Housing Data Overlooked As Fed Takes Center Stage

Aerial View of a Construction Site

RichLegg/E+ via Getty Images

The world is in a state of uncertainty. Whether the market has another leg lower or finally begins its recovery depends on the economy. Are rising interest rates and runaway inflation going to pull the economy into recession or can we truly get that soft landing?

The next few weeks of data will be crucial in determining which way we are headed. However, the economic data is being overlooked with the market’s undivided attention on the Fed. Everyone seems laser-focused on the Fed meeting on Wednesday, June 15th. I agree that this is an important meeting, but such undivided attention often leads to other things being overlooked.

So, while the rest of the world watches the Fed, I will be watching some major economic data that is coming out over the same time frame.

  • NAHB housing market index June 15th
  • Housing starts data June 16th

These affect a significant portion of the market directly and since housing is such a large portion of the economy it is a key GDP signal. These are also fairly complex news releases with lots of different data in them so let us discuss which bits are the most important and the implications they might have across the industry vertical.

Let us begin with a discussion of what these data points are, and what ranges to expect. We will then follow with how this impacts the relevant sectors and how I am investing to capture the opportunity.

What is this data and why is it so important?

Housing makes up 15%-18% of GDP. That makes it among the largest sectors of the economy and the data points that are about to come out are a gauge of the health of the housing market.

The NAHB Housing Market Index is a survey of a panel of builders in which they rate each of:

  • Current sales
  • Next 6-month sales outlook
  • Traffic of prospective buyers

Their responses of “good”, “fair”, or “poor” are then weighted and applied to the following formula as provided by NAHB (National Association of Home Builders).

“An index is calculated for each series by applying the formula “(good – poor + 100)/2” or, for Traffic, “(high/very high – low/very low + 100)/2″.”

In other words, if there are an equal amount of favorable and unfavorable responses the index will come out at 50.

The data comes out monthly and the past few years look like this.

NAHB chart

NAHB

The May read was 69, down from 77 in April. I believe the market is anticipating further declines in the number so anything 69 or higher would be seen as a positive when the data is released.

Sentiment surveys such as this one necessarily come with a tradeoff. The advantage is that it is forward looking whereas any factual data is going to be present or backward looking, and of course, the downside is that it is not objective data. It is entirely possible to get a negative read on the sentiment because the respondents are pessimistic for other reasons such as gas prices or the war, neither of which directly impact housing.

Thus, due to subjectivity, I think it is important to look at the NAHB market index in conjunction with objective data such as what will come out on Thursday, June 16th.

Housing starts data consists of three parts:

  • Building Permits
  • Housing Starts
  • Housing Completions

Here were the April numbers (released in May):

New residental constructions April 2022

NAHB

Generally, the number of completions will approximate the number of starts, so the significant gap above indicates a lengthening of construction timelines. The number of in-progress constructions is up because each one takes longer to complete.

Housing starts is inclusive of single-family and multi-family development with the breakdown tabled below.

New privately owned housing Units started

NAHB

With mortgage rates rising, housing starts are broadly expected to slow down. There is often a lag, however, as the process is often well underway before the actual start date. Thus, I would anticipate permitting to take a hit temporally before starts.

New residential construction

NAHB

Since permits have been strong, I think starts will remain normal or better for a bit, including in the May data which is to be released on Thursday. A big dip in new permits, however, could be seen as a harbinger of low activity going forward.

How I’m investing in the opportunity

My investments in housing stem from the basic idea that housing is broadly undersupplied in the United States – a concept which I believe is easily demonstrable. Single family home occupancy is full by historical standards, apartment occupancy of 97% is above what is historically considered full occupancy of 95%. People are using the housing units to this extent despite prices being high as a percentage of household income. This indicates that more households would be formed if housing were more affordable.

All of this adds up to more housing units being demanded than are currently in existence. With this undersupply setup, there are only two ways out of it.

Either builders get an extraordinary amount of business as they bring supply up to speed or the U.S. remains undersupplied and existing inventory flourishes.

I cannot tell which of the above will happen, but given the current valuations and the undersupply, I am confident that a mix of investment across the entire vertical will perform well. Each section within the vertical is in some ways a hedge for the others so they somewhat shelter one another, but the whole set should be benefitted by the broad shortage of housing.

Below are some of the offsetting factors which cause these to be mutual hedges:

  • High lumber prices hurt builders but benefit timber REITs
  • High housing starts/permits/completions is bad for apartments but good for builders
  • High rents as a percentage of household income hurts apartments but helps affordable housing like manufactured housing
  • Rising mortgage rates hurt home builders but help single family rental REITs
  • Rising mortgage rates hurt Agency mREITs, but help mortgage servicing mREITs

Inclusive of all these categories, there are north of 70 publicly traded companies. The housing shortage has been present since circa 2011, a few years after the Great Financial Crisis ground development to a halt. The shortage got worse in 2020 and 2021 as COVID knocked development activity below the sustainable level.

People need somewhere to live and that is either going to be existing real estate or newly constructed properties. Not many demand drivers in the economy are as large and as powerful as the need for housing. It is fertile ground for investment and makes up a large chunk of my portfolio. I have gone through each sector of the vertical one by one and each company within each sector and here’s my positioning from timber all the way to financing.

Timber/lumber

Four timber REITs are soon to be three as Potlatch (PCH) buys CatchMark (CTT). Based on both valuation and quality of operations I think Weyerhaeuser is the best positioned in this sector

Homebuilders

At low to mid-single-digit earnings multiples, the whole homebuilding sector looks cheap to me. Lennar (LEN) takes the cake for me however as one can get an additional 16% discount by buying the higher voting power but less liquid (LEN.B).

Manufactured housing manufacturers

Demand for MH is unequivocally strong and seemingly on a secular basis which has held market pricing up quite nicely. As such, the valuation isn’t as tantalizing as other parts of the vertical, but growth makes some names attractive. Flagship Communities (OTCPK:FLGMF) is well located to supply middle-America and is overlooked by the market due to its small size and Canadian listing.

Manufactured housing community operators/owners

UMH Properties (UMH) has long been in my portfolio as it gets to participate in the rapid organic growth of manufactured housing but has historically been the only value play in the sector. Recently, however, market prices have come down across the board causing Sun Communities (SUI) and Equity LifeStyle (ELS) to be GARP plays as well.

Apartments

While housing as a whole is undersupplied, domestic migration patterns strongly favor the areas of the U.S. with inflows over those with outflows. Sunbelt apartments such as those of Camden (CPT), BRT Apartments (BRT), or NexPoint Residential (NXRT) are favorably positioned as compared to the coastal locations. I am watching west coast apartment REIT Essex (ESS), however, as its market price has dipped so far as to make it a value REIT. Such a multiple is a historical rarity for a company as well-managed and successful as ESS.

Single family rental

Much like the manufactured housing manufacturers, the strength of this sector is well known which makes valuation only okay. That said, the business model is fantastic and Tricon Residential (TCN) is looking at ample growth rates with a long runway.

Residential financing

Agency Mortgage REITs are experiencing book value deterioration as higher interest rates cause the market value of their long-dated mortgage portfolios to drop. As coupons get higher, the reinvestment looks more favorable which will eventually lead to better earnings. There will be a time to get into agency mREITs, but I don’t think it is here quite yet.

Mortgage servicers are benefitting from reduced prepayment rates as locked in low interest rate mortgages discourage refinancing. New Residential (NRZ) is our pick of the lot as it is getting significant book value and earnings accretion. Its preferreds look even better than the common as they have a fixed to floating structure such that rising rates directly translate to higher dividends for preferred investors.

Back to the data released on June 15th and June 16th

There is no such thing as universally good or bad numbers in these data drops because it all depends on perspective.

Homebuilders want high starts/permits/completions and high sentiment on the index, but apartments and SFR want the opposite. Timber REITs are mixed in that they want high starts/permits but don’t really care about the sentiment read.

Manufactured housing production is not included in the starts figure, so they want it as low as possible.

With a balanced portfolio across the vertical, I am largely indifferent as to how the numbers come in, but I will be watching to see which sectors are relatively stronger or weaker as a result. While these companies hedge each other with regard to construction activity and interest rates, they are all benefitted by the housing shortage in America. Collectively, they are also part of the solution that will bring more affordable housing options to families.

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