Usually, earnings reports answer questions. Traders, investors, and analysts learn not just how the preceding quarter has gone for a company and sometimes what they expect in the near future, but also why things went as they did and are expected to go. That is all useful information with implications that often go way beyond the individual stock concerned. However, when homebuilder Toll Brothers (TOL) reported their fiscal Q2 results after the bell yesterday, more questions were raised than were answered.
The results were generally very good. TOL beat analysts’ expectations for earnings per share (EPS) handily, recording 50% growth to $2.85 versus the consensus estimate of $1.89, and did so on significantly higher than expected revenue. That is an all-around win for the company and its shareholders, one which would normally be considered good news for the economy and therefore for the market, but most people’s first reaction on hearing those numbers was probably the same as mine. How on Earth does a homebuilder have a blowout quarter when the Fed has raised interest rates consistently for over a year, up to and including doing so last month?
Interest rates are an important component of the effective cost of a house for buyers. So why, after the interest on the average mortgage has more than doubled over the last couple of years, is demand for new housing high enough to support still higher prices and allow Toll Brothers to report such great results?
The answer to that question will be well known by anyone who has thought about moving recently. Higher mortgage interest rates do discourage buyers to some extent, but they also discourage sellers. If your current loan is at around 3%, as most are after an extended period of low rates and a boom in refinancing, then paying off that loan and taking out another at, say, 7% means that just to keep your payment the same, you have to downsize significantly. That has led to a shortage of existing housing stock and put builders of new homes such as Toll Brothers in a strong position, even as supply chain issues wane and material costs stabilize or even fall as a result.
In his comments, Toll Brothers CEO Douglas Yearley said that he expects that limited supply to remain constant for some time, and the nature of the supply side of the housing market suggests he is right. Unlike most products, where there is finite supply and producers are incentivized to up production to take advantage of higher prices, increasing supply and bringing prices back down, housebuilders are actually better off keeping supply a bit restricted to support higher prices and maintain demand. The consistent demand and the time lag between starting and completing projects means that they are almost forced to think long-term. As I said, that is great for holders of TOL and other housing stocks, but what does it mean for the rest of us?
From a short-term perspective it is a good sign, being just one more indication that the American consumer is bearing rate hikes well and continuing to spend. It shows great confidence when people are prepared to take on higher mortgage payments, but it is one of those things that is great right up until it isn’t. At some point, that has to adjust. If the economy does take a turn for the worse, and history tells us it will at some point, demand will take a hit. When it does, the fact that so many people are taking on payments that stretch their budget and so many more are effectively stuck in their houses due to the cost of a new mortgage, will exaggerate the problem.
I hate to use the “b” word, but this is beginning to look more and more like an unsustainable bubble in housing, and circumstances suggest that we aren’t too far from it popping. The regional banking issue prompted by the demise of Silicon Valley Bank et al wasn’t really about mortgages, but it will have an impact there as the regionals, very influential lenders to homebuyers, become more conservative and tighten up their lending standards. That will take a few months to filter through into the numbers and may only prompt a marginal change in demand, but the impact on a market that is already as tight as a drum could still be big, and if that dents confidence, bigger still.
For now, Toll Brothers and other homebuilders are in a great position, with falling input costs and high demand keeping prices elevated. When Yearley says, "We believe the resulting supply/demand imbalance will continue well into the future, adding to the long-term tail winds that have supported the housing industry in recent years," he is basing that on what they are seeing now. However, the end to those conditions is foreseeable, and logically, isn’t far away. Investors can and should make hay while the sun shines but should also be aware that the weather isn’t constant, and Toll Brothers’ upbeat earnings report contains indications that while it is still nice out there, the clouds are gathering.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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