Are higher rates hurting the housing recovery? Not according to Lennar

LennarEnlarge GraphLennar Corporation is one of the United State’s largest homebuilders

Lennar Corporation (LEN) is a homebuilder with a primary geographic focus on the Southeast, South, Southwest, and Northwest. It has small exposure to the Northeast and the Midwest. Rialto Investments is its financial arm, which invests in real estate and manages funds that invest in real estate. In many ways, Rialto is similar to a hedge fund or private equity vehicle that invests in distressed real estate assets—whether properties, pools of loans, or mortgage-backed securities.

Lennar targets the first-time, move-up, and active adult homebuyer. The average sales price of a Lennar home last year was $255,000, which puts Lennar towards the lower end of price points, more in line with KB Homes (KBH) or Ryland (RYL), as opposed to the luxury end like Toll Brothers (TOL) or NVR. Lennar generally prefers to acquire land directly, as opposed to under options contracts.

Highlights of the earnings report and conference call

Lennar reported second quarter earnings per share of $0.61, which included a tax valuation allowance of $0.18. Last year’s second quarter earnings were $2.06, with a $1.85 tax valuation allowance. So apples-to-apples, earnings more than doubled from last year. Revenues were $1.4 billion, an increase of 53%, while deliveries increased 39%. New orders increased 27%.

Stuart Miller, CEO of Lennar, addressed the recent increase in rates: “Against the backdrop of recent investor concerns over recent mortgage rate increases, we believe our second quarter results together with real-time feedback from our field associates continue to point towards a solid housing recovery… Demand in all of our markets continues to outpace supply… Affordability remains high and despite recent interest rate increases, we have seen very little impact on sales or pricing.”

On the conference call, Miller gave further color on his view of the housing market. He pointed out that housing starts have been below 700k since the bubble burst (1.5 million units was the historical average from 1959 to 2002). Take into account an obsolescence rate of 300k, and you have a need for 1.2 million to 1.5 million units per year. Recently, we popped the champagne for a million unit print, which would have been viewed as a disaster in any other recession. In Miller’s view, we have more than absorbed the excess production during the bubble and have underproduced for years. The only thing that’s prevented massive shortages has been low household formation numbers. As a builder that focuses primarily on first-time homebuyers, Lennar has a good sense of the first-time buyer. While struggling with student loan debt, first-time buyers are moving out of their parents’ houses and establishing new homes.

One item that’s been a recurring theme has been increases in costs, particularly labor. Most of the price appreciation of Lennar’s new homes has been due to increased labor costs, as there is a shortage of skilled construction workers. Land availability is also an issue. The company views this issue ultimately as a positive, though, in that even though costs are increasing, Lennar is reducing unemployment, which ultimately fuels longer-term confidence and sales. The last headwind—a tough credit market—is starting to abate.

The takeaway

The takeaway from the earnings report is that so far, the hike in rates hasn’t affected demand, which has been confirmed in the MBA purchase applications index. Second, notwithstanding the drop in lumber prices, costs are going up, but margins are still increasing. Finally, the housing recovery was not driven by financial engineering (that is, the Fed), but by household formation. Overall, Lennar’s report was very bullish on the housing sector as a whole.