News & Our Thinking

Ken and Steve Smith examine the current state of the US housing market. They look at the unique dynamics at play, including interest rates, millennial household formation, and a shortage of inventory. Later in the episode, Steve shares his thoughts on two contrasting home builders: D.R. Horton and Green Brick Partners. Whether you’re a first-time homebuyer or a seasoned investor, this episode is a must-listen!

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Ken Crawford: Welcome to Conversations with Ken, a podcast where we discuss relevant topics and investing. I’m Ken Crawford, Senior Portfolio Manager with Argent Capital Management.  

Today I have with me, Steve Smith. Steve, please say hello. 

Steve Smith: Ken, thank you very much for having me. 

KC: So, Steve, you are new to Argent. Never been on the podcast. Perhaps you could give us a little history of who you are and why you’re here. 

SS: Sure, happy to! I joined Argent in October of 2022. Prior to that, I was at Fidelity Investments Canada as a Sector Analyst on consumer staples for two years. 

Before that, I was in New York when I was working on my MBA at Columbia Business School as a student in the value investing program. Prior to that, I was in St. Louis, which is my hometown, working at Edward Jones in equity research for about five years. 

KC: Great! Welcome back to Saint Louis! You have been a great addition to the Argent analyst team/investment team. One of the areas that you cover is the housing industry. 

SS: That’s right, yup! 

KC: Way back when, when I was studying economics, one of the rules of thumb was higher interest rates meant that the housing sector was in a difficult situation, and that seems not to be the case this go-around. Am I missing something, or what’s going on there? Can you explain? 

SS: Yeah, absolutely! I think that the environment that we’re in, I would still consider a housing down cycle. It’s not all positive out there. However, what’s interesting and going to be unique about the environment that we’re in today is, as you point out, even with higher interest rates and resulting higher mortgage rates for home buyers, available home inventory remains historically low. That’s a bit of a different dynamic from what we’ve had in the past US housing cycle.  

As an example, typically, you would have four to six months’ worth of home inventory on the market at any given time. That’s as a national average, but that figure stood at less than two months’ worth in January. And even in March, which is the start of the spring selling season, and when more homes are being listed, that number was still less than three months’ worth of supply.  

Even with higher mortgage rates, the lack of supply is creating a bit of a damper to the typical down cycle that you would see in the US, and we can go into the reasons for that lack of supply. 

KC: Let’s talk about that. Why are builders not building, or why is there lack of supply? 

SS: I think to start, you have to sort of separate the US housing market into existing homes and new homes.  

KC: Right. 

SS: Obviously, the builders are the ones that are doing the construction for the new homes. Existing homes are just the entire stock of everything that’s already in the system. The existing home piece is actually the majority of the US housing market in terms of sales in any given month or year. I’d say there are a couple of dynamics at play at the moment, resulting in the lack of housing supply.  

The first is the most recent dynamic, which you highlight the dramatic rise in interest rates since the start of 2022; a couple of interesting stats as it relates to that and why it matters. Most current homeowners either have no mortgage, or they have a mortgage with an interest rate that is below 4%, which is, of course, well below mortgage rates that one could get today when looking for a home. The surveyed 30 year mortgage rates this week were around 6.5%.  

Of all the owner-occupied homes in the US, 38% of those have no mortgage, so the mortgage has been paid. And 2/3 of primary mortgages, just the mortgage that one would have on one primary residence rather than a second home or investment property, have an interest rate below 4% and is the 30 year fixed rate mortgage. The result of those two factors is keeping owners in their existing homes for longer. They’re keeping them from selling those homes, which is resulting in much less supply of existing homes than you would typically have. 

KC: In my case, I’ve got a three and a quarter mortgage, and if I were to sell and buy something else, I’d be looking at substantially higher mortgage interest payments each month. 

SS: Yeah, exactly. That lack of supply, at the same time, has resulted in home prices falling much less than would typically be the case in at least recent housing down cycles, just given that there is a kind of very strong underlying demand still relative to the supply of homes that is out there. Existing homes tend to be 8 out of 10 or 9 out of 10 home sales in any given month, where new constructions are 1 or 2 out of 10. But that’s resulting in people that are seeking a home having to rely more heavily on construction. 

KC: Right, the dearth of the 8 or 9 out of 10. 

SS: Exactly, yes. 

KC: Okay, so what’s going on, on the other side, the supply side. 

SS: On the supply side, we have that overarching demand for existing homes on the terms of the new supply coming in. 

KC: Right. New construction. 

SS: This actually goes back before pre-COVID, in terms of why we have this chronic shortage at the moment in the US housing market. Because of the severity of the housing market crash during the global financial crisis, the US went through an extended period of under-building from 2007 through the following decade. There were just fewer homes being built each year than really needed to be. As it relates today, you have a very strong demand side. Of course, we all know that the rise of work from home since COVID has resulted in people moving into suburbs, buying homes. That’s a shorter-term dynamic. 

Something that is a bigger structural dynamic that we see as being very important for home builders in the housing market over the next decade is that there is a kind of generational shift underway. For the years following the global financial crisis, household formation in the US was very, very low. It was very depressed. Millennials were delaying having families. US household formation was under 1,000,000 households per year. Again, very low.  

This changed starting in the 2016/2017 timeframe, to where millennials are now forming households. They’re going out and buying house. We have seen a dramatic shift in household formation in the past five or six years. Households are being formed at greater than a million and a half per year again, which is the highest since before the financial crisis. 

If you go within the high level household formation numbers provided by the Census Bureau, there’s also been a dramatic shift from where in the years following the financial crisis, renters were driving household formation. Now owner-occupied units are driving household formation. You have these two underlying themes and as the millennial generation age, they enter the prime home buying age range of 35 to 44. That demographic has been growing since 2016, and will continue to grow into the early 2030s. It’s providing decade-long demand support, as it were, to the need for more homes to be built in the US. 

KC: You’ve got a demographic shift that’s positive for housing, and it looks like the millennials are opting more for houses instead of apartments. 

SS: Exactly, yes. 

KC: Given that, what are we thinking about housing, and what are we thinking especially again with higher interest rates? When does that come into play? 

SS: Certainly, the higher interest rate piece has kind of been at play in the last six months. There is less slower home buying than you would typically see. But again, that’s counterbalanced by the lack of inventory and the fact that people still need homes. We’re still in this kind of down cycle, phase four home builders and housing, as I mentioned.  

However, the trough thus far has been much higher than in past troughs, meaning that home builders are not having to cut back their production quite as much as you’d normally see. In a typical US housing cycle, the trough in annual homes built would be about a million or so. The annualized rate for the most recently reported month, well really the most recent trough month, which was April, was 1.4 million annualized home starts. Home builder activity is still fairly strong, which for us is presenting the opportunity to both own these companies long term based on some of these dynamics that we’ve talked about that are structurally supporting that industry, but also in the more near term and in the recent months that we’ve had where investor sentiment has been so negative on those companies. 

KC: Right, because they foolishly like me, thought higher interest rates meant bad for housing, so they ran for the hills. 

SS: The interesting thing is that with a lot of home builders, as in past cycles, you would typically expect land values lot values, major items on home builder balance sheets to be written down for those companies to say, “Yep, the value has fallen. We need to take that down. That negatively impacts the balance sheet.”  

That has happened to a very small degree this time around. Some of that is the dynamics we talked about, and some of that is better, more disciplined practices within the industry, which is a bit of a shift that we see as a positive long term. All that’s to say, we have a number of home building companies, building product companies, the suppliers to the buildings that we own across the portfolio at Argent. 

KC: Any of those in particular that you’d like to call out for our listeners? 

SS: The first in our Large Cap portfolio is D.R. Horton, ticker DHI. They are the largest home builder in the US. They are also what we consider to be a very strong operator within the industry. They’re very disciplined in what they do. They’ve really proved their asset model over time, meaning they become much better at buying and utilizing land and doing so in a very efficient manner, such that the profits that they actually make on the homes they build is much better than it has been in the past.  

They’re also a direct beneficiary and leader of consolidation that’s happening within the home building industry in the US, which is a very fragmented industry historically. In fact, the top 100 builders, if you go back to the early 2000s only had about 1/3 of the share of all homes being built in the US. Then in 2020, the most recent year that we have data for, based on a study that might come across the top 100 builders, had half of market share consolidation. And even within that, the top builders like Dr. Horton have gained more share than the average.  

KC: So, taking share. 

SS: Yes, absolutely. D.R. Horton is one, again, very, very good operator. The management team we respect and we think are good allocators of capital and run the business well. The business model benefits from having a very high share in their local markets and is also focused advantageously on homes that tend to be a bit lower in price point and a lower price point range which fits well with that millennial demographic trend of entry level buyers and second home buyers. 

KC: Household formation.  

SS: So that’s Large Cap. Another that I would highlight is at the other end of the gap aspect, Green Brick Partners, which is in our Focused Small Cap fund. A bit of a different story.  

What’s unique about them is both their geographic concentration in the Dallas Fort Worth metro area, as well as Atlanta. So very high growth markets, very good markets for home builders, and importantly, the fact that they have what’s called a land bank which is a lot of very valuable land that they own or control. They have many years worth of lots that can be developed for homes, and the result of this, along with that geographic location and what we see as a strong management team, leads to a company that has very, very strong returns on their equity, and is very disciplined with their capital. They maintain much more moderate leverage than many home builders do, making them a higher quality builder than the vast majority of home builders. They are, at this point in time, benefiting to an outsized degree from some of these dynamics that we’ve talked about, that being a lack of existing homes creating a lot of demand for the supply that they bring to the market and supporting their returns. 

KC: Right, right. Two good picks and the backdrop as you mentioned: better demographics, lack of supply, better management. It sounds like there’s no place like home! 

SS: I think that’s a good way to put it. 

KC: Well, Steve, thank you very much for the podcast. Thank you all for listening. If you have any questions or comments, please let us know and we’ll talk again soon.  

Thank you for listening to Conversations with Ken. For now, stay safe, stay well and thank you for investing your time with us. 

 

Opinions reflect the portfolio managers’ judgment on the date broadcast and are subject to change. A list of stocks recommended by Argent is available upon request. You should not assume that these recommendations are or will be profitable.