Real Estate Investing 101

Weak home sales! Strong designer home sales! A sector recovered! A bubble on the brink! Housing has soaked up plenty of headlines lately. But for all the cyclicality that housing exposes investors to (and that's a lot), it also exposes them to some fantastic rewards in the long run.

In this week's episode of Industry Focus: Energy and Industrials, host Michael Douglass and Motley Fool contributor Jason Hall give listeners a beginner's guide to long-term real estate investing. Learn about the different subindustries within housing, their pros and cons, a few of the biggest and best names from each, what risks you need to watch out for, and more.

A full transcript follows the video.

This video was recorded on Aug. 30, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Thursday, September 6th, and we're talking about the home sector. I'm your host, Michael Douglass. I'm joined by Jason Hall. Jason, great to have you on the show!

Jason Hall: Good to be here! Always fun!

Douglass: I'm glad! I certainly like it, too. Now, I should note folks, this was pre-recorded on August 30th. Generally, when we pre-record things, it's because we don't expect things to massively change, but that's kind of the definition of black swan events. Sometimes things change. Just keep that in mind when we're talking about the various things. Perhaps entire housing sector's bottom has dropped out in the intervening week. I'm hoping not.

Hall: I think it would probably take more than a week for that to happen, but since I've made that statement... black swan.

Douglass: [laughs] Right. We are making no predictions about what happens to the housing market in the next week. It's a really big and important part of the economy, real estate in general. I don't know about you, Jason, but my Facebook is just littered with folks trying to market me on real estate investing. I'm certainly hyper aware of how major the real estate market is to the country's economy.

Hall: Right. It's big. I think it's one of those things, too, where there starts to become a little bit of confirmation bias that creeps in with these kinds of things. There's been a lot of stuff in the news about housing. We've seen real estate prices in most markets have pretty much recovered from the bottom from the financial crisis. Also, in the past few months, there's lots of news about, we're actually seeing some weakness in home sales. And then, things like you're talking about, the investment income opportunities for real estate and that sort of thing.

So, there's all these things. People are like, "Hey, what's, what's going on? Are we going to see another housing crash? What's happening?" So, yeah, I think this is a really, really good show to talk about.

Douglass: I'm glad. Let's hop right in. Housing starts and existing home sales have been, as you noted, a little weak. Starts were down to 1.4% year over year in July, which is pretty in line with the very weak June. We've also seen some improvement in newly approved building permits. Single-family permits were up 1.9%. On the flip side, again, existing home sales fell 0.7% last month, the fourth consecutive month of declines and the slowest pace in two years.

There's a lot of different parts to unpack here. Let's back up a little bit and just talk about, home values, when it comes down to it, are an element of supply and demand. That's what they're a function of. When demand outstrips supply, prices go up. We have certainly seen prices going up. Median home prices have been up for 77 consecutive months.

Hall: Almost 6.5 years.

Douglass: Which is wild. It's not quite the bull market, but it's pretty close. It's up to $269,600. Zillow estimates median home value across the country at $218,000. Obviously some different inputs there. Estimates that values have increased by 8% year over year as of July, and forecasts another 6.8% growth in the coming year. There's a lot of reason, if you're a homeowner, to think, "This is good. Home values and prices are up." But there's a lot more to this story.

Hall: As there usually is, that's for sure. I think it's really interesting right now. This is about as supply and demand as it gets. I think one of the biggest issues is, if you go back to the global financial crisis, homebuilders just stopped. This is typically a really leveraged industry. Homebuilders use a ton of debt to acquire land. They have a three-, four-year inventory of land. They've got this debt they're paying on an asset that they're not getting a return on, and they won't for a couple of years. It really hit homebuilders hard. Essentially, what's happened over the past decade is, most homebuilders shifted to more of the premium end of the market -- luxury homes, custom homes. Weren't really focusing on entry-level properties because there were a ton of those already on the market. Foreclosures, properties that never sold. That inventory had to get sucked up before there was any need to build starter homes. That's a big reason why prices have gone up, because of the inventory situation and where the market has been.

Douglass: Yeah. And, as you noted, inventory has been very tight. The average listing closes in under a month. That means that this is a very tight supply situation. Interestingly -- you noted that homebuilders have been focusing on the premium side of the market. Another thing that really affects entry-level buyers in particular is interest rates. What we've seen is, of course, interest rates, those who have listened to Industry Focus for any amount of time know that until recently, I ran the Financials show. We talked a lot about interest rates. The Fed keeps increasing them. That is going to impact folks' ability to afford homes, along with the price. Your mortgage is essentially a function -- when you strip out property taxes and insurance -- of home price, how much you can put down, and the interest rate on the rest.

Hall: Interest rates, like you said, they do particularly effect starter home, entry-level buyers who generally will have to finance a larger portion of the home than somebody that's stepping up to a bigger house, or somebody that's downsizing and already has years or even decades of equity that they're able to apply and can carry a smaller mortgage.

Douglass: One of the other pieces with all this -- we've been talking about a lot of things that affect entry-level buyers. But on the homebuilder side, obviously there's some conservatism on their side, because they got burned pretty badly in the last crisis. But, home building materials have also gotten a lot more expensive. Homebuilders may be increasing prices, but their margins aren't necessarily getting that much better when they're doing that. For example, you know, Canadian softwood lumber imports have some additional duties on them, instituted by the Trump Administration in April 2017. That just helps constrain that supply of materials, making it all the more expensive and more difficult for home builders to then build these houses and turn an acceptable profit while doing so.

Hall: Yeah. That's an example of a tariff that absolutely directly gets passed right on through to the end consumer, the person that's buying that house. It's passed right along, it's absolutely passed right along.

Labor has been a major issue for homebuilders for five-plus years, especially in the hottest markets. It's another product of the financial crisis. A lot of tenured, skilled builders got out of the business, they went to do other things because there weren't any jobs building homes. It's been really difficult for homebuilders to find good, skilled labor. These guys in a lot of the markets have been able to make a ton of money. That's, again, been passed on. It's driven up home prices. It's also slowed their ability to build inventory quickly enough.

Douglass: Right. Let's talk briefly about, we've talked about the home sector as this big thing. Let's break that down a little bit, what the kind of general different ways of thinking about an approach in the home sector are. Obviously, you've got your direct homebuilders. We'll get more into specifics on all these after the break. You've got your home builders, the folks who actually build homes. You've also got the Home Depots (HD 0.37%) and Lowe's (LOW 1.10%) of the world, who are good about the home maintenance and things like that. That's been another big part. Then you also have ...

Hall: More of the specialist companies.

Douglass: Yeah! Tile Shop, Lumber Liquidators, yeah.

Hall: And then you have some of the companies that manufacture the products. That could include lumber companies, for instance. We'll talk about Trex (TREX 0.16%), a company I like that's in the decking business. There are even other ways. You can look at REITs that specialize in property. You could get really obscure and get into companies that manufacturer fasteners, for instance, that are affected by it.

But I think the best thing -- which we'll talk about -- we're getting pretty focused on the companies that are directly affected by housing, that get some benefit and leverage from higher prices, because people that might be more willing to stay in their home and just invest on improving their home vs. stepping up to a bigger home. We'll talk about that, especially with Lowe's and Home Depot.

Douglass: Yeah, there'll be quite a bit there. Before we head to the break, the big question to consider is, the sector has got some macro headwinds and some macro tailwinds. There are things that are definitely negatively impacting the sector, some of which are very much outside their control. But then, the fact that home prices have been increasing, let's call it a bit of a tailwind. Generally speaking, Jason, how do you think about the sector? If someone's new and thinking about, "Hey, is this a macro trend to invest in?" what would you tell them?

Hall: The first thing I would caution anyone that hasn't invested in housing or really doesn't understand housing very well is to understand that it can be viciously cyclical, from almost one quarter to the next. Especially when you look at stock prices for homebuilders. You have to understand that going into it. But if you think about it from a long-term perspective, there is a very big macro trend, in terms of millennials that are starting to move into the housing market. You also have retiring baby boomers who are starting to downsize and relocate. There are some really strong trends that, really, I think you could look at a decade of potential growth -- with the caveat that there are going to be cycles up and down over that period. But I think if you look a decade from now, if you invested in a basket of high-quality companies exposed to housing, in general, you would do pretty well.

Douglass: Jason, let's talk about specific ways to invest. It's inevitable, we're talking about homes, they're these things that you build -- let's start with the homebuilders.

Hall: That's a great place to start. Of course, it's also the most leveraged, most cyclical part. If you want to invest in housing, home builders are the ones that are going to be the biggest roller coaster. You have to acknowledge that going in. For instance, you go back to May. I was on Industry Focus. We actually talked about some home builders. We actually talked about some of the home builders we're going to talk about today. Since that time, since we recorded that show on May 3rd -- we're going to talk about NVR, LGI Homes, and Meritage Homes.

Douglass: Those tickers, real quick -- sorry to interject.

Hall: NVR is NVR. LGI Homes is LGIH. That's important to remember because there's an LGI ticker and it's not the home builder. Then you have Meritage Homes, which is MTH. Since May, the stocks are down 16%, 20%, and 7%, respectively.

Douglass: As of August 30th. Of course, your mileage will vary a little bit based on when this goes live in September, but you get the idea. They're down.

Hall: Yeah, they're down. And the reason they're down is the things that we talked about. You look at the housing data that the National Association of Realtors and the National Association of Home Builders provide, the Census data with housing starts, interest rates haven't gone up. These numbers come out, and the market reacts relatively quickly. Home builders typically get the biggest boost when things are good in the short-term and get the biggest beating when things are down in the short-term. Essentially, that's what you have. Again, the reason that happens is because these are companies that are relatively leveraged. They tend to use a ton of debt for an asset, their land, they're going to sit on for a few years before they get any return for it. That's what happens.

I guess we should talk about why I like these companies.

Douglass: It's interesting, heading back to the earlier part of our conversation, one of the things that you really noted was that a lot of homebuilders have gone for the premium end of the market. But, in a lot of ways, LGIH and MTH -- that's LGI Homes and Meritage -- have zigged where everyone else has zagged. They're really focused on starter homes.

Hall: Yeah, and they're smaller. Meritage Homes is one of the top ten builders. LGI is not quite that big. They're not scale of some of these others. That means that their focus on starter homes, they've been able to be a little nimble. I think it gives them more upside, in terms of being able to leverage this opportunity. You look at LGI Homes, it's very focused, the vast majority of its homes that it builds are starter communities. Sales went up 29% in the second quarter. Earnings per share surged 48%. They raised guidance. It's absolutely killing it.

Here's the funny thing, too. Gross margins were over 26% in the quarter. A lot of home builders are happy to see 20%. 26% gross margin is remarkable. And that's building starter homes, which actually can be more profitable than building custom homes or building in the premium end of the market. That's an interesting thing, there.

Meritage is a little bit of a different story. It hasn't historically focused as much on starter homes. About three years ago, the CEO said, "Let's really focus on this market," and they started acquiring more properties to start focusing on building starter homes. Now, about 75% of the land that they buy is dedicated to entry-level housing. It's really paid off. Their sales have come up. Their average sales price is falling as they're selling more of these starter homes, but it's driving their gross margins up as a result. Earnings per share, their pre-tax net income, has gone up double digits for five quarters in a row. It's really, really paying off.

Douglass: A lot of stuff to like there. Should we head on to home improvement?

Hall: We can do that.

Douglass: Alright, let's do it. Let's start with the ones that everyone knows -- Home Depot and Lowe's. As a relatively new homeowner, I've spent far more time in both of those stores than I had ever previously expected to.

Hall: I'm with you there. We're about five years into the house that we're in now. I live in Southern California. Just for some context, I would love to have a median home price of $269,600.

Douglass: [laughs] Living in the D.C. area, I'm with you there.

Hall: D.C. area, it's kind of the same way as us coastal elitists, I guess. But, yeah, we spent a lot of time in my local Home Depot with a lot of do-it-yourself projects. There's a lot of other people all across the U.S. doing the exact same thing. I think if you just look at the performance of both of these companies... Home Depot's stock's up 70% over the past year. Lowe's is up 58%. They're just absolutely crushing it. The interesting thing about both companies, especially in the U.S., they've reached a certain amount of critical mass, in terms of their store count. They're having to be a lot nimbler about where they add stores, looking at relocations, expansions, that sort of thing. But they're still growing sales 6%-7% a year, almost all same-store sales growth, which is amazing for a retailer. It's just phenomenal.

Douglass: Yeah. And it's interesting, because when I think about Home Depot and Lowe's -- one of the problems with most retail is that showrooming can happen. You can go out, fiddle with the thing, and then go buy it on Amazon. With Home Depot and Lowe's, that's a little bit tougher. If you're cutting a piece of lumber to precise specs, you can't really do that online nearly as easily. There are a lot of reasons to think that they are relatively -- I'm putting that in scare quotes -- insulated from this sort of e-commerce effect that's really impacted a lot of retailers.

Hall: I will put this one caveat in there. I just bought a lawn mower on Amazon. It was a better deal than what I could find from Home Depot. [laughs] But with that caveat, Home Depot has done an incredible job of building out their online presence. In the past couple of years, we bought a new washer and dryer. Both came from Home Depot. Found them online, the local store delivered them. I've bought a number of tools online and gone to the local store to pick them up. That's actually something Home Depot's management has really done a great job of, is making the omnichannel, where you can integrate all of your different channels together. They've done a really good job of making it so seamless to buy something online, go to the local store to pick it up. I can tell you, a third of the time or more, when I've done that, I end up picking up something else that I forgot, or something else that I decided that I needed.

Douglass: [laughs] Yes. Well, that's the beauty of the Home Depot run. There's always more. By the way, folks, those ticker symbols are: for Home Depot, HD; and for Lowe's, it's LOW. In terms of the two companies, how do you distinguish between the two? I think, on a surface level, they look very similar.

Hall: They do. The funny thing about it, too, is that with these two companies, it's really easy to establish a personal bias based on your customer experiences. And that can vary from one town to the next. We have a Home Depot that's close, and they're really good, so I love Home Depot as a customer. I've got a good friend that lives a town over that has a Lowe's two miles away. I'll let you guess which company he likes better.

Let's talk about some of the metrics behind it. If you think about it from a valuation perspective, they're really close. Home Depot trades for like 23.5X trailing earnings. 22.7X for Lowe's. They both have a dividend that's between a 1.5%-2% yield. These aren't huge income stocks, but they're both growing their dividend pretty well. I think Lowe's has a little more opportunity, maybe, to grow its store base. But it's smaller, it's a little bit smaller retail company. It's not substantial.

I would probably say Home Depot, just because, if you look at its performance, it has a little bit more stability with management. Lowe's has a new CEO in place who's been there less than a year. That's not necessarily a bad thing. But continuity of management is important.

I think the bigger concern for these kinds of companies is, they can be more affected by the consumer side of the economy than a home builder would be. For instance, if we see a recession, because consumer spending gets hit, chances are, if somebody's committed to buying a house, they're committed to buying a house. But somebody might put off that new lawn mower, or the new patio furniture, or the new barbecue grill, if they need to tighten their belt up a little bit. When it comes to the short-term issues with consumer spending, Lowe's and Home Depot are a little bit more exposed.

But, I think if you look over the long-term, these companies have great balance sheets, very strong cash flows, they do a really good job getting return on investments. I think over the long-term, they should both perform relatively well. But I just like Home Depot's management better. I think it's more established. That should continue to pay off for better returns.

Douglass: Yeah, I think that makes a lot of sense. Let's turn from these folks. Do you want to talk specialties next? What do you think?

Hall: Yeah, let's run through the specialties. I want to talk about them because this is an area where investors need to be kind of cautious.

Douglass: Extra cautious. Yep.

Hall: Yeah, absolutely. Absolutely. If you think about companies that can do really well in a niche, you think about Lumber Liquidators, which does flooring, you think about, Tile Shop, which, hey, they sell tile.

Douglass: It's in the name.

Hall: It's in the name, exactly. Floor & Decor, they sell flooring and they sell tile. These are industries that, to a certain extent, seem really ripe for consolidation. If you think about it on a national basis, yeah, Home Depot and Lowe's, they got some tile, they got some flooring. They don't have much of either and they don't really have a lot of the high-end, nice, really fancy stuff. But every town has half a dozen of each of these little stores that you can go into, right? The vast majority of national sales come out of these small little shops. The opportunity to consolidate and develop a national platform, you'd think you'd get the benefits of scale and all that kind of stuff, and it should lead to great returns. But it's been kind of tough going for investors in these companies over the past couple of years. Especially Lumber Liquidators and Tile Shop.

Douglass: Right. By the way, tickers: Tile Shop, TTS; Lumber Liquidators, LL. It's been a rough go.

Hall: It has. Lumber Liquidators, I think the biggest story is, you go back a few years, there was the 60 Minutes report about cancer and Chinese-made flooring. Short sellers were behind the whole thing. It got really ugly. The company pulled the products. They did all these studies of the products. They essentially determined that there was no significant risk here. That cost the company millions of dollars, and it's just now at the point of settling its remaining litigation about this stuff. It's carried on and on and on. It affected the brand reputation. It's just been a real struggle.

At the same time, the company has made changes and has started to recover. But its comp sales haven't returned. Traffic is still way down. The company's still valued relatively high based on its earnings. I own shares of the company, mainly because I bought it a long time ago. I continue to follow it. But I'm not convinced that I would look to buy Lumber Liquidators right now.

Tile Shop, for a little bit of a different reason, has had a ton of turnover in its management. It brought in a new CEO a few years ago who did what looked like an excellent job. Comps turned around, sales really recovered, profits were surging. The company started a dividend. Then margins started getting squeezed, prices started getting tight. Abruptly, that CEO is out the door, the founder of the company is back in charge as interim CEO. It's reported relatively poor quarters the past couple of quarters as it's shifting its focus away from low price and trying to move back into the higher-end stuff. Margins are going up. Gross margins are going up. But profits are still not that good. There's also issues with traffic.

Again, you think about Home Depot and Lowe's, that are growing these mid-single digit comps numbers. These specialty retailers, Lumber Liquidators and Tile Shop, they're not seeing higher traffic. And right now is a time that you should be seeing higher traffic. They're not delivering. So, I'm just not convinced right now that it's a good time to buy those companies.

Douglass: But you are a little bit more bullish on Trex, which is ticker symbol TREX. A lot of what they do is laminate decking.

Hall: Trex is a manufacturer. This is a completely different situation. This is a company that, coming through the financial crisis and great recession, was frankly on the verge of bankruptcy because of some debt that it carried and class action lawsuits, problems with products that developed mildew.

Anyway, a new CEO came in about a decade ago, brought in a new executive team, including the current CEO, who was the CFO under the prior CEO, who basically turned the company around. They focused on developing better products. Really did a great job with marketing those products. Have the best distribution by far in the industry. They have almost half of market share for this wood alternative grain decking. By the way, Trex is ticker TREX. The company has established this huge lead over anybody else in this alternative wood decking market. It's made for an incredible investment. I think, in terms of opportunity for growth, it's very good. Even though it has about 46%-47% of the market for the wood alternative decking, it has less than 10% of the total volume of decking sold. If you actually include wood, it has a small fraction of the market. There's tremendous room for growth. I think that the macro trend of millennials becoming larger participants in the homeownership arena is a good trend for Trex. These are consumers who also tend to focus more on environmentally friendly products. A completely recycled decking board that can last 20 years, doesn't require the chemicals, the stains and cleaners that wood decking require. I think that's just another really strong tailwind that should continue to drive Trex for a long time.

Douglass: I think that makes a lot of sense. Full disclosure, I have a deck, and I'm thinking about replacing it at some point. There's stuff there. It's interesting, I think people tend to think, to some extent incorrectly, that real estate is a super safe investment. There's really plenty of good evidence to say that that might not be the case. What you really have here is these different tranches. You have the homebuilders, which are, I think it's fair to say, fairly high-risk high-reward. You've got your really big retailers -- your Lowe's and your Home Depots -- that are fairly low-risk and provide some potential reward. Hard to say for sure because they've hit saturation. Let's say fairly low growth from here. Although, again, those same-store sales, as you noted, are really good.

Then you've got the specialty retailers, which, again, higher on the risk-reward spectrum. If they're able to triple store count, OK, that's interesting. But the question is, what's really going to happen? And then you've got manufacturers like Trex, which can be, sometimes, fairly sleepy businesses, but can provide some pretty impressive growth if well managed and in a good niche.

If someone's thinking, "I want to get some exposure to the home sectors," and they have some risk appetite, where do you tend to think might make the most sense?

Hall: I'm pretty bullish on homebuilders right now. Again, with the caveat, like you said, with the risk, because of the leverage. I'm a really big fan of LGI Homes, which has a lot more leverage than a lot of the other home builders. Again, there's that caveat. But I think in terms of upside opportunity, I'm a big fan. I think the market's also kind of pricing in a lot of that risk right now. It trades for 8.9X trailing earnings. That might seem like crazy super low. Homebuilders, because of the leverage and the high risk, they tend to trade for cheaper multiples than most stocks do. Compared to LGI Homes, Meritage trades for about 10X earnings. You see, it's actually trading for a cheaper multiple than a bigger, slightly less-risk stock. I like LGI Homes, if you're willing to take on that risk.

If you're interested in a home builder, and you want to reduce some of that risk exposure, I think NVR is worth a look. It tends to use a lot of options contracts to buy land. It doesn't outlay a bunch of capital and take on debt. That can affect its price to finally acquire that land. That might be affected a little bit because it pays a premium to hold the option to buy that land. If it backs out, it gives that money up. But it puts it in a much better situation, if the housing market were to deteriorate very rapidly. It's not exposed to so much leverage and debt that it has to continue to maintain. NVR is worth a look. Its multiple has come down. It trades for about 17X trailing earnings right now. It often trades above 20X. I think it's a pretty good value right now too.

Douglass: There are a lot of good things to like about these companies. Again, of course, a lot depends on your risk appetite. The other thing that I'll note here is that when approaching a new sector -- so, for folks who are perhaps not as familiar or as knowledgeable about the home sector -- it's often useful to try to construct an ETF out of a few different companies, just to give you exposure to different pieces, understand how they interlock with each other, and to also make sure that you haven't put all of your eggs in one basket. Just something to consider as you're pondering your portfolio allocations, if you're excited about homes.

Hall: Yeah. And I think you also don't have to buy all of your exposure to one company all at one time. Buying in thirds, or some other method of adding shares over a period of time, is a good idea. It can allow you to get in at a better value point. It can also allow you to learn more about the company and the industry and really understand your investing better, too.

I really want people to highly consider Trex, too. You look at the stock and it's up like 700% over the past five years. It's like, "Wow! That's crazy! All the best money's made, why would I buy that stock?" It has a $5 billion market cap. It's still a pretty small company. Are you going to get 660% returns over the next five years? Maybe, probably not. But I still think that the potential to outperform the market is absolutely still there. It's such a high-quality company, such a good management team, they do such a good job with capital allocation. The opportunity to grow is just tremendous.

Douglass: Yeah, absolutely. There's a lot of stuff like there. Alright, well, folks, that's it for this week's Energy and Industrials show. Questions or comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Jason Hall, I'm Michael Douglass. Thanks for listening and Fool on!