefit given that it builds in the suburbs of several large cities including Chicago, Indianapolis, Baltimore, Philadelphia, Pittsburg, Cleveland, Colulmbus, and Washington DC. Its presence in states such as Tennessee, Florida, Delaware, and Virginia may attract individuals with the ability to WFH to those lower-tax, lower cost of living locales. Even before the pandemic, NVR was building in four of the ten fastest growing states in recent years including Florida, North Carolina, Virginia, and South Carolina.

Thirdly, in the wake of the pandemic, interest rates have plummeted. Recently the 30-yr. fixed mortgage rate fell to 3%, the lowest level in history. Measuring home affordability in terms of the monthly payment, the 30-yr. falling from 4.5% to 3% represents a difference of over $300 per month for a $300,000 mortgage, which is certainly enough to move the needle for a renter, especially one who was already looking to buy. The high cost of housing is one reason typically given for the lackluster level of household formation. Lower rates help affordability at the margin, at least in terms of monthly payment. While it is impossible to know the long-term impact of WFH as well as migration away from urban centers, coupled with interest rates, these trends are likely to benefit the housing market.

Valuation

Given the need for housing in the US, I believe it is very likely that NVR will build more homes for the foreseeable future. Based on the price today of $3,840 and 2019 free cash flow per share of $232, the stock is trading at a free cash flow yield of just over 6%. It is difficult to gauge with any accuracy how many more homes per year NVR will build in future years, but I feel confident that the answer is “more.” Starting with a free cash flow yield of 6%, it does not take heroic assumptions to get to double digit compounding. This is especially true when you consider how NVR has historically retired its shares. Over the past decade, it has retired 4.5% of its outstanding shares per year, on average. And this is in-spite of very generous equity compensation given to management. This has been a tailwind to growth in free cash flow per share. Assuming a LSD to MSD increase in homes built per year and LSD annual share reduction, low to mid-teens compounding is not out of the question. And this comes from a company with net cash on the balance sheet with a very low risk of permanent impairment.

Risks

The biggest risk to the thesis is the performance of the economy over the coming months and years. The long-term financial impacts of the pandemic are uncertain as is the extent of the eventual recovery. Currently many workers are unemployed and unable to pay their mortgage and rents. Lenders have instituted moratoriums for those unable to pay, but these will eventually expire. High unemployment and an increase in foreclosures and evictions will negatively impact the housing market but the basic need for more homes will not go away. NVR weathered the real estate crisis without a single year of negative free cash flow which was much better than other builders, to say the least. Given its balance sheet and operating model, NVR is well prepared to handle whatever transpires in the real estate market over the next few years.

An additional risk is that of rising mortgage rates as this directly impacts home (and rent) affordability. I do not know how rates will change in the future, but I could certainly see a scenario where rates are lower for longer. NVR benefits from low rates, so it makes sense pairing the stock with other securities that may benefit from rising rates to help offset this risk. And again, the US has a housing shortage so regardless of what rates are, people will need a place to live.

Catalyst

Low mortage rates, aging millennials, work from home, housing shortage