Morningstar Magazine - June/July 2017 - 98

Investors

This Old Housing Recovery
After a decade of slow
growth, millennials are poised
to buy homes.

SECTOR RAP

Laura Lallos

The road to a housing recovery has been a long
one, but Morningstar's analysts are optimistic
about what lies ahead. In a mid-March
research report on the housing outlook,1 they offer
best ideas among housing-related stocks-
including Williams-Sonoma WSM and Bed Bath &
Beyond BBBY, discussed in last issue's Sector
Rap-and explain the variables underlying their
outlook. Millennials are a driving force, so much
so that they recently devoted a report to household
formation among younger adults.2
To explore their findings, I sat down with two of
the contributing authors. Charles Gross is a
basic materials analyst who chairs Morningstar
equity analysts' U.S. housing committee, and Brian
Bernard is an industrials analyst who covers
homebuilders. The conversation, which took place
on April 4, has been edited for length and clarity.
Laura Lallos: What has hindered the housing recovery?
Charles Gross is an equity analyst
who covers basic materials for
Morningstar Research Services.

Gross: When we look at the data series of starts
going back to just after the Great Depression,

basically, we do not see a decade this weak
in housing. I think what happened is the global
financial crisis severely hurt younger adults,
and disproportionately so. You saw higher
unemployment rates, you saw lower wages, and
those things have taken a long time to get back to
where we were even 20 years ago or so. As a
result, there's been the decadelong delay we've
seen, sort of a spring getting compressed.
But now you foresee robust residential construction
growth. What's driving that?

Gross: Ultimately, it's the unwinding of a lot
of the factors we've seen. Pent-up demand over
the past decade will slowly start to be realized over
the coming decade. When we look out right
now, we see labor markets are substantially tighter
than they have been. We've seen that turning
point since roughly about 2014, to where
job openings, for example, are back at early 2000
highs at this point. That's resulting in much
stronger wage growth. So, we're finally seeing
young adults essentially converge on the
median American, in the sense that they have
much lower unemployment rates, as well as
underemployment rates, and meaningful inflationadjusted wage growth. As those things come
to fruition, we see those propelling headship rates,
the portion of adults that are a head of
household. Young adults are able to move out
from their parents' basement, if you will, and
get their own place, whether that's an apartment
or house.

How are homebuilders appealing to millennials?
Brian Bernard, CFA, CPA,
is an equity analyst who covers
industrials for Morningstar
Research Services.

Bernard: As the recovery started to play out, homebuilders were actually shifting toward homes in
the $400,000-plus range, and not focusing
on the entry-level buyer. But now, as the recovery
continues to unfold, they see that there's a lot
of demand out there from those who can't afford
that type of house. So, now homebuilders are
starting to offer smaller, more affordable houses,
maybe a little bit farther out from the urban
centers, but cheaper for that type of buyer. It's
really been remarkable. D.R. Horton DHI was
probably the first builder that really started doing
that, and in the past year, other public homebuilders are coming out with products like that.

There are some builders like Lennar LEN that
aren't buying into that. They still think that
the millennials want to live more in the urban
areas, so they're spending more on more
high-density townhomes-still lower price, but not
quite that entry-level house that you think of.
And then there are some builders-Lennar and
Toll Brothers TOL-that are also investing in
rental properties. We think that ownership is going
to come back, but they're hedging if that's not
the case.
How might higher mortgage rates affect the equation?

Bernard: We're hopeful that, if we see rising rates,
we'll also see a strengthening economy with
rising wages. And there is the increasing
availability of these affordable homes. Even with
higher rates, these smaller homes will be
more affordable, so will require lower down
payments and lower mortgage payments. We see
this kind of counteracting rising rates.

Another thing to consider is that, even though
rates have ticked up, and a 30-year mortgage

1 Gross, Charles, Brian Bernard, Jim Sinegal, and Seth Goldstein. 2017. "U.S. Housing Outlook and Top Picks: Help wanted: Starter homes and mortgages for young adults," March 16.
2 Gross, Charles, Brian Bernard, and Seth Goldstein. 2017. "Millennial Households Are Down but Not Out: Falling unemployment and rising wages are poised to stimulate household formation
among younger adults," March 31.

Morningstar June/July 2017

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