Investing is about piecing together different bits of information into an illustrative picture—sort of a Wall Street version of the connect-the-dots game we played in kindergarten.
That’s why a recent headline from Bloomberg, which read "Home Prices in U.S. Rise at Slowest Pace in Almost Two Years," made my investment antennae stand up and motivated me to look for either confirmation that the real estate market was indeed slowing down or contrary evidence to explain if the weak summer sales numbers were just a temporary aberration.
What that Bloomberg article showed was that home prices in 20 US cities increased at the slowest pace in almost two years ending in July, rising at an uninspiring annualized pace of 0.5%. Those are, by the way, the worst numbers since November 2011.
That’s a change from the healthy real estate gains that we’ve seen for two years, and there are lots of other reasons to think that real estate is headed for a rough patch, if not downright trouble.
Warning Sign #1: Worrywart Homebuilders
You know who knows more about real estate than the Gucci-wearing loafers on Wall Street? The people swinging the hammers and putting their own capital on the line with every real estate project they start.
The National Association of Home Builders index of builder confidence dropped by five points from 59 in September to 54 in October.
Each of the index’s three components were sharply lower in October: the current sales conditions index fell 6 points to 57, expectations for future sales fell 3 points to 64, and traffic of prospective buyers dropped 6 points to 41.
Warning Sign #2: Widespread Use of Sales Carrots
Surveys are useful but far from perfect. A better gauge of builder sentiment is how many incentives—such as upgraded cabinets, wood floors, and high-end appliances—they’ll include to close a deal.
Make no mistake: builders don’t give away incentives unless they have to and builders are giving away tens of thousands of dollars in incentives to goose slumping sales.
“Incentives have increased because builders aren’t selling as well as they would like. … Rather than reducing prices (outright), they use incentives,” said John Burns of real estate research firm John Burns Real Estate Consulting Inc.
A Wells Fargo survey of 150 homebuilders reported that that percentage of builders using incentives rose to 26% from 17% in August of 2013 and 21% in July of 2014.
Homebuilder Lennar admitted that it gave away incentives worth $20,400 per house last quarter. Moreover, that $20,400 amounted to 5.8% of the sales price. That’s a heavy hit on profits!
Warning Sign #3: Sales Slowdown
In a recent report, Toll Brothers (TOL) warned Wall Street that its sales are slowing. Its sales contracts dropped by 4% in the last quarter and it now expects to sell 5,300 to 5,500 homes this year, down from its previous high-end forecast of 5,850 homes.
Moreover, as the above chart shows, home appreciation is now nonexistent and is threatening to turn negative.
Warning Sign #4: Profit Plunge Next?
Slumping sales and stagnant real estate prices are the precursor to profit disappointment. “Construction of single-family homes has been weak,” said CBRE Global Chief Economist Richard Barkham.
The first homebuilder profit warning was just delivered by KB Home (KBH) , who is selling fewer and fewer homes. KB Home delivered 1,793 homes last quarter, down from 1,825 delivered in the same period a year ago.
That translated into weaker profits. KB Home reported earnings per share (EPS) of $0.28 on $589.2 million of revenue; however, Wall Street was expecting $0.40 EPS and $646.76 million of sales.
Warning Sign #5: Watch the Real Estate Food Chain
There is a lot more to the real estate industry than just homebuilders—the furniture industry, for example.
Stanley Furniture just reported its quarterly results and delivered a loss of $2.3 million and 5.0% drop in sales.
“The demand for upscale wood residential furniture in the industry’s traditional channels of distribution remains relatively weak,” warned CEO Glenn Prillaman.
My vegetable farmer father was one of those people that thought real estate prices would never go down. The 2008 financial crisis and accompanying real estate crash proved that wasn’t the case and the growing number of worrisome data points are warning me that stocks in all the parts of the real estate food chain could be headed for trouble.
By Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.