Second-Level Thinking and US Homebuilders

Second-Level Thinking and US Homebuilders

6 Jul, 2023 | Stock Insight

The Standard & Poor’s Homebuilders exchange-traded fund (ETF), XHB, has increased by more than 30% in 2023 and 40% over the last 12 months. A number of homebuilder stocks such as PulteGroup (NYSE: PHM) and renowned value investor David Einhorn’s Green Brick Partners (NYSE: GRBK) have substantially outperformed even this lofty benchmark. Building supply stocks such as Installed Building Products (NYSE: IBP) have also performed strongly, outpacing even the rapid climb in technology stocks.

PulteGroup Pulte homes building corporation regional headquarters, corporate office with logo sign in Florida

This might seem surprising given the incredible demand for housing and renovation activity during the pandemic, and the dramatic rise in interest rates over the past 18 months. The cost of money has risen at the fastest pace on record and the interest rate on new and variable rate mortgages has nearly tripled. Shouldn’t higher interest rates make servicing a housing loan more expensive, reduce the demand for housing and renovating, resulting in lower prices and less homebuilding activity and therefore lower share prices for homebuilders and building products companies? Well actually, it depends.

Second-Level Thinking

Iconic fixed income investor and co-chairman of Oaktree Capital (now a part of Brookfield Asset Management following the merger in 2019), Howard Marks, highlighted the challenges of drawing direct cause-and-effect relationships in chapter 2 of his book “The Most Important Thing” (the book comes highly recommended, but for those who prefer more digestible content freely available on the internet, the majority of Marks’ teachings can be found in his “memos to clients” at no cost on the Oaktree Capital Management website. While they’re all valuable, the 2015 memo “It’s Not Easy” is the most applicable to this discussion).

Two of Marks’ most poignant examples of second-level thinking were:

  • “First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
  • “First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall far less than people expect, and the pleasant surprise will lift the stock; buy.”

Demand AND Supply

There’s no doubt that higher interest rates impact buyers’ ability to service larger loans. Ceteris paribus (all else being equal), this would lead to lower demand and lower prices for homes. Not all things are equal though, and this is only half of the equation. We know from microeconomics that the price and quantity demanded of a product or service depends on both the demand and its supply.

This is important because one difference between the United States and countries like Australia, Canada and the United Kingdom, is that buyers are able to obtain fixed-rate mortgages. Incredibly, these can be for up to 30 years! Understandably, there was a huge refinancing boom over the last few years as homeowners locked in incredibly low mortgage rates–a decision that will likely be one of the best of their financial lives.

Homeowner Mortgage Rates in the U.S. by Interest Rate

 Homeowner Mortgage Rates in the U.S. by Interest Rate

Source: Bloomberg

The only downside of locking in an extremely attractive interest rate for the next 30 years comes around if someone wants to move house. There needs to be quite a compelling reason to relocate when the average mortgage rate is now more than double what you signed on for 2 years ago–a very high-paying job or moving in with a partner, for example.

The outcome of this has been that less people are moving than ever before. This actually follows a bit of a long-term trend, and is a consistent theme in Australia as well: people are staying in their homes longer. To put some numbers on it, at its 2022 Investor Day, REA (owner of leading property website showed that the average property owner stayed in a home for 10.6 years, up 27% (or 2.3 years) from the 8.3 years 10 years ago. There’s a number of reasons for this change (including less desire to relocate for job opportunities), but no doubt the substantial amounts homeowners have spent renovating and furnishing their homes just the way they like it has a big impact.

Average property ownership duration

Source: REA 2022 Investor Day

Other influences on why housing supply is limited include strong levels of immigration, short-term rentals (such as AirBNB), and smaller household sizes brought about by fewer children per family, higher divorce rates and work-from-home arrangements (that have encouraged larger homes with better amenities such as heating/cooling). The Reserve Bank of Australia (RBA) estimated that the number of people living in each home fell from an average of 2.55 in late 2020 to 2.48 by mid 2022. While this might seem like a small change, in just 2 years this meant an extra 275,000 homes would be needed to house the existing population.

The trend is no different in the U.S., where the average household size was 2.5 in 2022, down from 2.55 in 2012 (you may notice a slight bump during the Global Financial Crisis, when the challenging economic conditions forced young people to move back in with their parents and homeowners and renters to take on extra housemates). Multiply this by the size of the U.S. population, and you can guess the results. According to CNN, the US housing market has a shortage of 6.5 million homes.

Average Number of People per Household in the United States (1960-2022)

Average Number of People per Household in the United States (1960-2022)

Source: Statista
The number of new homes being built is not putting a dent in this shortage. There has also been a dramatic level of underbuilding since the Global Financial Crisis–essentially as an overreaction to the extreme level of overbuilding prior to the crisis, which caused the huge bust. Locally, we have also seen a devastating impact from the supply chain challenges during the pandemic. A whopping 1,872 home builders declared bankruptcy in the 2023 financial year (up until May 14, according to the Australian Securities and Investments Commission). This is the largest number of insolvencies on record, and includes the likes of industry giant Porter Davis Homes, which went into administration in March with over 1,500 homes under construction at the time. In fact, since 2021, builders working on around 5,200 homes worth approximately $2.2 billion are estimated to have entered bankruptcy.

It’s Not Easy, But It Is Rewarding

It’s important to keep your investments simple and easy to understand. However, inexperienced investors can often draw false conclusions using first-level thinking–particularly about economic forces. This is why we have highlighted several times the success famous investors (including Peter Lynch) have had ignoring macroeconomic factors. As Howard Marks points out, it’s also essential to consider how the uncertainty and risk relates to the price of an investment. There’s no doubt that this is the most challenging part. As Berkshire Hathaway co-chairman Charlie Munger once said: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” But that’s also what makes it so interesting, and what gives investors the great opportunities for outsized returns.

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