Housing: There's 'plenty of construction to be had' in rental markets, analyst says

Wedbush Securities SVP of Equity Research Jay McCanless joins Yahoo Finance Live to discuss dwindling homebuilder sentiment, new home construction, and the overall state of the U.S. housing market.

Video transcript

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DAVID BRIGGS: New data shows construction of new homes rose more than 12% in August, this after a steep decline in July. This comes on the heels of a report that builder sentiment is down for the ninth straight month. Jay McCanless with us, Wedbush Securities Senior Vice President of Equity Research.

Good to see you, sir. So we talk about that number, up 12%. On the other hand, building permits are down 10%. It's a little bit confusing. Is there some reason for optimism in there?

JAY MCCANLESS: You know, thank you for having me. I think part of the issue with starts being a little delayed is supply chain, both on-- in terms of developing the land to get it ready to put the home on and then actually getting the home. constructed itself. As the parts and pieces become available, the builders are going ahead and starting.

I think the slower permit growth is a function of what you talked about with higher mortgage rates, maybe builders being a little more cautious until we figure out where mortgage rates are going to settle out. I also think that the builders already have a lot of homes that were underway. And, again, now that they're starting to get the parts to get them built and get them constructed, they may be slowing down a little bit of the forward production until they can catch up in the field.

SEANA SMITH: Jay, speaking of those higher mortgage rates, what do you think demand destruction potentially looks like? And how long do you see this challenging landscape here for housing lasting?

JAY MCCANLESS: Yeah, I wish I knew when the mortgage rates were going to stop going up. It's been a pretty challenging environment, certainly the highest rates we've seen in years. What we did see in August when rates stabilized for about-- or late July and early August, rates stabilized for about six weeks. That started to help bring some buyers back in.

Who knows where mortgage rates are going to go this time around. But if we could find a level and stay there, even if it is a higher level, that helps people figure out what their monthly payment is going to be, and conversely helps the builders, I think, generate more-- more web traffic and foot traffic to start people on that home buying journey.

RACHELLE AKUFFO: And, Jay, I want to ask about the neutral rating on Toll Brothers and the $50 12-month target that you have for them. Talk about some of the issues that are at play and what you think might potentially turn it around.

JAY MCCANLESS: Yeah, we're cautious on-- we like Toll Brothers, the company, but we're cautious on the stock right now just because that higher-end consumer, which Toll, that's their focus are luxury and higher-end consumers, that consumer seemed to have pulled back more in terms of confidence and willingness to buy a home than what we saw from some of the entry-level builders in the June and July earnings season.

So until we see that higher-end customer maybe a little more willing to step out and get a home, which we've seen it from some of the other builders, too, but that's, I think-- when we-- ahead of the June earnings cycle, the expectation, at least on my part, was that we were going to see maybe the entry-level consumer pull back a little bit, but that move up in luxury consumer would be able to ride out this change in rates.

And it's actually been the opposite. That entry-level, needs-based buyer who is growing their family, needs more space, that buyer, if they can find a payment that works for them and a home that works for them, they are going ahead and making the move. Whereas that higher-end consumer is being a little more hesitant right now. So that's the reason behind the neutral rating for Toll at this point.

DAVID BRIGGS: Most of the big home builders are down in the neighborhood of 30% on the year. Contrast that with what you see in KB Homes and why they outperform.

JAY MCCANLESS: So KB does about 55% to 60% of their quarterly volume in entry level. Their entry level, though, is more of a, call it a tweener, not really a spec smaller home to a home that a person can customize. We like their model. We like the fact that they focus on that 55% to 60% entry level because, again, that's where the demand seems to be.

Going into the print, we are ahead on earnings. But we do think that orders may be a little bit softer this time because, as opposed to some of what we call the speculative home builders, which are homes that are started without a sales contract, people who it may take six to nine months with their KB Home to receive it, they may be a little more hesitant to buy right now. Whereas with the three other names that we like, Meritage, Century, and Horton, they do have homes that are available for purchase within 60 days or less.

And the buyers seem to like that right now, because they can go ahead and lock in the rate on their mortgage, have an idea of what their payment-- monthly payment is going to look like, and I think that may give those three names a bit of an advantage right now versus KB. But, again, we do like the entry-level exposure. And as that buyer who may have a little more-- a little more money saved up or maybe a little higher income demographic, once that buyer starts to return to the market, we think KB is going to benefit from that.

SEANA SMITH: Well, Jay, it certainly is a very tough environment, a deteriorating environment for the housing sector right now. What do you think the impact will be on this space? Do you think we could potentially see consolidation as a result?

JAY MCCANLESS: You know, I haven't really seen consolidation in a couple of years. And I think, given the opportunities that some of the builders have in the single-family for-rent space, it wouldn't surprise me if we see some of the production that was going to go to for sale move to for rent. I can't rule out consolidation. But there are so many investors and dollars being earmarked and targeted to go into that rental market, I think there's plenty of construction to be had out there. It may just not be exactly what the builders had anticipated coming into this year.

And I think, also, you look at the competition for-- to for-sale housing, multifamily rents are still moving up 15% a month. Single-family rents are moving up 15% to 20% a month. So we think the overall shelter demand is still very high. It's just some of the builders may need to reset pricing and/or help out on the rate side to get people into those homes.

But when we look at the demand and the demographics, with the millennials being such a larger population that's fully in household formation mode right now, and you compare that to 2009 when we had too much inventory and not enough buyers with the Gen X generation, I think from a demand and a shelter demand standpoint, we're set up much better this time around than we were during the GFC.

RACHELLE AKUFFO: And, Jay, you mentioned multifamily projects. That was actually one of the bright spots in the home builder data. And that's, of course, being driven by some of the strong demand for rental properties. Are there certain companies that are in a better position to capitalize on this than others?

JAY MCCANLESS: Yeah, the two that we covered that play in the multifamily market-- or build in the multifamily market are DR Horton-- or sorry-- three, DR Horton, Toll Brothers, and Lennar, all three of them build multifamily projects to one extent or another. DR Horton has also started their own single-family for-rent division, where they're building whole communities, leasing them up, and then selling them in to investment funds.

And most of my other builders that I cover have started to move into the single-family for-rent space, either through joint ventures or doing some sales directly to investors. So, yeah, multifamily and single-family for-rent, again, those are other revenue opportunities for the builders. But to multifamily specifically, especially with some of the really strong rent growth we've seen in that market, Toll, Horton, and Lennar are going to be our most immediate beneficiaries.

DAVID BRIGGS: It seems to be where the trends are headed. Jay McCanless, appreciate you being here. Thank you.