Home Buying Heats Up—Just Enough

July is typically a slow month for real estate, but I recently heard a local realtor say she had to hire police officers to control the traffic at an open house last month. National numbers echo this strength. So much for the dog days of summer—at least in the housing market.

This wave of demand offers investors some fertile opportunities. Buying home builder stocks is the most obvious play, but the risk is too high in that group right now. The best bargains are usually found further down the food chain: in companies feeding the leaders.  

Last week’s release from the Commerce Department confirmed that national numbers for home sales look as bright as they do in my little Massachusetts hamlet. In fact, single family new home sales rose to their highest level in eight years. The seasonally adjusted annual rate increased 3.5% to 592,000 units from May’s estimate. The pace of new home sales is up 25% from last year.

And mortgage money is at a record low: 3.36% for a 30-year fixed home mortgage. That matches the record set in December 2012.

My bear radar perked up when I hear about traffic control for an open house. That reminded me of the 2005 housing peak when the local barber was flipping condos for a 50% profit. But we’re far from that level of froth. The estimated annual new home sales number of 592,000 is still nearly 50% below the 1.3 million peak 12 years ago.

We may never hit those peak numbers again. Many of those homes sold were to ghost owners—flippers who believed there was no end to buying high and selling higher. Of course, many of those properties were abandoned and lost to bankruptcies, leaving a wasteland of alligator-filled swimming pools (at least in Florida) and squatters in the nation’s most overbuilt neighborhoods.

Our housing market today has room to grow. New home sales fall within the normal band of 400,000 to 800,000 that we’ve seen since 1963 (excluding the 2005 peak). Given current numbers, new home sales can grow 35% before reaching the upper limit of that band. The good news for investors is that the growth is more constrained in this expansion. Many home builders went out of business in the 2009 housing implosion and, along with them, weak suppliers. While rates are low, lenders are controlling credit enough to keep speculators on the sidelines.

The four largest U.S. public home builders issued optimistic reports for the balance of the year. Each reported a high-single-digit to low-double-digit backlog. One of the most interesting trends is the migration to higher-priced homes, as consumers opt for more luxurious touches.

D.R. Horton, the biggest builder in the U.S. by a wide margin, noted on its second-quarter conference call that it has been offering fewer price cuts to customers while still keeping sales on track—another sign of strength. The value of D.R. Horton’s backlog increased 17% with units increasing 15%. The gap between those two rates is the increase in price per home.

The next three largest market players, Pulte Homes, Lennar and NVR, all reported backlog growth with a higher dollar value than unit growth, a trend mirroring D.R. Horton’s ability to charge higher prices.  

With confirmation that the home builders have solid orders in hand, my work begins to move down the food chain. I’ve been researching stocks that supply everything from doors to windows to cement to the home builders. The trick is to find those businesses with solid balance sheets and profit growth robust enough to justify valuations. I’ve already found two well-built stocks, one in the Profit Catalyst portfolio and another in Growth Stock Strategists portfolio, reaping profits from home-building growth as well as company-specific trends that supplement an industry on the move.