Two Ways to Play Housing

Posted On August 18, 2015 10:11 am

The aftermath of the financial crisis bubble is still shaping the housing sector. Here are two companies best positioned for the current landscape.

It’s no secret I’ve been bullish on homebuilders since last December when I identified Lennar (LEN) as one of my top picks for 2015. In April I made some adjustments to lock in over 100% gains on that position while maintaining upside exposure.

Since that time several trends have come into focus suggesting these two names are best positioned for big gains during the second half of the year.

The housing sector is still in recovery mode following the financial crisis which was brought about by a bubble in the housing market. The two largest trends that will driving the market now and next 12-24 months are:

  1. Millennials are showing a distinct preference for renting, particularly in multifamily units in urban areas, over owning a home.
  2. The lower end of the market remains moribund due to constrained credit, a relatively weaker rebound in prices which has led to a lack of inventory creating a negative feedback loop.

Taken together these dynamics tell me that the companies that focus on apartment rental units and those building high end homes are best positioned to benefit from the measurable but uneven housing recovery. The two names that look particularly attractive, though for very different reasons, are Toll Brothers (TOL) and Avalon Bay Communities (AVB) as they each address these two important trends. Before drilling down into the specifics let’s look at the current landscape of the housing industry.

Negative Equity Sinks Low End

Even as the average and median home price has increased some 29% from the 2009 lows it has become a market of “haves” and “have nots.” Most of the headlines concerning this divergence focuses on the differential pace of recovering between cities, with top tier cities coastal such as San Francisco, Miami and New York registering big gains while Midwestern locals such as Detroit, Atlanta and even Chicago experiencing flat or even a slight decline in prices over the past two years.

Location is certainly important but there is bigger disparity cuts across all regions that points to a structural problem in that may create a drag on housing market for years to come. Namely, the low end, or houses priced below $225,000 has barely experienced any recovery. This has resulted in a swelling of the number of homeowners that have negative equity or are “underwater” on their mortgage.

A recent report from Zillow states, “Negative equity continues to adversely affect the U.S. housing market, and will for the foreseeable future. While millions of previously underwater homeowners have been freed in recent year thanks to rapid home value growth, those that remain underwater are both more deeply underwater than others and likely own the kinds of inexpensive, bottom-tier homes that are unlikely to appreciate in value very quickly and may even depreciate.”

Zillow’s data shows that nationally, 51% of underwater homeowners owe at least 20 percent more than their homes’ value on their mortgage. The bulk of negative equity has accumulated in the bottom one-third of homes by home value.

Negative Equity 8.16.15

Having large swath of low end or entry level homes with negative equity has created an inventory problem. Since underwater homeowners find it virtually impossible to list their home for sale without undergoing a lengthy short-sale process or bringing cash to the closing table. These shortages of for-sale homes were readily apparent in 2013 and 2014, and continue to be an issue for millennials and first-time homebuyers looking to purchase an entry-level home.

Although the current overall inventory level still far below peak levels of for-sale inventory of 2011 there has been a notable increase over the past 18 months.

Housing Inventort 8.16.2015

It is the low end/entry level that drives the changes in inventory; think the large tracts of developments that were built outside of Phoenix, inland California and suburban Atlanta. The industry is hoping that demand will come return, and a lack of inventory because of high rates of negative equity will create competition among entry-level buyers, but so far, builders have been unwilling or unable to enter the bottom half of the market with new construction.

For this reason I’d avoid homebuilders that are focused on low end or entry level homes or have large land holdings such as Beazer (BZH), Hovnavian (HOV) and Saint Joe (JOE). These stocks have all been in a downtrend and I expect them to continue to struggle.

For Whom the Bell Toll Brothers

My top pick right now is Toll Brothers (TOL). It builds detached and attached homes in luxury residences which targets  move-up, empty-nester, active-adult and second-home buyers in 19 states mostly across the eastern third of the United States. It also creates and operates golf and adult communities. Basically, the upper class, the type of people that have most benefitted from the 6 year long bull market and can either pay cash or easily qualify for a jumbo loan.

What I also like and think will drive growth is Toll’s move into building multiunit condo projects in urban areas especially top tier cities. This will help them capture the affluent millennials whose first purchase is more likely to be a downtown apartment than a suburban home.

The stock has performed week, up some 16% year to date and just hit a new 52 week high on Monday.

TOl Chart 8.17.15

The company is set to release earnings on August 25th and I think a good report could catapult it to a new leg higher. I’m targeting the purchasing of January 2016 calls. Specifically;

-Buy January $45 calls at $3.00 a contract 

These options expire January 15th, 2016 giving a solid five months for the bullish thesis to play out. My initial price target is $48 a share which would provide a 150% gain in the call options. To manage risk I’d use a close below $36 a share as a stop loss for exiting the postion.

Right Time for the REIT 

Avalon Bay Communities (AVB) is engaged in the development, redevelopment, acquisition, ownership, and operation of multifamily communities. The company owns and operates 164 operating apartment communities comprising over 46,00 apartment homes in 10 states. Thanks to the shifting demand for rentals from millennials Avalon Bay has benefited from rising rents which has boosted profitability by an avarage of 12.2% over the past three years.

The company is structured as a REIT which has cut both ways. A few years ago when income hungry investors sought out REITs and MLPs shares of AVB more than doubled between 2010 and 2012. Shares have since been buffeted on expectations that rates are set to rise.

It currently yields a decent 2.8%, which enough to support the share price but not high enough to lure income starved investors. That’s ok as I think this stock should be bought for capital gains not income yield. The recent off the rally suggest others are waking to that notion.

The stock put in a double bottom at the $158-$160 level last month and is in a solid upward trending channel.

AVB chart 8.17.15

I think this trend should continue through the end of the year. Here too I’m targeting the purchase of January 2016 call options. Specifically;

-Buy January16 $175 calls for $8.50 a contract

My initial price target is $200 a share which would give the calls a minimum value of $25 or a 200% profit. To manage risk I would use a close below the $160 level as stop loss for exiting the position.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.