Investing in Home Builder Stocks: What You Need to Know

After years of tumbling share prices, investing in home builder stocks has been a profitable venture over the past few months.

Year to date, the exchange-traded fund for the home building industry, SPDR Home Builder (NYSE: XHB), is up by 26.1%.

It's the same story for individual home builder stocks, too.

Luxury home builder Toll Brothers (NYSE: TOL) has risen 25.9% since the first of the year. The largest home builder by market capitalization, Lennar Corp. (NYSE: LEN), has soared 43.6% in 2012.

So confident are home builders now that Lennar is expanding its corporate headquarters in Miami by 30,000 feet, an increase of one-third in square footage, according to an article in the South Florida Business Journal.

Home builder stocks, however, could be near the end of their steep rise. The housing market remains unstable and has triggered more skepticism in the sector.

Here's what you should consider before investing in home builder stocks.

What the Housing Market Data Tell Us

First, home builder shares were heavily beaten down by the Great Recession. On average, home builder stocks fell a stunning 81%. That plunge has only magnified the current rise.

Now the housing market faces unsettling factors on both the macro and the micro level.

For the macro indicators, U.S. housing prices remain unstable.

Home prices gained 0.6% in March from February, according to CoreLogic data released today (Tuesday). That's the first gain in eight months. But of the top 100 statistical areas measured by population, 57 continued to show year-over-year declines.

Goldman Sachs (NYSE: GS), while stating that we're reaching a housing market bottom, still sees home prices falling in 2012.

Clear Capital, a California-based real estate research firm,cautions that,"Individual markets reacting to their local economic conditions continued to exhibit a wide range of performance levels in 2011, with only 12 of the top 50 metro markets (24%), returning year-over-year price movement that can be considered stable."

Clear Capital defines "stable price movement" as price swings of less than 2.5%.

From that, Clear Capital projects that only 40% of the largest urban regions in the United States will be "stable" this year.

Yale Professor and housing market expert Robert Shiller said in an interview while at the economic conference in Davos, Switzerland earlier this year that he did not expect housing prices to recover anytime soon in the United States.

"I don't see any reason to think that prices are going to start heading up dramatically now," Shiller said.

This housing market instability has made for volatile home builder stocks.

Volatility is measured by beta with the average for the whole stock market being neutral at one. Lennar Corp. has a beta of 1.75, meaning it is 75% more volatile than the entire market. Toll Brothers also moves more than the market, with a beta of 1.10.

Even though home builders have seen a healthy rally, the volatility and housing market data has triggered an increase in short positions on home builder shares.

What Do the Shorts "Know" About Home Builder Stocks?

A short position of 5% or more is considered to be a sign of trouble for a company or a sector. At present, the SPDR Home Builder exchange-traded fund has a short position of 24.08%.

That is stunningly high for an exchange-traded fund, or any security for that matter. A short position of that magnitude represents a tremendous lack of confidence in the investor community that home builder stocks can maintain recent gains.

This is shown also in the individual home builder stocks.

While Lennar Corp. is optimistic enough about the future to greatly expand the size of its headquarters, the short position on the company has now reached 18.63%. Toll Brothers has a short position of 8.79%.

Short sellers borrow stock and sell it at the current price, but are obligated to replace the shares they borrowed at some point in the future. If the stock falls, they profit. But if the stock rises, and particularly if it rises quickly, the shorts stand to lose.

That could set up a short squeeze, with investors who are short scrambling to "cover" their positions and minimize losses before the stock goes any higher.

Of course, the good news necessary to create the squeeze may never come.

The Risk of Investing in Home Builder Stocks

While home builder stocks have delivered hefty profits for investors, those gains have started to slow.

This week home builders have slipped. SPDR Home Builder ETF is down about 3% in the past five days. Lennar has fallen almost 4%, and Toll Brothers is down 0.5%.

Home builder stocks also are weighed down with risk.

First, the stocks aren't cheap. The price-to-earnings ratio for Toll Brothers is now 129.70. For Lennar Corp., the P/E ratio is 69.43. The average P/E ratio for a stock on the Standard & Poor's 500 Index is around 14.

For Lennar, there also is a debt issue that worries investors. The company has a debt-to-equity ratio of 1.50. That means it took 1.50 in borrowing to produce every dollar of asset value.

Servicing this debt will not be easy for Lennar when earnings-per-share growth is down this year by 4.97%. Short-term trends are worse as, on a quarterly basis, earnings-per-share growth is off by 44.67%.

Toll Brothers is also struggling with debt, with a high debt-to-equity ratio of 0.62.On a quarterly basis, both sales growth and earnings growth have plunged for Toll Brothers. Sales growth is off by 3.64%. Earnings-per-share growth is down by 182.43%.

So when it comes to the recent run-up in shares of home builder stocks, recognize there is more there than meets eye. The housing market bottom promises to be a bumpy one.

By the way, we'll know more about what to expect later this month when Toll Brothers reports earnings before the bell on May 23.

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