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Homebuilders
Affordability runs out of gas
Nishu Sood, CFA
Research Analyst
(1) 212 250 4756
nishu.sood@db.com
Rob Hansen
Research Associate
(1) 212 250 5182
rob.hansen@db.com
Fundamental, Industry, Thematic, Thought Leading
Deutsche Bank Company Research's Research Product Committee has deemed
this work F.I.T.T. for investors seeking differentiated ideas. Here we analyze the
significant and wide-reaching impact of rising gas prices on the homebuilders. A
housing recovery requires new and existing home transactions to resume, but the
sudden and severe increase in commuting costs is a major new hurdle for
potential homebuyers. There is a clear impact on affordability, but we also see
strategic implications as far-flung builder communities become less attractive.
Deutsche Bank Securities Inc.
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
FITT Research
Top picks
Centex (CTX.N),USD14.67 Buy
Ryland Homes (RYL.N),USD24.69 Buy
Companies featured
Centex (CTX.N),USD14.67 Buy
2008A 2009E 2010E
EPS (USD) -21.71 -1.18 0.26
P/E (x) – – 56.4
EV/EBITDA (x) – – 31.0
D.R. Horton (DHI.N),USD11.90 Hold
2007A 2008E 2009E
EPS (USD) -2.26 -4.58 0.45
P/E (x) – – 26.2
EV/EBITDA (x) – – 27.2
K. Hovnanian (HOV.N),USD6.46 Hold
2007A 2008E 2009E
EPS (USD) -10.11 -8.14 -2.34
P/E (x) – – –
EV/EBITDA (x) – – –
Lennar (LEN.N),USD15.35 Hold
2007A 2008E 2009E
EPS (USD) -12.31 -0.89 0.38
P/E (x) – – 39.9
EV/EBITDA (x) – – 21.9
Meritage Homes (MTH.N),USD15.66 Hold
2007A 2008E 2009E
EPS (USD) -11.01 -2.25 -0.12
P/E (x) – – –
EV/EBITDA (x) – – –
Pulte Homes (PHM.N),USD10.78 Hold
2007A 2008E 2009E
EPS (USD) -9.02 -3.01 -0.09
P/E (x) – – –
EV/EBITDA (x) – – 44.5
Ryland Homes (RYL.N),USD24.69 Buy
2007A 2008E 2009E
EPS (USD) -7.90 -1.16 -0.29
P/E (x) – – –
EV/EBITDA (x) – – 89.5
Toll Brothers (TOL.N),USD19.91 Hold
2007A 2008E 2009E
EPS (USD) 0.22 -0.64 1.40
P/E (x) 124.6 – 14.3
EV/EBITDA (x) 25.4 – 8.2
Fundamental: With higher gas costs home buying power takes a hit
Higher commuting costs mean that potential homebuyers have less to devote to
mortgage payments and the impact is substantial. Home buying power lost over
the past five years due to rising gas costs is equivalent to 25% of current home
values, with 10% lost in the last year alone.
Industry: Evaluating gas price impact specifically for the builders
Rising gas prices are a particular problem for builders because their communities
tend to be located at the edges of metropolitan areas, resulting in long commutes.
We computed gas expenses based on where builders’ communities are located
and found that miles driven for residents are 22% higher than national averages.
Thematic: Builders’ strategies could need some changes
During the downturn, many builders have refocused on their core entry level
product. Unfortunately, sustained higher gas prices could make this a difficult
strategy if demand shifts inwards. Pro formas for land purchases in outlying areas
would need to incorporate meaningfully lower demand.
Thought Leading: Taking a closer look at affordability metrics
Much has been made of recent headline increases in affordability. We explore
some reasons why the increases may not be all that they seem. For example,
adjusting the Realtors’ association’s index for gas prices reduces it by 23%, more
than wiping out recent notional affordability improvements.
Non-bubble and Southern markets likely to see a greater impact
This analysis runs counter to conventional wisdom that builders with more
exposure in non-bubble markets are better positioned. We argue that non-bubble
markets, especially Texas, are likely to be more impaired by sustained higher gas
costs. Higher gas prices are generally negative for the builders, so we are lowering
target prices overall; however, in our worst-case analysis we are also increasing
assumed write-offs in non-bubble markets to 46% from 35%. The builders that
have the least exposure to high-impact markets are NVR, MDC and Toll, while
those that have the most are Meritage, Ryland and Lennar.
Table of Contents
Executive summary ........................................................................... 3
Outlook: Pain at the pump means pain for the builders............................................................3
Valuation: The worst-case gets worse for non-bubble markets ................................................4
Risks: Macro data remains a top concern.................................................................................4
Affordability runs out of gas............................................................. 5
Overview..................................................................................................................................5
How much have gas prices affected home buying power?......................................................7
Rising gas prices – perception vs. reality ................................................................................15
Determining company impact ........................................................ 17
Analyzing company exposure to the most affected markets ..................................................17
Strategic implications ..................................................................... 20
Shifts in demand patterns .......................................................................................................20
Land prices – wither the ‘exurbs? ...........................................................................................21
Affordability and the gas tax .......................................................... 23
Assessing the affordability metrics .........................................................................................23
Issues with affordability measures in general .........................................................................24
Higher gas prices as a tax on affordability ..............................................................................25
Valuation/risks................................................................................. 27
Assuming higher write-offs in non-bubble markets ................................................................27
Summary of methodology.............................................................. 31
Key data points and calculations .............................................................................................31
Data sources..........................................................................................................................32
Appendix A....................................................................................... 33
Executive summary
Outlook: Pain at the pump means pain for the builders
The relentless rise in gas prices over the past five years has been well chronicled, but we
think the implications for the builders are generally less well understood. The two main ways
consumers can counter rising gas costs are either to change their driving habits or to change
where they live. Thus rising gas costs are important in the near and long term for both the
builders and the overall housing market.
In this report, we explore and quantify the impact of rising gas costs on the builders and find
wide-ranging implications. There is an immediate hit to affordability, as increased commuting
costs reduce how much home a prospective homebuyer can afford. There are strategic
implications as well, since the core of most homebuilders’ business remains far-flung
communities where homebuyers used to “drive ‘til you qualify”. Demand could potentially
shift away from outlying areas, forcing builders to ramp up closer-in townhome and infill
activity. Land that was purchased with expanding metro areas in mind has already been hard
hit in value – sustained higher gas prices could render it effectively worthless.
Higher commuting costs a substantial hit to home purchasing power. In this report, we
focus on rising gas costs as they would affect potential homebuyers in a builder’s
community. Since builder communities are typically at the edges of metro areas, commuting
costs are higher – we calculated 22% higher than average mileage requirements for residents
in builder communities. We also computed how much purchasing power has been lost with
rising gas prices – on average roughly $54,000 in purchasing power has been lost since 2003
and $22,000 in the last year alone (assuming current mortgage rates). Compared to current
average home prices of roughly $218,000, purchasing power loss is 25% in the past five
years and 10% in the past year. The impact of rising gas prices is the same as if mortgage
rates were 247 bps higher over a five year period or 98 bps in the last year.
Metro level analysis – that retreat to Texas doesn’t look so good anymore. Commuting
distances differ significantly across the 25 major builder markets we analyzed, with some
commutes exceeding 50 miles each way, and some under 20 miles. Also, regional home
price variation means that the relative impact of purchasing power loss varies across the
country. When all factors are considered, conventional wisdom about favorable market
exposure is somewhat turned on its head. In particular, Southern markets including the major
Texas markets and Atlanta rank high in terms of the impact of gas prices. This should not be
surprising, considering how large these metro areas are and how low home prices are. For
builders that have seen these markets as a refuge from bubbles bursting elsewhere, it could
be. When we look at the builders with the least exposure to affected markets, NVR, MDC
and Toll stand out; those builders with the most exposure are Meritage, Ryland and Lennar.
Since rising gas prices influence affordability significantly, in this report we also take a closer
look at widely followed affordability metrics from the Realtors’ and Homebuilders’
associations. We review the shortcomings of these metrics and affordability metrics in
general. When we adjust the Realtors’ affordability index for gas prices, it falls by 23%, more
than offsetting the recent rebound driven by lower home prices and interest rates.
Valuation: The worst-case gets worse for non-bubble markets
We are lowering our target prices, reflecting a higher probability of our worst-case scenarios
being realized and some adjustments to our assumptions for non-bubble markets. We first
articulated worst-case book value scenarios for the builders late in 2007 (see “The ‘worst
case’ comes knocking at the builders' door”, 7 December 2007). This is our second
adjustment to these scenarios since that time, the first recognizing a present value factor for
realization of deferred tax assets.
Rising gas prices mean the worst-case is the most likely scenario. Generally, we view
the impact of rising gas prices as a negative for the builders, one that would elevate the
probability of worst-case scenarios being realized. As we noted in recent weeks, the worstcase
is looking more and more like the base case for the builders (see “Quarterly Building
Wrap: Comfortably numb, but not cured just yet”, 15 May 2008) and rising gas prices only
serve to underscore this. Whereas the probability of our worst-case scenario in late 2007 was
roughly 25-30%, we currently estimate it at about 70-75%.
Southern, non-bubble markets most likely to be affected by gas cost impact. For bubble
markets like Sacramento and Inland Empire, rising gas costs add insult to injury by heaping
yet another problem on the builders; nevertheless, gas prices in bubble markets are generally
one problem among many. In southern markets, on the other hand, we think rising gas prices
stand out more and are likely to have a greater impact on demand. In order to reflect this, we
are adjusting our assumptions for pricing and absorptions in our worst-case assumptions for
non-bubble markets. Whereas we had previously written off 35% of finished land values in
Southern markets, we now write off 46%.
Our overall methodology for setting price targets remains the same – we apply a target price
to book multiple against our worst-case book value scenarios. Our target multiples
incorporate a penalty for higher liquidity risk. Our worst-case book value per share is simply
current book value per share less worst-case write-offs. Our target price-to-book multiples
incorporate a liquidity risk penalty based on a relationship that emerged between price to
book and CDS implied default probabilities in August 2007 (with the worsening of the credit
crisis). The correlation of the regression relationship is high at between 85% and 96% since
August. We think adjusting for worst-case scenarios resolves the uncertainty investors
currently feel regarding book values. We think the CDS market is the best way to differentiate
among the builders because it has been early and accurate in assessing liquidity risk since
the credit crisis began. We use the equation [CDS Implied PB = (CDS Y Yr default probability
x Slope) + Constant], (comparable to [Y=mX+b]) to reach our CDS Implied Price-Book ratio.
A summary of our adjustments to our target prices is shown in Figure 27 (see page 29).
Risks: Macro data remains a top concern
At this juncture, the chief risks for the builders are macroeconomic – both the risk of more
severe weakening in the broader economy and labor markets as well as an increase in
inflation. Job losses would further exacerbate declining demand for the builders, while rising
inflation would spike mortgage rates. In addition to economic concerns, the wave of
foreclosures sweeping through the existing home market put severe pressure on pricing and
delay recovery in new home communities. As this report describes, rising energy and
gasoline prices are negatively affecting homebuyers’ purchasing decisions. Upside risks
include an unexpected easing of mortgage standards and ongoing government efforts to
shore up the housing market. For example, a homebuyer tax credit could have a near-term
beneficial impact on demand if implemented broadly and over a set period of time.
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