Investors often discuss the importance of a diversified portfolio. This means that not only should your brokerage account be spread into a wide range of investments, but one's overall net worth should also resemble an evenly sliced pie. With most Americans having a large portion of wealth tied to their home, more exposure to the housing market is not the best idea.
The problems with the housing market
When you break it all down, the current problem with the housing market comes down to supply outweighing demand. Currently, more than 4.6% of all the homes in the U.S. currently sit empty. Here are three reasons why I think that number is going to get even larger.
- More potential buyers being denied mortgages. The National Association of Realtors had 33% of its members reporting that clients had been denied mortgages in November. That was more than 3.5 times higher than the previous year.
- For every foreclosed home that sells, two more are foreclosed on by the banks.
- The government may sell a quarter of a million homes, which Fannie Mae and Freddie Mac have sitting on the books, to large investors who will turn them into rental properties. This will add to the 4.2 million empty for-rent homes on the market now.
The money pit
With so many vacant homes, builders such as Hovnanian Enterprises, D. R. Horton (NYSE: DHI ) , Lennar (NYSE: LEN ) , KB Home (NYSE: KBH ) , and PulteGroup (NYSE: PHM ) are not going to see demand return to pre-bubble-bursting levels anytime soon. To see my point, take a look at these figures: KB Home had revenue of more than $9.3 billion in 2006; that number is now only $1.3 billion. The story is the same for Pulte, which saw $14 billion in revenue during 2006 and currently brings in just $4 billion. It's a similar story for the rest.
My colleague Neha Chamaria pointed out that new orders and backlog units are on the rise for the homebuilders. While most of these homebuilders are seeing a rise in backlog of around 20% and new orders are up about 35%, as shown above, that's from a low base. These companies would have to increase revenues multiple times over to get back to even.
The chart below shows how the stocks of these companies have fallen as demand slid -- and, the stock price has not yet rebounded.
Don't get greedy
With the housing industry showing signs of turning around, homebuilder stocks could produce some large gains in the future. During the same time, home prices around the country should also begin to rise.
Here are three possible scenarios if you were invested in both a home and the homebuilders, or as I call it, trying to double dip in the pool of greed.
- Both the stock price and your home's value increase, resulting in a double boost to your personal wealth (win/win).
- Both the stock price and home prices increase slowly over a number of years to a meaningful value. The money you have in your home is a sunk cost, plus you need a place to live anyway. But the money invested in the homebuilders' stock would have had a better opportunity to grow had it been placed in other investments (win/lose).
- The worst-case scenario is a possible second decline in housing prices. This would also hurt homebuilders' margins, which would lower stock prices. Investors' personal wealth would be taking a one-two punch (lose/lose).
From this perspective, I don't think the odds of winning the greed-induced real estate bet are worth the risk.
This brings us back to why diversifying your portfolio and finding a more suitable place to put your money, instead of homebuilders stock, is so important. Here at The Motley Fool, we also understand this can be a challenging task. Luckily for you, our analysts have already done most of the heavy lifting. Take a look at this free report explaining which company we have picked as the "top stock of 2012." It will only be available for a limited time -- click here to read it for free.