The big role that government policy can play in the housing market is often undersold. Most homebuyers think of a mortgage transaction as something between them and the bank. In reality, there are background players that play a critical role, particularly the government. A government guarantee can be a critical factor in determining whether they even get a loan and how much it will cost. Government guarantees, in particular, are generally great things for borrowers, but they also are good things for the housing industry in general, particularly homebuilders like PulteGroup (NYSE:PHM).
Increased limits for government-backed loans in 2020
The Federal Housing Finance Agency (FHFA) recently increased the conforming loan limits on a home loan up to $510,400 (from $484,350 a year ago), effective in 2020. The conforming loan limit sets the ceiling for loans that can be purchased by the government-sponsored entities (GSEs) of Fannie Mae (OTC:FNMA) and Freddie Mac (OTC:FMCC). Government-backed loans (aka conforming loans) are guaranteed by the government, which offers advantages to both the borrower and the lender.
The increase in loan limits makes it easier for borrowers to afford properties in two ways. First, conforming loans allow a lower down payment than non-conforming loans (typically jumbo loans, which are larger than the conforming limit). Fannie Mae has a program called HomeReady which permits down payments as low as 3% will permit down payments that low. Second, conforming programs permit lower credit scores from potential borrowers than most jumbo lenders are willing to allow. Simply put, it is easier to get into a home with a conforming loan than it is without.
Move-up buyers versus first-time buyers
While much attention has been paid by professionals and policymakers regarding the first-time homebuyer, and while this demographic segment has not been participating as much as in the past, the move-up homebuyer is still a critical part of the market. The builder that will benefit most will be the one with average selling prices right around the upper limit of conforming loan values. Entry-level builders (such as D.R. Horton (NYSE:DHI), who's average home selling price is under $300,000) won't be affected by the limit bump since most of its properties already qualify for a conforming mortgage. Luxury builders like Toll Brothers (NYSE:TOL) won't be affected much either since their average selling prices are close to $900,000 -- too high for a conforming loan to begin with.
Pulte has made a commitment to the move-up buyer
PulteGroup is a geographically diversified homebuilder with several brands and operations in 24 states. The company believes that its scale gives it an advantage over smaller builders, particularly in financing. Looking at its overall portfolio of homes, the company has average home-selling prices pretty close to the FHFA loan limit. Pulte has made a commitment to growing the move-up sector, purchasing JW Homes (a brand focused on the move-up buyer) which increased average selling prices by 14% from 2017 to 2018. The move-up buyer would be the person who bought their first home, lived in it for several years and now has the home equity (and income) to trade up. Pulte offers the option for buyers to customize their home from different kitchen configurations to wiring for a smart home.
Pulte's financial services arm originates mortgages and sells the loans it makes in the secondary market. The company doesn't hold these loans for investment the way a bank would. Last year, Pulte originated $4.4 billion in loans, of which 88% qualified for government backing. Here again, the increasing number of government-guaranteed loans helps them. Why? Mortgages with a government guarantee are worth more to an investor than mortgages without. From an investor's point of view, a loan with a government guarantee has no credit risk. If the borrower stops paying, the investor will still get paid on time. Investors are willing to pay more for mortgage-backed securities with that feature. This means Pulte will be able to sell these securities to investors for higher prices than jumbo loans. Higher prices mean higher profits on the loan. While financial services aren't a major generator of income -- it represented about 4% of Pulte's $1.3 billion pre-tax income in 2018 -- an increase in the price Pulte gets for the mortgages it sells will drop straight to the bottom line, and Pulte doesn't really have to do much more than it is already doing to gain that extra income. Aside from the pickup in mortgage profitability, the homebuilding sector has a bright future ahead of it.
An obscure change can mean additional profits for builders
While the entry-level homebuyer is where the biggest demand lies, the move-up buyer is a critical piece of the real estate market. Changes in mortgage loan limits are usually something only noticed by market professionals. However, the changes will have an impact beyond the simple borrower/lender relationship. Homebuilders like Pulte which operate at the cusp of the limits will see the most leverage from this change.