Time to Load Up on Home Builders?

Key Points

• Homebuilder stocks as a group have performed well in the last year, driven by expectations that the Federal Reserve would lower interest rates.
• At the same time, individual companies in the industry have navigated the challenges posed by inflation and housing costs with different degrees of success.
• Investors should exercise caution to be sure that an investment target has fundamentals that suggest the potential for continued growth.

Investors and home buyers alike have watched eagerly as market optimism for homebuilder stocks has grown throughout the last year. The iShares U.S. Home Construction ETF BATS: ITB, a benchmark for the broader industry, rose to a 1-year high in mid-October and is currently up more than 38% in the past 12 months.

The bullish view that has predominated in the homebuilder space may be due to anticipation of the Federal Reserve's first rate cut in years, which was confirmed in the FOMC meeting in September.

As of mid-November, the Federal Reserve has announced a second rate cut, and analysts are still expecting more to come. This could theoretically be a boon for homebuilders, as it reduces their costs of borrowing to finance construction projects. Still, the ITB has cooled a bit in the last month, tempering its year-long gains with a drop of about 6.5% since mid-October.

Could this represent a dip and an opportunity to buy select home construction stocks? A closer look at three companies in the industry reveals a more complex and varied picture.

MTH: Single-Family Home With Room to Grow, But Potential Barriers

Meritage Homes Corp. NYSE: MTH builds single-family attached and detached homes throughout the southern portion of the U.S. As an entry-level homebuilder, Meritage develops properties catering to first-time homebuyers, a group that has faced significant obstacles to home purchases in recent years.

Analysts at Raymond James recently downgraded Meritage to a "market perform" based on an expectation that the firm will face near-term earnings pressure. Other factors impacting this downgrade may include labor concerns related to policies proposed by the incoming Trump administration, the potential for higher mortgage premiums among buyers using Federal Housing Administration loans, and more.

Nonetheless, MTH shares have a "moderate buy" rating overall and, based on consensus price target estimates, upside potential of more than 20%. The company's forward P/E ratio is 8.5, considered competitive for the industry a potential sign that shares may be undervalued.

TOL: Success Navigating the Complex Luxury Space

Toll Brothers Inc. NYSE: TOL is a Pennsylvania-based firm developing residential and commercial properties. Its fiscal 2024 third quarter saw a 2% year-over-year improvement in home sales revenues while net income and earnings per share were each down slightly relative to the year before. However, delivered homes rose by 11% during that same period.

As a homebuilder operating in the luxury space, Toll Brothers has faced significant market volatility in recent years thanks to inflationary pressures and consumer concerns about the economy, both of which have driven customers to seek out more affordable housing options. The continued growth of the company's deliveries is testament to Toll Brothers relative success navigating this landscape.

Another bright spot for the company is its recent announcement of a partnership with Daiwa House to develop a new 73-unit luxury condominium property in West New York, a fast-growing portion of the broader New York City metro market.

Analysts rate Toll Brothers as a "moderate buy." They see a shift toward earnings growth of 8% for the homebuilding company.

KBH: Negative Impact of Mortgage Rates and Inflation

KB Home NYSE: KBH builds a variety of single-family homes for first-time and first-move-up homebuyers across most of the U.S. Like the firms above, the company's business has been impacted by customer sensitivity to mortgage rates and inflation. In KB's case, the impact was enough to cause the company to miss analystast quarter, while housing gross profit margin declined and the number of homes ordered predictions for profit in the l remained flat from a year prior.

Still, despite the challenges in recent months, shares of KB Home are up more than 46% in the last year and peaked at an all-time high of almost $90 around the time of the Fed's September 2024 meeting. Analysts are now cautious, rating the firm a "hold" and expecting the price to decline by 1.4%.

Assessing the Industry

Some companies in the homebuilder industry may present a compelling value proposition given their capacity to grow in select portions of the market. However, as KB Home demonstrates, others are facing external hurdles that limit their top- or bottom-line performance alongside a rapid increase in share price driven by hopes that lowered interest rates could stimulate sales. Together, these two factors may prompt investors to exercise caution.