Building the Case for Housing Stocks

Despite the unprecedented, pandemic-led blow to the economy, real estate markets in both the U.S. and Canada continue to show resilience. In Canada, home construction roared back with 245,604 units in July, nearly 16% jump from 212,095 units in June, in a stark contrast to steep declines and sluggish recovery in other area of the economy. In a similar trend south of the border, the U.S. housing starts, a key measure of U.S. homebuilding, rose more than 17% in June compared with May.

Although well below its pre-pandemic high, the trend still represents a strong turnaround in construction activity. A conspiracy of factors including favourable demographics, demand growth, ultra-low borrowing rates and softer stress test requirements have created a growth tailwind for the housing sector, helping it spring back stronger than anticipated.

Increased homebuilding activity boosts profitability for companies that supply goods and services to the real estate market. These companies stand to benefit from demand growth that underpins the continued momentum in homebuilding both in the U.S. and Canada, according to Morningstar equity research.

Canadian lumber giant, Norbord is the largest global producer of oriented strand board (OSB), with majority of its mills located throughout the U.S. and additional capacity in Northern Europe.

“After seven lean years for residential construction, we expect favourable demographics, a tighter labour market, and looser mortgage availability to spur a mild improvement in homebuilding activity over the coming decade,” says a Morningstar equity report, published before the coronavirus outbreak.

In his August note, Morningstar equity analyst Charles Gross points to Norbord's strong second-quarter performance, which was supported by better-than-expected homebuilding activity. “Sales fell nearly 6% because of production cuts, but adjusted EBITDA more than doubled to US$84 million in the quarter,” he says, noting elevated OSB prices have prompted him to materially raise the 2020 profit outlook.

He recently raised the stock’s fair value from $30 to $33, prompted by strong performance. He cautions, however, at the current market price the stock is overvalued, but forecasts North American OSB prices will gradually rise over the coming decade as homebuilding gains momentum.

The largest U.S. homebuilder, Lennar (LEN) operates the eponymous brand that targets first-time, move-up, and active adult homebuyers. The firm’s financial-services segment provides mortgage financing and related services to homebuyers.

The company’s strong second-quarter performance shows it’s shaken off the COVID19-induced weakness prompted by large-scale economic shutdown. With buyers returning to the market and restrictions easing, “Lennar's orders increased 7% year over year in May, and through the first two weeks of June, orders were up 20% compared with the same period last year,” says a Morningstar equity report, noting that “the company is seeing an influx of buyers looking to move out of densely populated urban areas, while other buyers feel safer buying a new home rather than an existing home.”

Historically low mortgage rates, ownership affordability, and an unprecedented spike in the personal savings rate indicate that “more households may have a large enough nest egg for a down payment,” adds the report. “We expect first-time buyers will be a key driver of future housing demand, and Lennar is well positioned to capture these potential buyers as this market segment represents 40% of Lennar's homebuilding business,” says Morningstar sector director, Brian Bernard, who recently raised the stock’s fair value by about 5% to US$79.