How Investors Should Approach 2022's Homebuilding Volatility

In this clip from "Real Talk" on Motley Fool Live, recorded on Feb. 11, Motley Fool contributors Jason Hall and Matt Frankel discuss the many moving parts of home building in 2022 along with the many challenges the industry faces including the high demand and shortage of homes.

Jason Hall: LGI Homes (LGIH -0.32%) reports earnings in a couple of weeks from now. I think it's still going to be toward the end of February. But, it reports monthly home sales and announced earlier this month that it closed 442 homes in January. I went back and looked at January 2021 and it sold 650 homes a year ago. Already, we see the home closings are falling substantially. Essentially, what has happened is home builders are running out of inventory. Matt, you and I have talked about this multiple times. They've sold through their inventory so much in late 2020 and all of last year sold through their inventory, and had to accelerate their builds just to try to meet demand. We saw record margins for a lot of these companies, record earnings for a lot of these companies, and we still see their orders continue to grow. The issue that we're running into now, and I think we're going to find out a lot more about this when LGI does report, is they're running into the fact that this is the part where it's going to take a lot longer to catch up than normal because there's just not as much prepped land. You don't have land that has infrastructure in place, that has water that's already in place, that has electrical that's already there, and that already has fiber that's run. Now, that adds a year to being able to fully develop that land and actually start building houses and selling houses on it. I think we're going to learn a lot more about all of those pressures this year, and the first half of the year is probably not going to be great compared to last year for a lot of these companies. I think they're still going to get great margins. Their selling prices are probably going to continue to go up. But, then we get into the second half of the year as their inventory situation starts to improve a little bit, we might start to see some improvements from the first half. But then, Matt, this is something I wanted to get your thoughts on. I begin to start being a little bit more worried about continued supply chain pressures, lumber costs, labor costs, and then the rising interest rate environment when we get into the second half of the year. Now, we're starting to put pressure on affordability. Is that potentially going to start squeezing margins for these companies and their operating margins aren't going to be as good, it's going to affect their cash flows and earnings. I think that is a realistic expectation for how the cadence of 2022 could play out for home builders pretty broadly. What do you think?

Matt Frankel: I think there's a lot of moving parts in the homebuilding space that we just haven't seen before.

Hall: Right.

Frankel: I don't think we've ever seen an environment where the price of lumber has had such a wide range over the past year or so.

Hall: Yeah.

Frankel: I don't think that's ever happened. From bottom to top, it's like a 4x in lumber costs over the past year. I don't think we've ever seen this type of labor shortage in the U.S., at least in my lifetime, and this much wage pressure. I can never remember since I started work when I was 15. I don't remember wage pressure like this. A lot of different moving parts that you spoke about as having had to deal with or at least for decades haven't had to deal with.

Hall: They're more extreme than usual. I mean, it gets back to the basics of the three Ls. Labor, lumber, and land. The variability of that is a real challenge right now.

Frankel: Having said that, I am worried about it a little bit long-term. I think of it as more of a big short-term challenge, and I'll tell you why. A lot of these home builders have massive backlogs because of what's been going on in 2021. They've already agreed on a contract price for those homes. In some cases, it's like a year's worth of building that they've already committed to at a certain price, so they are at the mercy of materials' costs. They are at the mercy of labor availability and wage pressure and things like that. Margins could definitely be under pressure in 2022 more than people are expecting because of all of those moving parts that are existing on homes that they've already committed to sell for a certain price. I mean, I'm looking at NVR (NVR -0.47%) NVR settled just over £5,000 in the fourth quarter. They have a backlog of almost 13,000 houses that they've already committed to buying for a certain amount of money or committed to sell for a certain amount of money.

Hall: That's six months and this is a big biller, right? That's a lot.

Frankel: Right. Having said that, their gross margin increased in the fourth quarter on the homes that they did sell. That's a positive sign going into this.

Hall: Yeah.

Frankel: If things stay the way they are today, the margin should stay fine. It's what happens if the price of lumber doubles like we saw in the middle of 2021. What happens if they can't find enough workers and that backlog expands further and it pushes this pre-committed revenue stream out even further. That's what I really worry about. I think the next 10 years or so are going to be fantastic for home builders. But, I don't necessarily feel that way about 2022.

Hall: Yeah. I think the market generally agrees. If you look at stock prices for a lot of these companies. They are trading at single-digit, trailing earnings, multiples, and the prices have come down pretty sharply. A lot of these stocks are down. You think they are like a cloud services stock as much as a few of these are down over the past few months. The market sees some of those same worries. How I think about it as an investor is, I do think now for long-term investors looking at the next 3, 5,10 years, there's some appealing buys with the understanding that they could continue to fall. You have to be cognizant of that because a lot of these guys, their volume levels are going to look like 2019 sales. If you go in without understanding, be willing to dollar-cost average and build out your position. It could play out because it's like you said, these are largely temporary things that are going to work themselves out and these really well-run companies are going to get through it fine. Just as an investor, you shouldn't risk capital that you can't risk that volatility for the next few years.