Should you buy US housebuilders?

The American property industry has a lot to answer for. Dodgy subprime mortgages caused the financial crisis, costing taxpayers billions in bail-outs. And the bursting of the house price bubble has hammered the US economy.

However, many now claim that the worst may now be over. Warren Buffet recently said that “housing will come back – you can be sure of that”. With unemployment falling, there is even hope that people will start buying homes again.

This had led to a surge in shares of American housebuilders. In the past six months, the share price of Puite Homes (US: PHM) has nearly doubled; and that of KB Homes (US:KBH) has risen by over 80%. Lennar Corp (US:LEN) and DR Horton (US:DHI) have gone up by 60% and 40% respectively.

Is this the start of a trend – or a ‘dead cat bounce’?

House prices are low, but little growth is expected

There’s no doubt that US house prices have done their fair share of adjusting to a new reality. From their peak at the start of 2006, inflation-adjusted prices have tumbled by more than 40%. They are also 10% below the average price from the start of 1987 to 2011.

Indeed, the S&P Case-Schiller Index has fallen to real levels not seen since the end of 1998. Meanwhile, interest rates are lower, and personal incomes higher, than during the 1990s.

However, just because property is cheap, that doesn’t mean that prices will suddenly explode. It’s much harder to borrow money to buy a house now that ‘liar loans’, and the other scams of the bubble era are things of the past. Total mortgage lending in 2011 was $1.54bn, down from $4bn in 2003.

The latest Zillow Home Price Expectations Survey suggests that prices will stay flat for the next few years, not picking up until perhaps 2015.

The foreclosure glut

For housebuilders, it’s not just a question of prices. It’s about the quantity of houses they sell too. At the peak of the boom in 2005, 1.28 million new houses were sold across the US. However, if we look at sales data from 1963 to 2011, and new household creation, trend sales look as though they should float around 800,000.

Even returning to that level will take time. Last year, there were only 304,000 sales. The large amount of existing unsold inventory will prevent sales rapidly returning to trend levels.

Although the deal reached with banks to settle the mortgage scandal involved writing down some loans, the short-term effect on prices will be negative. Concerns that banks did not properly document who owned the property secured against loans led to several states stopping foreclosures. Now that banks have agreed to pay compensation, they can restart that process.

This will lead to a flood of inventory coming back on to the market, crowding out new sales. Even before the deal, a quarter of home sales in the last quarter of 2011 were either foreclosures or distressed properties.

Now, Brandon Moore, the chief executive of RealtyTrac, thinks that lenders will “aggressively dispose of distressed assets held up by the mortgage servicing gridlock”. He expects “to see foreclosure-related sales increase in 2012”.

Government support is fading too

Less government support will also temper price rises. From 2007 to the present day, the US government has tried to prop up prices. In 2009/10 the Federal Reserve purchased $1.25 trillion-worth of mortgage-backed securities (MBS). However, it now focuses on government bonds. The amount of MBS held by the Fed has fallen to $840.8bn.

Although Barack Obama has said that there will be continued aid for housing, the US Congress needs to agree with any plan. Republican opposition makes this unlikely. For example, Mitt Romney, the leading Republican, has stated that support should end.

Buy houses, not homebuilders

We are cautiously bullish on American house prices. For those who have enough money to finance the required deposit, homes are cheaper than they have been in years. So, if you’re looking to pick up a holiday home in the US, it’s a good time to do so – we’ll have more on this in a future issue of MoneyWeek magazine.

However, firms that build homes are another matter. Shares in the sector are simply too expensive given that many of the builders are still losing money. Even DR Horton is trading at a price /earnings (P/E) ratio of over 37.