It is no secret that the U.S. housing market is on the rebound. More people are getting jobs, the unemployment rate is falling, and the housing price indexes are increasing. Still, there are hidden risks in the abnormally low interest rates that are fueling consumer demand.
Home builders will face serious difficulties when interest rates return to their historical norms and fewer people can get mortgages. Investing in relatively stable home improvement stores gives upside exposure and limits the downside risks in the event that the bottom falls out of the market.
The Home Builders
Home prices have been rising, but in many markets it is substantially cheaper to buy than to rent. Toll Brothers Inc (NYSE:TOL) is a home builder that focuses on the higher end of market with an average selling price of $573,000 in 2012. Its focus on this market segment is a major strength as it allows the company to benefit from America’s growing upper class. Regardless, financial crises easily scare luxury buyers, as the 2008 crisis showed.
Toll Brothers Inc (NYSE:TOL)‘ debt load isn’t excessive with a total debt to equity ratio of 0.69. Its numbers have come back since the great recession, but its current return on investment (ROI) is only 0.1%. Toll Brothers Inc (NYSE:TOL) is one of the better home builders, but with expected 2014 earnings per share (EPS) of $1.45 and its current share price around $35 it is too expensive.
is profitable and continues to move into multi-generational housing. There are a number of older Americans that cannot afford the costs of assisted living. Lennar’s multi-generational homes are cost effective alternatives between independent and assisted living.
Lennar Corporation (NYSE:LEN) is trading at high valuations with an expected 2014 EPS of $2.47 and a current share price around $43. It currently has a gross margin of 12.6% and a ROI of 8.9%. If interest rates rise, Lennar Corporation (NYSE:LEN) and Toll Brothers Inc (NYSE:TOL) could suffer a sharp fall in margins. The chart below shows how in a couple of quarters home builders can go from being highly profitable to very unprofitable.
Home Improvement Stores Offer a Safer Path
The above chart shows how home improvement stores didn’t suffer a giant drop in profit margins. All of the companies suffered, but the home improvement stores were able to maintain more of their customer base and keep a tight control on costs.
Home improvement stores offer exposure to the housing market, without some of the headaches of investing in volatile home builders.
Overall The Home Depot, Inc. (NYSE:HD) looks like a better investment than Lowe’s Companies, Inc. (NYSE:LOW). Both companies sell home improvement products in similar markets to similar demographics. The firms are similarly valued with a price to earnings (P/E) ratio around 25.
The Home Depot, Inc. (NYSE:HD) recognizes that the days of insane housing growth are over.
It is looking to make its operations more efficient and boost its return on invested capital invested (ROIC) to 24% by 2015. Lowe’s 2015 ROIC goal of 16.8% is substantially lower than The Home Depot, Inc. (NYSE:HD)‘s. Home Depot’s ROI of 16.6% and profit margin of 6.1% are significantly higher than Lowe’s ROI of 8.6% and profit margin of 3.9%. These numbers show that The Home Depot, Inc. (NYSE:HD) is better at turning capital into profits.
America’s housing market is coming back and more consumers have disposable income to renovate or buy a new home. This rebound is built on low interest rates and investors should be careful. Home builders are stuck in a very volatile business, and low interest rates only make the situation more dangerous.
Home improvement companies like The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW) offer a safer way to play the rebound. Their revenues and profits are not as volatile as home builders’ revenues and profits. The Home Depot, Inc. (NYSE:HD) is the better option as it runs a more efficient operation than Lowe’s Companies, Inc. (NYSE:LOW). If The Home Depot, Inc. (NYSE:HD)’s valuation decreases then it is definitely worth a second look.
The article Invest in Housing Without Breaking the Bank originally appeared on Fool.com is written by Joshua Bondy.
Joshua Bondy has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Lowe’s. Joshua is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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