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Homebuilders Downgraded at Wells Fargo on Weak Housing Reports

The 30-year fixed mortgage rate averaged 5.78% in the week ended June 16, up from 3.11% in the week ended Dec. 30.
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Soaring mortgage rates are slamming the housing market.

For example, pending home sales dropped 3.9% in April from March, the sixth straight monthly decline, according to the National Association of Realtors.

"Pending contracts are telling, as they better reflect the timelier impact from higher mortgage rates than do closings," Lawrence Yun, NAR's chief economist, said in a statement. "The latest contract signings … are at the slowest pace in nearly a decade."

All the negative housing news is affecting Wells Fargo analysts’ view of homebuilder stocks. “Our proprietary housing-market checks in May confirmed that housing inflection happened in April,” they wrote in a commentary.

“The slowdown was more evident at the value end of chain (entry level speculative builders) and is slowly broadening -- the luxury, build-to-order builders will be the last to feel it.”

Softness Surprises

Further, “given the unprecedented rise in interest rates year to date, housing-market softness is hitting faster than many anticipated,” the analysts said.

The 30-year fixed mortgage rate averaged 5.78% in the week ended June 16, up from 3.11% in the week ended Dec. 30, according to Freddie Mac.

“Inflation and Fed actions will determine how trends will play out,” the Wells Fargo analysts said. But “investors will continue to assume the worst-case scenario and value stocks based on risk factors, such as entry level exposure, land risk, margin decline potential etc.”

In terms of the analysts’ stock ratings, “given that fundamental housing data is likely to incrementally get worse from here and continue to feed negative investor sentiment, we try to estimate how much lower the stocks can go based on perceived risk,” they said.

Downgrades

As a result, the analysts downgraded M.D.C. Holdings  (MDC) - Get Free Report and Meritage Homes  (MTH) - Get Free Report to underweight from equal weight and downgraded Toll Brothers  (TOL) - Get Free Report to equal weight from overweight.

M.D.C.: It has a “high-risk perception” from owning the most lots among its publicly held peers, the analysts said. “Its lower prepandemic land base indicates risks to gross-margin sustainability.”

Meritage Homes: “Normalization to precovid levels would risk solid advances made since 2020,” the analysts said. Earnings tripled over the two years through 2021, beating peers. A lower prepandemic land base and slightly higher balance sheet sensitivity pose problems, the analysts said.

Toll Brothers: “It’s a midcycle play, but the current cycle is near an end,” the analysts said. “Build-to-own luxury is holding strong for now, but should follow the general housing market with a lag as the cycle inflects.” Further, “its affordable luxury product line resilience will be tested for the first time.”