D.R. Horton, Inc. (DHI), Lennar Corporation (LEN): A Housing Bust & Changes

The American dream of owning a home looks to be under increasing pressure. Although the rebound from the post-recession low has been nice, investors need to watch that they don’t get blindsided by potential housing industry changes.

A Housing Bust

The 2007-2009 recession was financially driven. Essentially, too many people were buying homes. That included a mix of purchasers, from those who could afford the price to those who bought way more house than they could afford. Lenders made matters worse by offering loans with exceptionally loose standards.

When the bubble burst, those who couldn’t afford to pay their loans defaulted. Those who could keep paying were left to answer the question of how much money to put into keeping a house worth less than the mortgage loan on it. Many chose to let the bank have the house.

It was an ugly time for just about every company even remotely tied to the housing market, particularly home builders.

A Recovery

That was then, however, and this is now. Home builders and housing-related stocks have seen an impressive pick up in demand. Although that’s off shockingly depressed levels, many used the rough spot to streamline their businesses and, essentially, become better companies. That’s resulted in heady price advances for home builders like D.R. Horton, Inc. (NYSE:DHI) and Lennar Corporation (NYSE:LEN). Both of these companies serve the first time home buyer.

Even though sales at D.R. Horton, Inc. (NYSE:DHI) are only about a third of their 2006 peak, the company used the recession to materially reduce costs and set the business up for higher profitability during an eventual upturn. Those corporate moves have allowed earnings to quickly recover back to levels last seen in 2003 and 2004, despite 2012 revenues that are only around half of what the top line was in those years.

Lennar Corporation (NYSE:LEN) also used the recession to clean house and streamline its business. Sales at this home builder peaked in 2006 and came in at only about a quarter of that level in 2012. However, earnings jumped from about $0.50 per share in 2011 to over $3.00 a share last year. Although increases of that size are unlikely to continue, the company was able to earn over $8.00 in 2005. So, there remains plenty of earnings upside if the housing market continues to improve.

Both D.R. Horton, Inc. (NYSE:DHI) and Lennar Corporation (NYSE:LEN) are building homes in the market’s sweet spot because institutional buyers like Blackstone have been buying vast swaths of low priced homes. With so many low priced homes shifting to rental status as a single family home institutional market is being built, there’s little option but to buy new construction. That should be a nice tailwind for these companies over the near term.

Changes

However, there are changes that have taken place or are being discussed that could throw a wrench into the recovery and long-term potential of the housing market. For example, banks tightened their lending standards after the recession. That means that today’s home buyers are in better financial shape and default risks should be lower.

However, that decision also dragged out the housing market’s recovery. For every action, there is a reaction. Two issues being discussed today that could have long-term implications are increased down payment requirements and the potential for a change in mortgage interest deduction rules.

Trying to stop banks from lending to uncreditworthy buyers is understandable. However, increasing the amount of cash needed up front across the board will make it harder for everyone to buy a home. If such a change were to be enacted, there will likely be an adjustment period where sales drop off as would-be home buyers save up more money.

Changing the mortgage interest deduction, meanwhile, would alter the industry’s dynamics totally. Using debt would be less desirable because the actual “cost” of debt would increase. Without that deduction, some home buyers might decide to hold off on a purchase or chose to rent instead of buy.

Nothing Happens Overnight

Nothing happens overnight, which is good. It means that home builders and housing-related stocks probably have more room to run. Momentum accounts, then, should still like D.R. Horton, Inc. (NYSE:DHI) and Lennar Corporation (NYSE:LEN). If home sales keep advancing, their shares are likely to follow along for the ride.

Longer term, Blackstone’s move into the rental market may prove prescient. People have to live somewhere, and if they don’t own the house in which they live, then they are renting it. And, even if industry changes draw out the process, housing prices are likely to head higher over time. That’s an extra kicker for Blackstone and its shareholders.

The asset manager, despite owning over 26,000 homes, is widely diversified. So the impact of the property push will be muted somewhat. A more focused play on the institutional single family home market would be real estate investment trust (REIT) Silver Bay Realty Trust Corp (NYSE:SBY).

The company’s portfolio of over 3,000 homes hasn’t been fully rented. That’s a big occupancy risk in the near term, since the REIT only had tenants in 50% of its homes at the start of 2012. However, it opens up upside potential as the homes are fixed and rented out. A nearly non-existent dividend yield, however, means income investors should look elsewhere for now.

Watch and Listen

In the end, investors in or looking at the single family home market should keep an eye on the bigger picture changes that are taking place. The reaction to any change could be long lasting.

The article It’s Harder to Buy a House originally appeared on Fool.com and is written by Reuben Brewer.

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