Stocks to sell

Amid 2023’s continued stock market drama, homebuilder stocks have remained surprisingly resilient even as analysts predict an imminent crash. But homebuilder financial and operational reporting is built on a foundation of lagging indicators. Those indicators may be catching up to reality.

The homebuilding market is rife with examples of the bullwhip effect; changes in consumer demand trigger reactions visible months later. Complicated by long logistics tails and stretched supply chains, low interest rates during the pandemic led to an upswing in consumer and institutional demand and a surge in home values as supply shrank.

Companies like DR Horton (NYSE:DHI), KB Homes (NYSE:KBH) and Lennar (NYSE:LEN) reacted by aggressively purchasing as much land suitable for development as they could, constructing houses at a rapid pace as soon as they had access to the necessary raw materials. However, when central banks started hiking interest rates through 2022 and into 2023, average 30-year mortgage rates popped from the low 3% range to over 7%, rising alongside a newly sluggish economy and job losses.

What happens to homebuilder stocks when fresh supply meets a demand that no longer exists in a market vastly different from just a year ago? Investors should be preparing for an unfortunate surprise.

Surprising Homebuilder Stocks Statistics

Standard financial and GAAP metrics provide a common language for comparing companies across industries, but effective analysts need to understand sector-specific metrics. For homebuilders and real estate construction firms, two critical non-financial metrics are the cancel rate and inventory.

Cancel Rate

The cancel rate refers to the percentage of homebuyers withdrawing from a contract for a yet-to-be-completed property. There are countless reasons for cancellations, which often spike during periods of economic uncertainty. Buyers typically sign contracts for new homes before construction starts, and a lot can change in the months between then and handing keys to the new owner. Increased cancel rates, especially amid poor economic performance and rising interest rates, can be a leading indicator of future financial difficulties.

New Home and Quick Move-In Inventory

New home inventory is a straightforward concept and refers to the total number of completed homes a company has that remain unsold and unoccupied. Carrying inventory costs can significantly impact a company’s bottom line, especially if supply exceeds demand and includes necessary utilities to prevent mold, security checks, property taxes, on-call maintenance, and more. The longer a property remains unsold, the tighter the ultimate profit margin.

Companies often obscure internal levels if they reflect possible profitability headwinds; a stand-in is the national quick move-in inventory (QMI) count. QMI properties describe those ready for occupation within 90 days and thus capture a sizeable portion of homebuilders’ unsold or canceled properties. Furthermore, QMI shows broad supply levels, including older homes which sell at a discount compared to new builds. Today, QMI is up more than 100%  than last year, meaning inventory is well past demand levels.

Effect on Homebuilder Stocks Performance

Inventory and cancel rates impact homebuilder stock performance, but effects aren’t often immediate or even quickly apparent. For example, DR Horton’s 2022 report showed an increase in the cancellation rate from 17% in 2021 to 21% in 2022. The company’s stock performance did not reflect the increase in cancellations and inventory — and is actually up more than 40% in the last year.

If you’re confused, don’t worry. Homebuilders report revenue when keys change hands.

So, today’s revenue lags by nearly a year as companies report contracts signed near the start of rate hikes. This method is more precise as it doesn’t artificially inflate revenue via early recognition and avoids the stickiness of backtracking after cancellations, but it means low-P/E homebuilder stocks are throwing false signals to investors.

Worsening the situation, prior build contracts mean firms must continue building even if supply surges, creating a vicious cycle of outpacing demand and eating carry costs.

These homebuilder stocks, seemingly on sale with low price-to-earnings ratios and solid reporting, may soon shock unaware investors.

DR Horton (DHI)

Source: Casimiro PT / Shutterstock.com

Current Cancellation Rate: 21%

P/E: 7.3x

As I wrote above, DR Horton’s stock is still running despite market corrections. But its cancellations are on the rise, and inventory is outrunning demand. The company reported $14 million in asset impairment for unsold inventory’s fallen value as real estate markets suffered.

DR Horton maintains multiple revenue streams, including rental properties, and may be better poised to withstand stock shock. Still, much of its recent investor presentation material glosses over key concerns like cancellations and inventory.

DHI insiders also sold a slew of stock in May 2023, possibly indicating administrative concerns over future prospects.

KB Homes (KBH)

Source: Sundry Photography / Shutterstock

Current Cancellation Rate: 36% (from 11%)

P/E: 4.7x

KBH’s cancellation rate far outpaces DHI’s but has critical advantages that may help cushion the company. KB Homes executes a modified “just-in-time” manufacturing process it calls “built to order,” designed to minimize the effects of stale inventory.

Whether its process, which pushes stagnant stock forward before new builds, can account for tripled cancellations remains to be seen. Its presentation materials get ahead of the inevitable narrative by framing swollen inventory as a good thing. “[With a backlog] we can manage starts to achieve even-flow production at the community level, generating efficiencies in overhead and cost to build … and we have greater predictability on deliveries.”  

Lennar (LEN)

Source: madamF via Shutterstock

Current Cancellation Rate: 26%

P/E: 6.9x

Strangely, Lennar doesn’t readily report quarterly cancellation rates as other homebuilder stocks do. While the stat isn’t required, it is an industry standard, and the reporting latency compounds to slow an already-lagging indicator series. Still, its annual cancellation rate doubled in 2022 and it’s unlikely the curve flattened thus far in 2023.

Furthermore, Lennar offers homebuyers a suite of pricy options that may prove detrimental. Seeking to smooth the process, Lennar’s “Everything Included” program, solar integration, smart tech, and more were sought-after features when rates were low and buyers couldn’t get enough of real estate. Today, those niceties may be out of reach for buyers and ultimately contribute to steeper inventory carry costs.

On the date of publication, Jeremy Flint held a short position in DHI. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Jeremy Flint, an MBA graduate and skilled finance writer, excels in content strategy for wealth managers and investment funds. Passionate about simplifying complex market concepts, he focuses on fixed-income investing, alternative investments, economic analysis, and the oil, gas, and utilities sectors. Jeremy’s work can also be found at www.jeremyflint.work.

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