Firms to watch with housing shortage set to benefit homebuilder

The double whammy of a declining stock market and rising interest rates has been pummeling homebuilder stocks this year, resulting in rock-bottom valuations.

Those valuations make housing stocks look like the worst home in a bad neighborhood. But in reality, the industry is the cheapest house in an undervalued neighborhood.

In early April, the average forward price/earnings ratio of homebuilder stock prices to projected 2022 earnings was only four times earnings, the lowest of any industry in the entire U.S. stock market. This ratio dipped to 3.5 in mid-May, when the iShares U.S. Home Construction ETF (ITB) was down about 30% year-to-date. Shares of some large builders, like industry leader D.H. Horton, have fallen by nearly 40% this year.

This decline has been triggered, in part, by investors’ assumption that rising mortgage interest rates will hollow out the market by discouraging buyers. Never mind that bidding wars in some brisk local markets are producing sale prices higher than lender appraisals, forcing buyers to come up with additional cash at closing.

This market heat hasn’t stopped investors from dumping shares out of fear that rising rates will soon tamp down demand. As a result, many of these stocks have gone from being a bit overpriced to substantially underpriced in just a few months.

Yet rumors of the industry’s impending weakness have been greatly exaggerated. The battered condition of these stocks is actually an opportunity — reflected by elevated price targets from analysts — because data indicates that a chronic housing shortage will continue to fuel high demand, despite higher rates.

Though mortgage rates are expected to keep rising, they’re still quite low and will likely remain that way for at least the next year or two. In the past several months, typical rates on 30-year fixed-rate mortgages have shot up to about 5% from around 3%.

Yet historically, this is by no means high. Since 2011, rates had rarely dipped below 5%, and many buyers shopping for their second or third homes can remember paying 8% to 9% in 2000 or 10% to 11% a decade earlier.

Faced with the alternative of soaring apartment rents — as of April, up an average of more than 25% year over year and expected to continue rising with high inflation — many buyers will undoubtedly still see owning as the best financial option.

Many of those with already-challenged budgets will just buy less expensive homes, so higher rates may suppress demand largely at the lower end. Priced-out low-end buyers may be forced to rent, benefitting builders of multi-family housing.

The current dearth of available homes is likely to continue for as much as a decade. Statistics from the U.S. Census Bureau and Credit Suisse show the depth of this shortage with these readings of key market gauges:

• Historically, the nation has had a running supply of…