Warren Buffett Loves These 3 Real Estate Sectors: Should You, Too?

Warren Buffett invests in a slew of industries through his holding company Berkshire Hathaway (BRK.A -0.40%) (BRK.B -0.22%). From textiles to insurance to manufacturing to utilities to financial services to real estate, Buffett's focus is on industries with a proven track record of growth, demand, and profitability.

When it comes to real estate, there are three sectors in this industry that Buffett is focusing on right now. Does that mean you should, too? Let's take a closer look at the sectors and how investors might benefit from buying in.

1. Brokerages: There is one that's set to outpace Berkshire

Liz Brumer-Smith (eXp World Holdings): HomeServices of America is Berkshire Hathaway's real estate brokerage firm. Focused primarily on residential home sales, the brokerage has roughly 46,000 real estate agents in over 900 brokerage offices in 33 states plus the District of Columbia. If you add in HomeServices of America's franchise network of around 360 franchisees it brings its agent total to 99,000, making it the largest brokerage firm in the world.

Brokerage firms earn revenue from each sale their agents make. The more agents a brokerage has, the more money it can potentially make. The residential real estate market has been on fire over the last few years, which has been great for brokerage firms across the board. Although sales are slumping now over rising concerns about a housing market correction, the business model at its core can still manage long-term profitability.

The only real estate brokerage that can even come close to effectively competing with HomeServices of America is eXp World Holdings (EXPI 5.23%). That makes it a potentially fantastic buy to gain exposure to this profitable sector of the industry. eXp World Holdings is a virtual brokerage, meaning it doesn't maintain brick-and-mortar offices in cities across the U.S. the way HomeServices of America does. Yet it still managed to build a network of over 84,000 agents in 22 markets across the globe (who work remotely from home).

The company is by far the fastest-growing brokerage today. In the past two years, it's increased its agent numbers by 180% while expanding into 18 new countries. Unsurprisingly, its revenue has soared. Since the company went public in 2015, its earnings per share (EPS) have grown by 37,000% while its free cash flow has increased by 138,000%. The company also has a major advantage over other brokerages in that it carries zero debt.

There are certainly headwinds for the brokerage firm, the most obvious being the housing market slowdown which could affect its revenue in the coming years. The company's stock-sharing incentive program for agents could also have a dilutive impact on share values if the company doesn't maintain its share repurchasing program. But at the moment there is no major cause for concern. Its second-quarter revenue rose by 42% year over year, gross profit was up 34%, and it repurchased $50 million of stock in Q2 2022. It pays a $0.18 per share annual dividend which yields 1.33%.

The stock took quite the beating in the tech crash this year and trades down roughly 63% year to date, making today's pricing an opportune time to get in.

2. Title insurance: Buy the big dog in a sector Berkshire competes in

Mike Price (First American Financial): In addition to residential real estate brokering, HomeServices of America offers a host of other real estate services, including mortgage originations and banking, property and casualty insurance, home warranties, relocation services, and title insurance. I want to drill down into that last category: title insurance.

Every home purchased with a mortgage is required to have title insurance. There is no central database in the U.S. with all title history, so purchasing title insurance protects both the homeowner and the lender from an asset purchase where the seller doesn't actually have a strong claim to the title.

Title insurance companies typically do a load of research to trace the title, sometimes back decades, and then offer to insure once they are reasonably sure that the seller has true title. The title company also usually offers closing services to ensure that the deed of trust (or whatever the local term is) is correctly filed. This is an important point -- if the title research process is done correctly, there shouldn't be a risk because the title company can prove that the title is legitimate and was transferred correctly.

First American Financial (FAF 1.64%) is the 800-pound gorilla in the title insurance space. According to a recent management presentation, First American has a 23.1% market share in the title and settlement services sector. Its revenue is up 12.4% annually over the last five years and cash flow is up even more over that timeframe at 17.9% annually. It rode the bull market in real estate to new heights as a company.

The question is, how it will do through a potential bear market in real estate? Interest rates are up, prices are starting to drop, and sales are slowing. Fewer home sales mean less revenue for First American.

This downturn isn't the company's first. First American managed well through the dot-com bust, the Great Recession, and the pandemic. Company management projects that new purchase and refinance originations in 2022 and 2023 will still be higher than what the company did in 2019 -- and any other year after 2007.

Even if the downturn is far worse than management projects, the company can simply stand by, investing the revenue it gets from existing premium payments and waiting for the market to come back. If a downturn forces its competitors out of business, that just means more potential new customers.

3. Affordable housing: Berkshire believes in it. Do you?

Kristi Waterworth (LGI Homes): Buffett is a big fan of affordable housing. With his acquisition of Clayton Homes in 2003, he demonstrated this by putting his money to work investing in housing for the average Joe. Although Clayton Homes is mostly known for manufactured housing, it completed approximately 11,000 site-built homes across 12 states in 2021 as Clayton Properties Group.

Like Clayton Properties Group, LGI Homes (LGIH 2.26%) focuses on affordable housing, which is a niche in the construction industry that remains terribly underserved.

LGI Homes stand out from the competition and it looks similar to Clayton Properties Group because of its ability to make affordable housing widely available and also profitable. An average LGI Homes property sold for $356,719 in the second quarter, versus an average of $403,800 for an existing home in the U.S. in July 2022.

In the second quarter, LGI Homes' community count decreased to 91.3 (from 105 in Q2 2021). But its gross margin on each home sold has increased to 32% in Q2 from 27% last year. The improved margins give the company a little more wiggle room to maintain operations should real estate prices drop further due to rising interest rates.

Overall, the real estate market continues to suffer from a lack of existing home inventory, with just 3.3 months of supply available in July 2022. Economists at the National Association of Realtors consider six months of inventory to be a healthy amount, and the industry has not seen that number for years. Even at 3.3 months, the market is still 45% below that six-month mark. That shortage bodes well for LGI Homes.

Home builders -- especially affordable housing builders -- are just as important as ever, regardless of what the headlines on rising mortgage rates might imply, and LGI Homes is a quality builder with stock that can be had for a bargain right now.