Big investments in small homes
Homebuilders would seemingly be an obvious way to play home construction, but they require impeccable timing. Leaders like KB Home (NYSE:KBH) are profitable on the income statement, but virtually all free cash is reinvested into the business. Continuous reinvestment is good during the boom years, but when housing invariably slows, homebuilders are substantially leveraged to the downside because they carry their inventory on the balance sheet. Homebuilders face a systematic problem: They are always most invested in real estate at the top of a cycle, not the bottom.
How can investors play a shift toward smaller, more affordable homes? One of the best investments may just be The Home Depot, Inc. (NYSE:HD). It’s certainly not cheap, at 17 times forward earnings expectations, but it is uniquely positioned to benefit from a housing recovery. Should small homes come back, buyers will be snapping up homes constructed in 30 or even 40 years ago — homes which may require some remodeling to be move-in ready.
In the last 12 months, The Home Depot, Inc. (NYSE:HD) generated $5.8 billion in free cash flow, giving it a free cash flow yield of 5.3%. The Home Depot, Inc. (NYSE:HD) revealed on its conference call that it processed the largest number of customer transactions in its history during its blockbuster second quarter.
Finally, investors who aren’t convinced that higher rates will cripple housing transactions should look to the title insurance industry. First American Financial Corp (NYSE:FAF) is a title insurer trading at just 1.6 times tangible book value. Going forward, a shift away from refinances to purchase transactions should increase revenue and bottom-line profits. Title insurers sell only one policy in a typical refinance transaction; however, in a sale transaction, both the buyer and mortgage issuer buy title insurance. The company currently trades for less than 10 times forward earnings expectations.
As rates come off their lows, housing prices may feel a pinch, but we shouldn’t forget there’s still an option for buyers priced out at the margin: Buy a smaller home. When push comes to shove, renters annoyed with cramped apartments and hefty rental payments will find a smaller-than-ideal home a better alternative than no home at all. Home sales should continue their brisk pace, making money for well-positioned investors.
The article Higher Mortgage Rates Could Revitalize Smaller Home Sales originally appeared on Fool.com and is written by Jordan Wathen.
Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends First American Financial and Home Depot.
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