Real estate actually had some wiggle room in 2022...

That might sound like an odd notion, considering how housing stocks fared. The S&P Homebuilders Select Industry Index fell 30% last year.

But believe it or not, fundamental homebuilder performance didn't take a significant hit.

You see, 2022 was more of a transition period for the sector. At the beginning of the year, homebuilders were on top of the world.

Interest rates were still low. The credit market was healthy. And homebuilders were making their way through huge backlogs, thanks to pandemic-fueled demand.

But as the year progressed, things changed...

Interest rates crept up to levels not seen since the Great Recession. Mortgage rates rose with them. And by the middle of the year, more and more homebuyers were backing out of home-purchase agreements.

On top of that, new-housing demand was slowing down.

Despite all of this, homebuilders were still working through their record-high backlogs. So it looks like the industry fell 30% without a serious decline in performance.

Homebuilders managed to avoid a disastrous 2022. So you may be wondering if the market overreacted... and if it's time to jump back into the homebuilding sector.

But these backlogs won't last forever. And as I'll show you today, one homebuilder in particular could feel a lot more pain before the year is through.

It could be a while before homebuilders see such a great run again...

As we said, these backlogs aren't going to last forever. In fact, you can expect homebuilders to cut prices to try to lure buyers back to the market.

Rising mortgage rates, still-high inflation, and continued global supply-chain problems could also lead to a decline in demand and profitability.

According to Freddie Mac's Mortgage Market Survey, mortgage rates are at 20-year highs right now. The average rate on a 30-year fixed mortgage is up 96% since the beginning of 2022. And adjustable-rate mortgages are up more than 150% over the same period.

This makes the possibility of a slowdown for homebuilders much more likely...

Even if homebuilders just return to a "normal" environment – as opposed to the boom times we've seen in recent years – valuations still won't look as compelling as they do now. So investors in homebuilding stocks may be disappointed.

Take D.R. Horton (DHI), for example...

D.R. Horton is the largest homebuilder in the U.S. by volume. It was one of our favorites before the housing cycle peaked around mid-2021.

The company primarily builds and sells single- and multifamily homes.

Since the Great Recession, D.R. Horton's Uniform return on assets ("ROA") has soared from negative levels to more than 25%.

Take a look...

As you can see, 2021 and 2022 were historically great years for the company.

That could give you the wrong impression about what's on the horizon... D.R. Horton's average Uniform ROA is closer to 10% in normal times.

The market understands that the past two years weren't the norm...

Investors actually expect a significant drop in profitability in the coming years.

We can see this through our Embedded Expectations Analysis ("EEA") framework. It uses Uniform Accounting to determine what investors expect from a company based on the current stock price.

The market thinks D.R. Horton's Uniform ROA will fall to 9% in the next five years. Take a look...

Investors know that the company is facing significant risk going forward.

D.R. Horton's EEA might look far too pessimistic... or it could appear historically accurate. It all depends on how far back you look. And that could turn into a dangerous trap for investors.  

You see, if you only pay attention to the past two years, the business seems resilient to rising interest rates. This might look like a good time to buy in at a discount.

But in the long term, the market expects D.R. Horton's Uniform ROA to be right around its 15-year average. Even that could prove difficult in today's high-interest-rate environment.

And if ROA falls even lower – to the negative 2% levels it hit in 2009, for example – even pessimistic investors could be disappointed.

Homebuilders have a long way to go before returns get back to pandemic levels. Until the story changes, we'd recommend staying away from D.R. Horton – and the sector as a whole.

Regards,

Rob Spivey
January 10, 2023