Most Americans have the bulk of their net worth locked up in their homes, making maintenance and upkeep a key part of preserving their investment. Many homeowners also like to do remodeling and renovation work from time to time in order to make their homes better tailored to their needs and improve their value. To serve the resulting demand from both do-it-yourself homeowners and the professional contractors who do that work for a living, specialty home improvement retailers offer the products necessary to get jobs done. Let's take a closer look at home improvement retailers to see how they can make for smart investments.

What are home improvement retailers?

The home improvement retail industry is composed of businesses all sharing a common goal: selling products to enhance the value of homes. The specific business models of those businesses vary greatly from company to company, though. Some of the best-known chains, including Home Depot and Lowe's, are big-box retailers with broad product offerings spanning just about every aspect of home improvement, from lawn and garden to raw lumber products and from kitchen and bathroom accessories to windows and indoor and outdoor flooring.

Hd Bucket
Source: Home Depot.

Other smaller players have a more focused approach to their business. For instance, Lumber Liquidators doesn't have products to serve every possible do-it-yourself project, instead choosing to specialize in wood flooring. Similarly, Trex has chosen to concentrate on alternative materials for decks. By homing in on very specific areas, these companies can develop additional expertise that broader-line home improvement retailers can't always match.

How big is the home improvement retail industry?

Given the size of the U.S. real-estate market, the opportunities in home improvement retail are massive. According to statistics from the Home Improvement Research Institute, total home improvement product sales totaled $290 billion in 2013, and sales growth is expected to accelerate this year, with the HIRI anticipating 6.5% growth to $309 billion in 2014. With the recovery in the housing market, growth has come from both major segments of the industry, as sales to contracting professionals rose 3.4% while direct-to-consumer sales climbed 4.5%.

Ll Company Source Pic
Source: Lumber Liquidators.

Those figures are consistent with figures from the bigger retailers in the industry. Home Depot has seen revenue recover to pre-financial-crisis levels, having grown almost 16% over the past three years to almost $79 billion. Lowe's managed to avoid a major drop during the post-housing bust years, and its sales have climbed almost 10% from 2010 to 2013 to about $53 billion.

How do home improvement retailers work?

Home improvement retailers make money in the same way any retail business does: by charging prices that are higher than what they pay to suppliers. For home improvement product manufacturers, specialized retailers offer better sales volume opportunities than all-purpose department-store retailers, so home improvement retailers have some pricing power that they can use against suppliers in order to bolster their own profit margins. For instance, Home Depot, Lumber Liquidators, and Trex all sport profit margins of around 7% -- and while that might not look spectacular, it's well above the 2% to 3% margins that most big-box department-store retailers attain.

Homebuilder Navy

Source: U.S. Navy, Wikimedia Commons.

What can complicate matters for home improvement retailers, though, is the difficulty of catering to both halves of their customer base. Ideally, home improvement retailers want to charge relatively high prices to infrequent do-it-yourself retail customers, as they'll typically be willing to pay up in order to get limited-scope jobs done. At the same time, though, retailers want to treat professional contractors well, as they offer the prospect of repeat business that can drive overall revenue -- but will be much more cost-conscious in order to keep the prices they charge their homeowner-customers down as much as possible. Threading that needle can be a challenge for those home improvement retailers that choose to serve both segments equally, but that strategy can pay off if executed well.

What drives the home improvement retail industry?

The financial health of home improvement retailers is clearly linked to prospects for the housing industry generally. When home prices are rising and building activity is strong, greater demand from professionals coincides with greater willingness on the part of homeowners to tackle do-it-yourself projects or contract for renovations and remodeling services.

Homebuilder Tmf

To some extent, though, weakness in housing doesn't automatically translate to weakness for the home improvement sector. During the housing bust, many homeowners who were underwater on their mortgages were unable to move, and so rather than trading up to newer homes instead spent money improving their existing homes to serve their needs. Nevertheless, given the declines in availability of home equity loans and other funding sources during recessionary times, bad housing markets pose obstacles for home improvement retailers and require additional strategic thinking.

As long as housing is on solid footing, home improvement retailers will generally prosper. As changing conditions like rising interest rates start to raise questions about the length of the current housing boom, though, investors need to watch the sector carefully to make sure they don't get caught in a downdraft.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Home Depot, Lumber Liquidators, and Trex. The Motley Fool owns shares of Lumber Liquidators and Trex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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