In this episode of Industry Focus: Energy, Nick Sciple and Motley Fool contributor Jason Hall discuss the housing market. They talk about how the housing market has been affected by COVID-19 and what the future might hold for the industry. They also give a breakdown of three housing stocks, how they have performed so far, and whether they look like good investments.

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This video was recorded on June 25, 2020.

Nick Sciple: Welcome to Industry Focus, I'm Nick Sciple. My guest today is Motley Fool contributor Jason Hall. Jason, great to have you back on the podcast once again.

Jason Hall: Always fun to be on, and you know what, we're continuing the streak of not talking about oil companies; I'm pretty excited to talk about our topic today.

Sciple: Yeah, I'm looking forward to talking about an industry where there aren't imminent bankruptcies coming down the line, and that's what we're going to be talking about today with the housing market. Before we get into some of the players in the industry and some companies that you're interested in, what is the current state of the housing market today in the context of COVID-19?

Hall: Well, obviously, it's kind of dealing with a little bit of a dual-pronged attack, right? So, first of all, rewind back to March, and a lot of homebuilders had to shut down operations, at least temporarily, while states and local governments, kind of, circled the wagons and figured things out. And at some point, it started to open back up in most places, because housing is a critical need, an essential service. But it's harder, because a lot of these -- you know, they're still facing the same social distancing guidelines and things like that. They can make it harder and make it take longer and cost more to build houses. So, on one side you're having a major impact on the supply side. That's been the story for housing for a decade, supply, you know, there's not enough. So, it's exacerbating that in the short-term.

And then on the demand side, there's also pressure, because, I mean, you got [laughs] 20 million Americans out of work right now, that are technically filed for unemployment. Then you have millions more that are gig economy workers that may not qualify for unemployment that are also out of work. So, it's kind of a weird spot. But I think there is still a very bright future, but we'll talk a little bit more about that.

Sciple: Yeah. I think one of these factors to discuss, when you talk about people being out of work that's negatively affecting the housing market, but on the positive side, there's been this stimulus from central banks that has really pushed down interest rates. To what extent is that affecting the market and affecting the ability of people to pay?

Hall: Well, that's something I can comment on personally. We upgraded to a larger house, which is kind of the other side [laughs] of what we're actually going to be talking a lot about today with the homebuilders we're going to talk about. But we upgraded in November to a larger house, mainly because I've worked from home for a number of years and we have a small child and we just needed a little more space. Bought a house in Southern California. Our mortgage is $500,000, which I know most parts of the country that's insanely large, but it's actually relatively small, it's a conforming loan. And our mortgage rate at the time was 3.75%. We were ecstatic, that's a great, great rate. We just funded a new loan two days ago at 3%. And I think that's about where interest rates are, the average 30-year rate is. What did you find, Nick, 3.1% or so, somewhere on there right now?

Sciple: Yeah, roughly 3.1% today. Coming into the year we were about 3.75%, so it's a really significant downward move in interest rates.

Hall: Yeah. And it's hard to, for historical context, you know, I can remember in the 80s, when my parents signed a 15-year mortgage for 12%. So, just for context from the highs and the lows, this is insanely cheap. And historically, you know, a 6% or 7% interest rate on a 30-year loan was a reasonable rate. So, rates are insanely historically low right now. So, I mean, that's definitely a great tailwind in terms of more people are going to consider housing because loans are cheaper than they've ever been.

Sciple: Yeah. And so, as we're looking at the market today, maybe we can swing into some of the companies we're going to talk about. Meritage (MTH -1.28%) is one of the first ones that we wanted to discuss, and they've put out some numbers when it comes to what they're seeing as far as demand coming back in the middle of May toward the end of April. So, what are we seeing from these companies in terms of the market starting to return back to some semblance of normal?

Hall: Yeah. So, Meritage Homes, I can't remember if Tom or David picked it in Stock Advisor a number of years ago; I think it was Tom. So, it's a premium pick, it's a company that I like a lot. They focus just the, kind of, underlying business, they focus mainly on starter homes and entry level housing, but back in May, May 18th they dropped the press release; and they tend to drop press releases on a pretty regular basis about where volumes are in home sales and closings. May 18th, they dropped a release that said that cancellations were, like, 20%; which was not unexpected, because with everything with COVID and people losing jobs, that kind of stuff.

But the surprising thing was that Steve Hilton, the Founder and CEO, said that sales momentum increased during the last two weeks of April. This increase in traffic and orders has carried over into May, so we expect this month's orders could be in line with last May. So, it's been six weeks since he made these comments, but he essentially said in the middle of May that the traffic that they were seeing in the beginning of May indicated that their orders for May could be equivalent to May of 2019. That's incredible, right, that's absolutely incredible.

Sciple: Yeah. For the market to have returned so quickly, you know, when we look at Meritage's strategy focusing on the entry level market, do you think that might have positioned them to maybe recover more quickly relative to folks that might be toward the higher end of the market or positioned in a different segment for a different customer?

Hall: Yeah, you know, I think so, just because that's the segment of the market where there's absolutely the most pent-up demand. As somebody younger than I am, Nick, you can talk to this even better than me. But, you know, if you go back, something you and I talked about offline before the call was, you know, I was an active investor during the last recession and financial crisis. And the chatter for the first, you know, three or five years coming out of the global financial crisis and the Great Recession was that we had an entire generation that was not going to buy houses; that things had fundamentally changed and that millennials were not going to be homebuyers. You know, they were going to live together and they were going to live in apartments and they were never going to get married and they weren't going to have kids, and all of this stuff. And I mean, you could Google and probably find a thousand headlines that say, you know, "Will millennials ever buy houses?" And, you know, they are, they're buying houses, they're getting married, they're having kids, they're doing all of the same things as every other generation. It's just, you know, they got handed a pretty ugly hand, dealt a pretty [laughs] ugly hand and it just has taken them longer to get there.

And fast-forward to today and you have a situation where there's massive pent-up demand from millennials, and the next generation, it's going to be the same thing, that are very interested in buying homes, they're very interested in houses, and you have just a lack of inventory. It's only been in the past few years that more homebuilders have started to transition to building more starter homes.

Meritage is a great example, this is a company that five years ago, the majority of the homes they were building were custom homes, they were move-up homes, they were -- you know, somebody would come to one of their -- they'd see their showcase, and they'd go in and they'd look at it and then they'd sit down with the catalog and they'd pick out the floor plan they wanted and they'd pick out the appliances they wanted. And they would put down a deposit and then they would have that custom home built to their specifications.

There was a decent business, right, but Hilton and the rest of the management team realized that it was time to shift to where the market was going, and that was to starter homes. And about five years ago, the company started spinning most of their land development, they started buying land, that about 75% of it was going to be targeted at entry level houses. So, these are homes that are more affordable, they're smaller, they're more condos and that kind of thing, that are part of this mix, more townhomes that are part of this mix. But the big thing is, they're building a lot of more homes on spec, in other words, they're speculating there's going to be buyers. And they don't have a showcase where somebody comes in and they preorder and then they build it to their style they wanted. They built the house, it's done, it's ready. And then the people come and see it, and they either buy it or they don't.

So, there tends to be potentially more risk there, because you don't have a firm order in hand, but the flipside is that, even though these houses cost less, they are more profitable. The margins are better, because a lot of the customization tends to require more labor and can be more expensive. And you just have a little better utility of scale when you're building starter homes with a limited number of floor plans. And so, the margins are better, even though their average prices have come down, their gross margins have generally improved over the past few years as they've shifted more and more of their mix into this starter home market.

Sciple: Yeah, that entry level part of the market, as I look at the data, this seems particularly attractive. Because as you mentioned, you look at millennials, I think the median age of millennials is around 31 or 32 right now, and if you look at the historical long-term median age of first-time homeownership, that's right around that same age. And when you're a person who is coming into their early to mid-30s, there's a structural time in your life where if you want to have kids and raise them in a home with a yard and that sort of thing, you need to buy a house and make that decision sooner or later.

And so, we're entering this period just structurally within the demographics of this millennial generation where a lot of folks are going to have to make that decision. And I think you add in, I can tell you personally from being stuck in a one-bedroom apartment for the better part of the past three months working from home, you certainly get stir crazy. So, when you've got this demographic structural demand that was already in place, being buoyed by people just being tired of being in their apartment, being cramped inside, that sort of thing, I think it really adds some fuel to this trend.

Now, Jason, you mentioned building houses on spec and to the extent that that introduces risk into the business model, I know lots of folks are very cognizant of risk and looking at the balance sheet of companies in the context of what's going on in COVID. There's a lot of uncertainty of whether we're going to get a second wave or that sort of thing, when you look at Meritage's balance sheet, how do you see them positioned to withstand some potential disruptions and uncertainty coming forward?

Hall: So, I think this is something you have to be cognizant of with homebuilders. Homebuilders typically, if you start getting into the valuation, you'll notice that they tend to trade for really low price-to-earnings multiples, and they can look super-duper cheap as a group, but that's because there is risk.

 I mean, in a way there is a little bit of the leverage risk that you see with other businesses, because your typical home builder what they do, is they'll own, you know, three or four- or five-years' worth of land to develop. And they have to buy the land, and that costs money, and typically they don't want to tie up a ton of cash in that land. So, they tend to take on loans. And they use a lot of debt to buy that land. And that results in pretty high leverage ratios. The risk with that model is, when you have an economic downturn, and this one's a little bit weird, a little bit different, but your typical economic downturn. It takes, you know, multiple years for the economy to recover, for jobs to recover. And you have a prolonged period of time when housing sales is down.

And we don't know what this is going to look like with COVID, but the risk is, if there's a prolonged downturn in home buying that affects these companies, they're going to be sitting on this land that they can't develop, because they're not selling their properties, but they still have to continue to service that debt. So, the downside is they can weigh on their earnings, if home sales fall enough, it can lead to large losses, it can force them to have to sell land at a loss simply to clear it off their books and reduce expenses. So, it can compound the pain in downturns, which is the biggest takeaway.

So, that's why with a company like Meritage and LGI Homes (LGIH -1.57%), ticker LGIH, that we'll talk about as well, you have to be cognizant of the fact that they do carry higher debt levels. So, for example, Meritage Homes debt-to-EBITDA over the past year is 3.3X, LGI Homes is about 2.7X. And those are pretty high leverage ratios compared to other industries that you'll see. So, it's just good to be conscious of that.

Sciple: Absolutely. And to a certain extent, because they're carrying these real assets and putting leverage against them at maybe less risk than if you saw a less capital heavy business carrying debt, but certainly if there's a prolonged downturn in the housing market, not positive for these companies. You mentioned LGI Homes, ticker LGIH, how does that company and their positioning differ from what we've talked about with Meritage?

Hall: So, Meritage has been around for a good bit longer. LGI Homes is a newer company, it's smaller, based in Texas. And essentially, these are two companies that have really similar models, but LGI is even more, kind of, baked into the starter homes market. They're more in on starter homes than Meritage, which is still, to a certain extent, transitioning through some of their legacy developments, and they still have some custom, proper homes, that they're still going to continue to sell.

LGI is more focused on starter properties, it's again, smaller, so I think there's more potential upside for it to continue to expand. They're just two that I view them similarly, it's kind of the big brother and the little brother in a way. I really like LGI a lot, I think they've done a really good job to get into some really great growth markets in Texas, in the Southeast, whereas Meritage is still dealing a little bit with some of its legacy markets in Southern California that haven't necessarily been as forgiving. It's certainly not as easy to build starter homes in some of those markets. So, I think it's a little more nimble, but I like it and Meritage, both.

Sciple: Yeah. So, when we look at LGIH, this is the company that really crushed it coming into the year. So, through the first five months of the year, even despite COVID, total home closings up over 22%. In the first couple of months of the year they had record closings. So, when you look at this company, I mean, it seemed as though that they were really firing on all cylinders until COVID. And they put out their May data and they're getting pretty close to where they were last year. So, encouraging signs as far as performance for the company so far.

Hall: Yeah, I think so. And again, this jobs market that we're in right now with unemployment the way it is, it's kind of bifurcated in that if you think about a lot of the people that have lost their jobs so far, it's service jobs, it's retail jobs, people that may not necessarily have been in the home buy market to begin with. You know, we can talk about [laughs] economic inequality at another time, but I think the reality is that you think about so many other people, young people that are working, they're still working, right, they're just working remotely, that are still working.

And I think what we saw to start is just the impact of COVID, right, the lockdown, the social distancing guidelines that caused so many people just to stop even looking for homes, they couldn't, they couldn't go see a home. [laughs] It was against the law. So, I mean, I'm really interested to see over the next, you know, 60 days, 90 days, once we get more data, how much, to Steve Hilton's point, how much does traffic pick back up? Do people continue to do -- like, I know they've been able to do a really good job of quickly shifting to virtual viewings, to try to meet the moment.

So, I'm really interested to see how much unemployment really affects home buying. Is it hitting homebuyers or not? And my gut reaction is it's probably hitting less than your typical recession does, because there's nothing typical about the way that unemployment has happened so far.

Sciple: Yeah. Well, there's still a lot of uncertainty in the market, we shall see. Last thing on LGI Homes, when you look at the balance sheet there, you mentioned earlier, a little bit lower debt-to-EBITDA ratio relative to Meritage, anything else we should call out there on the balance sheet and their just ability to withstand a prolonged downturn if one were to arise?

Hall: Yeah, I mean, I think the reality with these companies is, [laughs] they tend to, kind of, walk a finer line. You look at LGI Homes, I think it ended last quarter with, like, $120 million in cash and short-term investments. Meritage has, like, $800 million. And another one we're going to talk about here in a minute, NVR Homes, the ticker is NVR, has over $1 billion in cash.

So, again, it's the ability to ride out a prolonged downturn, is certainly -- Meritage and NVR are in far better shape there, LGI is, kind of, riding a little bit of a finer line. But I think it has access to capital, it's just it doesn't have a lot of cash on hand right now.

Sciple: Okay. And so, moving on to NVR, like you mentioned this will be the last company that we discuss here. And they have a different approach to land acquisition that changes the risk profile somewhat relative to these other guys.

Hall: Yeah, it really does. And, again, it shows up, if you start looking on, you know, you look at the bottom-line, you look at that debt-to-EBITDA of 0.6X, and a debt-to-equity of 0.063X, NVR Home, they're mostly on the, kind of, the Mid-Atlantic area, they're headquartered in Virginia. So, they're up in New Jersey, New York and Virginia and Charlotte, you know, kind of that area.

Ryan Homes is one of their big brands, but they tend to buy a lot less land, and their strategy for many years has been to use options to acquire land. So, you know, they pay a premium to the landowner to hold an option to buy the land after a year or two years. And the benefit is that that gives them the ability to walk away from a piece of property, and sure, it's going to cost them that premium that they've paid. But they can avoid being leveraged to the hilt at the worst time to be rich in land and poor in cash. So, that model I really, really like a lot.

I think it provides a lot of ballast for an industry that, sure, if you think about, you know, the demographic tailwinds are phenomenal for housing over the next 10 or 15 years, they're tremendous, but this is still going to be a cyclical industry, right, there are going to be ups and downs, interest rates are going to affect it. You know, short-term economic headwinds are going to pop up. And the companies that have the ability to ride out those downturns are the ones that can generate the best meaningful long-term returns and the companies that are the most leveraged, even in a great growth industry, you know, [laughs] you can get from beginning to end and not generate a lot of meaningful return for investors, just because you blow through a ton of capital every time things get a little bit shaky. So, I think NVR is far, far safer, far less risky from that sort of thing.

Another thing I also like about NVR, as the company, has had a pretty steady, a pretty conservative, aggressive, yet well-run share repurchase program. Over the past five years, they've repurchased about 10% of shares outstanding, and that's returning a lot of value back to shareholders who've remained long-term investors.

The one thing [laughs] with NVR is, you look at the stock, and it's in the one comma club, it's almost $3,200/share at recent prices, which can be pretty scary. I own one-and-a-half shares. [laughs] So, my brokerage allows me through the app to buy fractional shares. And I think that's a great thing, and I think investors who aren't necessarily looking to throw +$3,000 as a starting point at a single investment should look at a fractional share of NVR.

Sciple: Jason, what do we know about NVR's performance so far this year following COVID? It seems they've been a little bit more tightlipped about their status relative to these other folks.

Hall: They have. While Meritage dropped that release in, kind of, mid-late-May, and LGI Homes dropped that release on June 3rd, we haven't heard anything from NVR, the last thing that they reported was on April 30th, they announced $600 million in senior notes at a 3% interest rate. Hey, there's that 3% number, right? And that's a 10-year note that they acquired, so they access some more cash at cheap costs. But there's no SEC filings or anything that's updated on their sales results. And an interesting thing that is, kind of, in that mid-May period, there was a, kind of, a breakout from the three stocks, if we look at -- when was it? I think you were looking at it earlier.

Sciple: Yeah. So, it's right about the beginning of May, you see a period where this group of three companies: LGI, NVR and Meritage had for the most part throughout the year traded together as a group, and you see about the beginning of May a period where --

Hall: ... yeah, May 1st, yeah, LGI and Meritage were up 43% and 37%, respectively, and NVR is up about 5%, which I mean, 5% in a month-and-a-half is not too bad, but a huge, huge separation between them. And I really do think it just boils down to, and this is total speculation, but we've seen a ton of new retail investors jump into stocks over the past couple of months. I mean, that's kind of been a big headline that we've seen is the numbers that have been reported by E*TRADE and Robinhood and all these companies -- for especially, young people jumping in and opening brokerage accounts.

I mean, I just can't help but wonder that you got two stocks that trade for less than $90/share and a stock that trades for $3,200/share, and I can't help but wonder if that doesn't explain some of the separation in the price acceleration between them. But also, I think it's just the reality that NVR hasn't said anything, right? The market has nothing to really navigate on. And NVR and LGI, both, they do a lot of the same things and they've both said relatively positive things.

Sciple: Right. Absolutely. So, it doesn't concern you that we haven't heard any updates from NVR on their status?

Hall: To the contrary, I think, if there's anything that it does for me, is if I were looking to put new money into a homebuilder today, I think I would be more interested in looking at NVR then the other two, simply because the other two -- I mean, if you go back, if you look at year-to-date, so just kind of normalizing back to, kind of, the pre-COVID world, LGI Homes is up 21% since January 1st. Meritage Homes is up 17% since January 1st. And we know that we're going to sell a hell of a lot less homes in the second and third quarters of this year than they did last year, it's just, it's almost a given, right? I mean, I think by the end of the year, maybe things will normalize, but we don't know for sure that they're going to normalize because we just don't know with COVID, right?

I mean, I think -- you know, I don't want to get [laughs] bogged down too much in this conversation, but if you just look at the science and you look at the data, COVID is a bigger risk right now than it was three or four months ago. And I think that's easy to overlook, because more of the economy has opened up, but I think that there's potential implications that the market is not pricing into those two that it has priced a ton of optimism that may not necessarily prove out to be true in the short-term.

And I think, to the contrary, I think NVR, just because the stock price is such a big number, it's the better value point at this point, right? And over the long-term, I would not hesitate to buy all three today at these prices if I were going to hold for a decade, which I intend to do, but I think if I was just going to buy one of the three today, it would certainly be NVR, because it trades at a much better value point.

Sciple: Okay, Jason, kind of, last question going away. We told a story here about this growth in demand for entry-level homes and, really, an undersupply that creates a scenario where it looks like these businesses can thrive. Obviously, COVID is an issue in the near-term that we're not sure how it will play out, but discounting that, assuming we return back to some semblance of normal, what could happen to where this thesis may not play out?

Hall: So, I think the thesis is going to play out, it's just whether the individual companies, you know, participate in, it is the big question. So, you have to realize that homebuilders spent the better part of eight years not building entry-level housing. Coming out of the global financial crisis, homebuilders had just about ceased operations. [laughs] I mean, we were at a point we spent four or five years where the homebuilders were building at a rate that was below replacement level.[laughs] I mean, the actual supply of housing fell for the last couple of years that housing supply fell, because you started looking at the number of houses that were being destroyed, vacant properties and things that were just being levelled. I mean, we actually went for a time where the housing supply shrank modestly. So, we're still trying to catch up to that.

You just look at housing prices, you read everything. Affordable housing is, I mean, that's a generational priority. I mean, it's enormous. So, for me, I don't think it's whether or not that thesis is going to play out, because there's no doubt that over the next decade, over the next 15 years, a tremendous amount of affordable entry-level housing is going to be built and going to be purchased in the United States, what it boils down to is whether the management teams for these companies can be disciplined enough and avoid the catastrophe that comes along with having too much leverage at the wrong time that can devastate shareholders, because the company has to take drastic steps just to stay afloat.

Sciple: Alright, Jason, thanks, as always, for joining us on the show and sharing all your expertise on housing and every other area of the market that you like to follow.

Hall: I have good news for you, Nick, Southeastern Conference football players are on campus and they are practicing.

Sciple: Hey, on that note, we've got positive news everybody and we'll see you next week.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for making us sound so nice. For Jason Hall, I'm Nick Sciple, thanks for listening and Fool on!