Deidre Woollard: All right. Welcome to the Millionacres Hour, and we're going to talk about homebuilders this hour. When I talked Jason about setting up this, he's like, "Yeah. They're all doing great." That made me think about how you look at companies when they're in a situation, when the whole group is doing really well due to market conditions. Because I was thinking about it. I think that sometimes when a company is doing well because of that, you almost have to watch it more carefully. What do you think about that?
Jason Hall: I think so especially when you're talking about homebuilders in this business that is very cyclical, and in general, they tend to have more leveraged balance sheets. So when you have companies that are in a highly cyclical industry and also have highly leveraged balance sheets and don't tend to carry a lot of cash, and their working capital amounts can be pretty small. If the cycle turns, when it inevitably turns, these great results can get really ugly, really fast. It's the Warren Buffett quote about, "When the tide goes out, you find out who is swimming naked."
Deidre Woollard: [LAUGHTER] Exactly. I think that's one of the things that I heard on some of the earnings calls too was because companies like D.R. Horton, like LGI Homes, they're all saying record quarter or second-highest quarter. But in all of that, I also heard that just little whisper of caution and that knowledge that it can't last forever. We're in this odd cycle. You and I have both been following this. This is the first year I was listening to a conversation with Lawrence Yun, the economist from NAR the other day and he was saying that, this may be the first year that we're almost to the level of historical homebuying. So we've been below homebuilding. We've been below that level for what, a decade?
Jason Hall: Yeah. I'd say since 2010, at least probably 2009.
Deidre Woollard: Yeah. We're just almost getting to the level where we're building enough historically, which doesn't mean necessarily that we're building enough for the coming generations and household formation because we're not when it comes to that.
Jason Hall: Yeah, I mean, we're building as many as we should in an average year is basically what he's saying. That doesn't mean we're caught up because we're still worth 3.5, four maybe five million houses short.
Deidre Woollard: Right.
Jason Hall: I mean, there's this major gap, and it's the pressure. You can see some of that pressure on some of these companies numbers and we'll get into the numbers later. But I just wanted to tease one right. That thing really points to it a lot is like Meritage Homes for the past four or five years has been going through this transition away from custom homes was really more than half their business. You go back five years ago, and now it's like 20-25 percent of their business. During that transition, you saw their average sales price falling, falling, falling, falling. You look at their orders now it's going the other way. Even though they are still selling more and more starter homes. So that right there is the number to me that talks about the pressure on the market right now.
Deidre Woollard: That is an interesting point because that makes me think about what was happening before the pandemic. Before the pandemic, we saw a lot of these homebuilders saying, "Okay, not a great market for us were priced a little high. We're going to start working on reducing our square footage. We're going to start aiming more at the starter home market. We understand that we should look at cheaper areas." Then came this time when they couldn't do anything wrong. So some of them are continuing with that plan, Meritage is one that, like you've said, are moving away from custom, LGI Homes, I know doesn't do any custom at all. But we're starting to see where they almost don't have to do that pivot anymore and go towards the starter market, because homes are selling across the board. I mean, one of the things I found interesting was Toll Brothers, which is at the upper high-end of the homebuilders, they had a phenomenal quarter, partly because there's plenty of people who made a lot of money in the stock market or who are ready to buy and looking for so much more space right now.
Jason Hall: Right. Or didn't spend any of that disposable income last year, and their savings rate skyrocketed. It's enormous. Deidre, talking to you here, I think it was in the Millionacres Hour actually about this time a year ago when we started hearing some of the data about luxury home sales, they were up, I don't know if like some crazy high percentage point, and here we are a year later, and you have a Toll Brothers that's still doing well. It's definitely a case of that rising tide lifts all boats. But I think the biggest thing is I want to emphasize, it's not just a rising tide, it's raining after a decade of drought.
Deidre Woollard: Yes.
Jason Hall: Right.
Deidre Woollard: Yes but.
Jason Hall: But? [LAUGHTER]
Deidre Woollard: [LAUGHTER] Because things are going to always change, and I think that is the risk of the rising tide. One of the things I wanted to talk about today with homebuilders is, when a sector is booming, how do you think about it? Everything in this particular sector is doing well right now. So is that a thing where you try to pick a winning horse, you try to pick two with some different strategies, you try to figure out how to protect yourself against the future. I think that is the really interesting part of this is because yes, just about every homebuilder had a great quarter, their balance sheets are looking great, but you also want to dive into the individual strategies, and I think one of the things that I'm watching as I look at homebuilders is what are they doing besides just homebuilding? The traditional method of building homes directly for sellers. So I think a lot of them are starting to do some really interesting things.
Jason Hall: I agree. We've definitely seen a lot more, it seems like a lot more of these homebuilders are focused on the balance sheet discipline, using more options. A little bit less just buying the lots, but still you look at the leverage ratios and there's a lot to be cognizant of as an investor. Let's hit this, let's talk about some of these key things that you're watching for.
Deidre Woollard: But let's talk about options version, just explain what that is for the Fool. So the difference with homebuilders, you can do two things. You can either directly own lots or you can have options to purchase lots, and it's like you have the opportunity to buy those lots later. Traditionally you mostly saw homebuilders, just buying lots, and then I think it was probably after the great financial crisis that you started to see this shift more towards the option strategy and VR.
Jason Hall: But everybody has done that.
Deidre Woollard: Yeah. Yeah, I think NVR was the first one, but then, everyone has gone toward that end. Now, I'm seeing some Homebuilders look at what is a healthy ratio? Is it owning the lots 50 percent options because when you go too far the other way, one of the things I think some of the Homebuilders ran into, is they couldn't get access fast enough. Because all of a sudden, they had to turn on the home building machine to capitalize on demand. If you've got options, you maybe aren't able to move quite as fast as if you own the lots out, and the permits are there and everything is all ready to go, immediately start building.
Jason Hall: I think it's interesting. You look at Horton, and we'll talk about Horton here too. But either directly or through Fourstar Group. I was reading through their transcripts. This surprised me when I saw it. Horton only owns 24 percent of its lots. More than three-quarters of its lots are through purchase contracts, through options. That really surprised me that it was that substantial for that big of a player. I mean, theirs is unique because they basically have first right of refusal.
Deidre Woollard: That was one thing that was interesting on their call too, was talking about that relationship with Fourstar which essentially they own, I think it's 60 percent of Fourstar I believe and then Fourstar owns a lot.
Jason Hall: Forestar is a lot developer for anybody that doesn't know. That's basically what they do, is they buy lots, and they prep them.
Deidre Woollard: Yeah.
Jason Hall: I mean, that strategy, it's become basically the de facto strategy in the market. It's one of those things too that I think the risk is you have more companies that see the opportunity to jump in the middle and acquire and be like a mini Fourstar in an area. Now here's the bottom line, you use that strategy as a home builder, there's a cost to using it, and you talked about that. One cost is how quickly you can tap lands. If need to accelerate development of that land and you don't own it, it's going to cost more to do that in some way either if you have a purchase contract, you're going to have to accelerate access to capital, that cost money. The seller of the land, maybe they're going to want more to move forward quickly. If you don't already have terms built-in to allow you to do that, there could be an additional costs, or simply, guess what? Somebody else wants to develop it too, and you don't have an option for the land, [LAUGHTER] you're going to pay more. What's the biggest issue right now? Everything else costs more, so you have to pass that cost along. We'll talk about this too. We've seen margins, but that's one things you're watching for is are we going to run into a wall of cost where passing those costs along, it's just not going to be a guarantee.
Deidre Woollard: I think the other thing when thinking about options and land is the impact of remote work, is part of what changed this because one of the reasons that home builders start to look at options is options give you pivot power. Okay, things aren't going so well in California, we've got options over here, we can just keep moving and shuffling around a little bit. That's a great thing to have.
Jason Hall: Absolutely.
Deidre Woollard: But when you've got remote work and almost everywhere, seems like an okay place to build, then it's not as powerful a strategy. I think that's what happened was that some of those exurbs just really became more attractive to people. I think that last year we thought about this remote work as a temporary thing. Earlier this year, we thought about it still like, okay, we're all going back to the office September, October, the Delta variant, the ones that are coming after that, all of that is changing this for May. Well, this was a cycle to maybe this a long-term way that things are going to be, and we're all going to need room for home offices because we're not going to go back to the office five days a week. That just changes the whole map of the country in a lot of ways.
Jason Hall: Yeah, it does. That's the thing that gets back to one of those, how do you think about this industry in this space because this isn't Zoom video communications or some software company that has massive operating leverage and their incremental margins are 90-something percent for new sales at some point, there are real fixed hard costs and things like access to skilled labor in the market. That all those implications or the ad levels of complexity. It's one of the reasons. I'll talk a little bit more about this later once we get through earnings. But this is one thing that I think it's easy to, sometimes as investors, especially if we try thinking about market being an all-time high, as we think about the price to sales ratios or some of these great hypergrowth companies, and then you look at PulteGroup, Lennar, Meritage Homes, LGI Homes. The most expensive of those stocks on a trailing basis is LGI Homes and it trades for 9.1 times earnings [LAUGHTER] not sales, but the market value is these because of that leverage, because of the cyclical risk, and because of all of those fundamental challenges of operating in that business and the risks that things can change very quickly.
Deidre Woollard: Absolutely. We've got a question from Kelly about the combined with the cost of building materials. That was something that I wanted to us talk about. Earlier this year we saw Lumber up 400 percent year-over-year, were not dealing with that now, thank goodness, but I think Lumber prices are set to rise for a couple of reasons one of which is the impact of the fires on the West coast and not just in the US but the Vancouver area where a lot of that framing lumber comes from British Columbia, it's starting to get a little challenging. Some of the timber reads were talking a little bit about that on their earnings, that may end up changing those cycles. It's not just lumber that we're dealing with, it's steel is going up, cement has been up and down, and also the ongoing supply chain problems. One of the things that a lot of the homebuilders talked about was appliances. Because so many appliances, it's really cool that your refrigerator talks, but it needs a chip.
Jason Hall: Guess what? Yeah it needs a chip.
Deidre Woollard: [LAUGHTER] Good luck getting one.
Jason Hall: How happy are you about that talking refrigerator now?
Deidre Woollard: It was all so cool, like everyone sees it at CES and it's like, this is great, our refrigerators will do all these things.
Jason Hall: In turn the consequences. Here we go. Just anecdotally, we ordered a new dishwasher last year. It took about four months. It's all of those things, the implications are very real. They really are very real. What's next?
Deidre Woollard: [LAUGHTER] I want to go through some things to watch. We talked a little bit about Lots. One of the things that I saw in the earnings from the different homebuilders that we are looking at is Sunbelt. Obviously, I feel like I keep talking about the Sunbelt every time I'm talking about real estate, but the migration trends are really long-term. I hear so much now about the cost of doing business in California. I know you're in California, but the homebuilders are all saying the same thing, which is, ''We want to be there, but we don't want to be there too much because it's too risky, it's too expensive.'' They're starting to find that they can catch some of those same consumers that are going to different places. I feel like I keep talking about Boise Idaho on these shows, but the inflow migration there is incredible, obviously Texas, Austin, places like that, Florida. But the other trend that I'm seeing too is a little bit of more these builders starting to look at some of the central states where prices for land might be a little cheaper. Mid Atlantic, the central are certain areas around, some of the larger cities in Ohio are starting to become appealing to some of these builders.
Jason Hall: I think you see the same trend happening in the Midwestern college sounds.
Deidre Woollard: Yes.
Jason Hall: Because they tend to have infrastructure in place. They tend to have good schools because college teachers want good schools, so local public schools are pretty good. They have a lot of those things. It'll be interesting to see if that trend does continue to expand across more of the middle of the country and it could be enormous. It can be a huge economic uplift for a lot of areas that have suffered from brain drain when their best and brightest graduate from high school, they go off to college and then they never go back to where they came from. I think there are potential implications 10 or 20 years down the road that it could be incredible. This terrible brutal crunch that has so many people what hard farther say your comment in here being 28, just asking these United tell you that yes, one day you will [LAUGHTER] be able to own a house. I know it feels a little this dystopia here for a lot of people, I get that. But I do think that there is the potential that with the remote work movement and all of those things happening, this could be the great rebalancing. It's possible.
Deidre Woollard: Well, yeah, Rich Barton, the CEO of Zillow, has called it the unlocking of mobility and you've talked about that before that. But given that the average time that people stay in a house when they buy a house has gone up dramatically over the last 10 years. You're supposed to stay in the house five to seven years, it's now 7-10 and so that too has been something that's continued to happen. But there is that possibility that people might want to be more mobile and so I think that's a factor to look at as well.
Jason Hall: I'm going to circle back to what you just touched on there with people staying in their homes longer. Because we focused on homebuilders right now and how incredibly short-supplied the housing market is and the gorilla in the corner, or is it an elephant in the corner? The gorilla in the room? Whatever it is, it's big.
Deidre Woollard: I think it's an elephant, but I know where you're going.
Jason Hall: Mixing the metaphors here. But the key is existing inventory.
Deidre Woollard: Yeah.
Jason Hall: We're still incredibly short supplied. In terms of home sales every year, that existing stock is still the vast majority. It's still where the most people find homes and existing homes. Baby boomers are not downsized. Baby boomers are not, sure a lot of them are relocating to Sunbelt as that kind of stuff as they retire and look to lower their tax bill and get somewhere with better weather in that sort of thing. But they are buying big expensive houses. They're selling their big expensive house in California or New Jersey and buying a big expensive house in Florida or North Carolina. But a lot of them aren't. A lot of them just are not doing.
Deidre Woollard: Are not aging in place.
Jason Hall: The aging in place trend is big. There's positive things about it. If you think about it from just at a starting perspective, these people stay in the communities that they've established relationships, so less people becoming isolated as they age, which is a big issue. You have people being more active, tend to have healthier, longer lives. There's a lot of positives from a demographic perspective, but it doesn't match up with what the housing experts were expecting to see for people our age, Deidre and younger, who want to buy a house or we're ready to move out of the house because now they've got a couple of kids and it's getting a little bit claustrophobic and we need more space. Mom and dad's not, they're not retiring to Florida now and making that five bedroom house available.
Deidre Woollard: [LAUGHTER] Well, yeah. I forget when it was at WSJ had that article where they had the term, Silver Tsunami. I was stuck a lot Silver Tsunami it hasn't come. Talking about the aging in place one of the things that I've been studying too, is that has lead to a remodeling boom really all across the country consistently is that, people are thinking about aging in place differently. They're figuring out do they have to add different things for the stairs, maybe they move the master bedroom down to the first floor. There's all things that people are thinking about when they think about how to use their space differently.
Jason Hall: I think you just made a case to buy Home Depot, I mean that's basically what are Lowes.
Deidre Woollard: [LAUGHTER] You cannot go wrong with Home Depot or Lowes at least right now. But there's also this thing of are these homes that come up for sale going to be in the places that people want? The idea before the pandemic was probably not because nobody wants to live in the suburbs and everybody wants the city and everybody's going back to urban. That whole thesis has completely shifted.
Jason Hall: Yeah.
Deidre Woollard: Going back to the homebuilders, the fact that that thesis has shifted is part of the reason that these homebuilders are having these great results because they're not doing infill development, they're doing development outside of cities and they are finding that if people only have to go into the office two days a week, they're fine with living 45-minutes out from where they work.
Jason Hall: Deidre, I'm going through exactly that. My wife is taking a promotion at work and we're here in Southern California. She is taking a promotion at work and we're moving. She is going to be working in Boston and she is only going to have to go in once or twice a week most weeks, but she needs to be there as part of the leadership team for that area and all of her staff are going to be going into that office and they're based there. But we've decided we're going to live 30, 45 minutes outside of the city and it's common this same year. Totally it's our situation, but other professionals at Apple knows that are going through similar moves. It's the same thing. Even though it's part of the remote work, there's a relocation that still necessary, but our situation now, we live a mile from her office. We don't have to live a mile from her office anymore and that substantially increases our ability to get a lot more. A lot of people are seeing the same thing. They're looking for that, that's what they want. The homebuilders they're racing to build houses in those places.
Deidre Woollard: Boy, and you brought up something else to that, that desire for more too because if you both are at home and she is only going to the office a couple of days a week and you need a home office, that is changing floor plans and we've seen a lot of that. The homebuilders have also talked about that, not just in terms of how they built, but also how they position homes, positioning one of the bedrooms as a home office or something like that. Changing a little bit the floor plans so the bedrooms don't have adjoining walls getting a little more space in between using hallways, things like that. Really, it's very interesting with homebuilders because you've got this impact of some short-term trends or some trends, it seems to be evolving. But when you're a homebuilder, you have to try to make decisions years in advance to some of them. It will take four to six months to build the house but before that you have permitting, you have to deliver fully all of the plans and thinking about the materials you'll use and all of that well in advance. So you have to try and fix that.
Jason Hall: This is not just found in the line of code and if it crashes we just remove the line of code and it's fine.
Deidre Woollard: Yeah. Which is actually one of the reasons that it's both great to invest in homebuilders because there's that stability, but it's also risky because there's not that ability to pivot the way that they'd like to.
Jason Hall: Exactly. But at the end of the day, I think it's one of those things where we're adaptable as a species. That's the reason we've accomplished everything we have as the human animal and we're really good at adapting spaces to work. But whether you've got kids or a spouse or you're single, at some point you've probably done a lot of Zoom work in your kitchen of the past year and a half. You don't want to do that anymore. It's about finding a space that is for work and is not also the space that you sleep or the space that you eat, or the space that you entertain guests, that it is a space just to work. I think that's the key and it's gotten more. Needing that a little bit more.
Deidre Woollard: Yeah, that's a pretty profound shift because if you're going to be working from home for six months, yeah you can do it at the kitchen table. If you're going to be working at home for the foreseeable future, you don't want to and it's not good for you psychologically. Let's take a look at some of the numbers. I wanted to dive into Meritage, I know it's one of your favorites and the numbers were just amazing. But we are seeing some a little bit of a decrease in orders, which I thought was interesting. I think some of that might be price-driven. What are you thinking?
Jason Hall: It's price-driven but actually it's also intentional. On the earnings call they talked a little bit about it. They're trying to ramp up the number of course, the word just fell out of my brain, individual developments, that's what I'm looking for here.
Deidre Woollard: I don't know, sorry.
Jason Hall: The communities.
Deidre Woollard: Communities.
Jason Hall: Yeah. They're trying to ramp up the number of communities that are actively selling. But the past six months, nine months, really, has been so insanely busy. They sold through a lot more than they expected to sell through. They intentionally tried to throttle orders in this last quarter, to maintain some inventory as they transition. It's a little bit intentional, but a lot of it, I agree. I think if you look at their order price, jump back up to like $430,000 at the end of the quarter, and they were 420. Was it 420? Yeah. Average selling price and orders was above $420,000, and they had been running in the 380s. Their actual closings have been in the 380s. Definitely, some price pressure that's impacting these guys.
Deidre Woollard: Yeah. Well, that's an interesting fact too because their starter homes are now more expensive. It's all just been out of control, but one of the things they've talked about the 23 percent year-over-year increase in home closing revenue. That got them to 1.3 billion for the second quarter of 2021. They've got that problem where they can't really make prices go down too much because at this point, they have to protect their margins too.
Jason Hall: They have been so far. We've seen their margins. We go back three or four years ago and margins were in the low 20s, 20, 21 percent. At the time there were some challenges. It was a few years after the housing crisis, and the company have been struggling. Finally, the demand was recovering, and the problem back then was finding skilled labor. Labor costs were weighing on the margins. It seems like a lot of that has been addressed over the past few years, and now we're dealing with all of the materials costs. Labor supply, it's still short. But a lot of it is just there's so much demand for it. But so far they've been able to hold those margins. I think they actually might have had second or third highest gross margins on home closings, that they've had in maybe ever last quarter, but at some point, passing along higher-cost, you're just going to hit a wall with that. But so far they've surprisingly been able to do it. I want to call out their land inventory too, because their land inventory is up. It was at 43,000 last year at the end of the quarter and was up to 63,000. That's a 40, 45 percent increase in their land supply. If you look at their run rate of 3,000 houses, but at their growth rate, that's probably six years supply of land for these guys. That's a decent amount of inventory. Their plan is I think they wanted to get to like 300 active communities.
Deidre Woollard: Yeah. They've got 226 now.
Jason Hall: Yeah. The goal is to get the 300 by next year or so. That's a pretty solid goal. They're going to have to continue pretty aggressively adding to that land inventory to be sustainable at this higher community target that they have.
Deidre Woollard: Yeah. Exactly. That's an interesting thing too is because they're having to accelerate. With the homebuilders you have to put your foot on the gas but also have your foot hovering over the break at the same time just in case. I think that's one of the things that we're just seeing all of these companies wrestle with is like, what are we going to do with the cash that we've got right now? Are we going to buy more lots? Are beginning to buy more options. Are we going to buy back stock? From our balance sheet, what are we going to do in order to position ourselves, because it really, it's going to change at some point?
Jason Hall: Well, and there's the risk. I want to just bluntly state with the risk is, because we talked about the risk with land. The risk is if you buy land, you've paid for it, or in most of their cases, you've taken on debt, so you're servicing the debt to cover that land. You're sitting on an asset for multiple years before you ever develop it. If you have too much land when the cycle turns, you have land that you're still having to pay for that now, economically, it doesn't make sense to develop, or you can't develop as much. But there is one thing worse than having too much land when the cycle turns. That's having too many houses, when the cycle turns. That's the point you are getting out there, is they have to throttle that capital investment in building more properties to make sure you don't end up with too many properties in the wrong market, or too many homes that are built in an area where the demand is weakening, or the market turns, the cycle turns, interest rates go up, something happens. Whatever the thing is that turns off the music. You don't want to have too much of a thing that you now can no longer get enough money to cover the expense of.
Deidre Woollard: Because most of these companies were around during the great financial crisis and during the time period when they were building out, like Southern California, like out in Lancaster and Palmdale, or in Florida or outside of Vegas or the excerpts of Phoenix. Both these homebuilders went through that experience of all of a sudden realizing that nobody wanted the houses where they were building, and the foreclosure crisis really hit those newer communities to some extent a little harder than the rest of the country. They have that stat memory in their minds when they are thinking about this, how not to be left holding in the bag, even though it's a completely different situation now than we're dealing with then.
Jason Hall: Yeah, I think that's a key thing. It is very different because again, we're paying the Piper now for the decade after that where we were not developing enough housing to meet the consistent long-term demand. There are two things I want to touch on about Meritage before we move on that I think are important. Number 1, another part of their year-over-year order decrease that's important is you have to remember, that period of time, at the end of the first quarter and then the beginning of the second quarter, where things stopped. Where there was a period of time where there were no orders. Then the second quarter things, particularly in May and June, things went bananas, and there was a lot of business that didn't happen late in the first quarter, that happened in the second quarter. Meritage second quarter last year was absolutely enormous. It was gigantic growth. There's a little bit of that lapping, a tough comp period at play here. I don't think there's any trouble here and I don't think this is a sign of some sort of a cyclical shift. But there are some pressures going on with rising prices. You look at how much more of their order book is showing the average cost. They are selling a higher percentage of starter homes now than they did even a year ago. Those are real pressures and at some point that's going to either affect the company's bottom line, or it's going to slow its pace of sales. The last thing I wanted to mention too is Meritage CEO Steve Hilton, retired as CEO, I think at the beginning of the year. But one thing I've noticed he's still executive chairman. He's still on the board. He's still pretty involved, because he's been on their earnings calls. He's still involved strategically with leading the company's not in their day-to-day operation. I think it's positive, because he's been such a guiding hand for the company, and it's good to see him still being involved.
Deidre Woollard: What do you think about other avenues that Meritage has? One of the things that I'm worried about is that they are still mostly focused on directly building for individual clients. They haven't really announced any deals that I'm aware of with build to rent or things like that like PulteGroup is doing with Invitation Homes. Is that a concern at all for you?
Jason Hall: It's not. Just because I think there is so much pent-up demand for starter housing, starter housing in the market is so undersupplied, and on the grand scheme they're top 10 homebuilder, but the difference between the top three and the bottom seven of that top 10 is pretty significant in terms of the scale of their building. D.R. Horton has 0.5 million lots in its inventory. Meritage has 63,000. There is such a big difference, and because this is such that starter home is so much the underserved part of the market, I think even if we do see a shift, the worst-case scenario is Invitation Homes or a private equity group buys a community. Because I can promise, even though it's not part of their strategy, they're getting calls and they're having conversations.
Deidre Woollard: I would assume so, yeah.
Jason Hall: Even though it's not identified part of their strategy, I think being a pure play is smart because you've got a few that are pure plays in this. I think there's going to be demand. I don't think it's a weakness to not have that part of their clear strategy or their selling strategy.
Deidre Woollard: When we're talking about housing blooms and housing bubbles, that is the thing that is making all the difference this time in terms of what could happen with homebuilders and why I think homebuilders don't have to be as worried about that is because there is that backstop. We've got billions of dollars in capital from public companies like Invitation Homes, but also from private funds. I think I see the amount of money going into these private funds that are buying single-family residences at scale is just enormous. I've never seen anything like it. There's billions of dollars going into this space not just coming from the US, there's companies from Canada coming to invest in the US, there's a lot of desire for institutional investors to hold large scale single-family rentals at a level that really hasn't existed before. I think Invitation Homes and Blackstone show that this was possible for institutional investors. Then in the past decade we've seen that become really developing asset class, and so for a lot of these homebuilders, that would be the backstop if something does happen and there isn't that demand from the individual buyer anymore. Margins will shift, it'll be a different price at the end, but those homes probably aren't going to just sit there the way they might have in a different type of cycle.
Jason Hall: Yeah, I think that's the case. I also think that it's a necessary strategy shift for a lot of private equity, a lot of institutional that has historically focused more on maybe office buildings or other commercial because there is a lot of uncertainty there about how stable the cash flows can be from a lot of those assets in certain markets. Because we don't know what the next five-years is going to bring the total viability for that space. I think it's going to be huge. It's going to be important, but we know housing is going to be important. We know there's going to be demand there. I think there is a little bit of a shift of the risk profile that's behind that transition. We've seen the acceleration over the past year, and I think a lot of it is just the calculus of, we have a big endowment, we need something that's going to protect our capital and generate whatever our cash-on-cash rate of return metric minimum is. Do you buy what looks like an undervalued office building or do you buy single-family residential housing? I mean, I think it's pretty obvious where you can predict steady cash flows and where the calculus might change.
Deidre Woollard: I think part of that too is that the business model had to evolve.
Jason Hall: Right.
Deidre Woollard: I think that was part of genius of what Invitation Homes did they showed what the system could look like. Because I think what everybody saw was, why would I possibly want to have to manage 12,000 homes? That sounds like a nightmare.
Jason Hall: Right.
Deidre Woollard: I think that they've showed that it's possible to put in a system that can work and then you can get those great returns at scale.
Jason Hall: Yeah, because that's easy to think. It's one thing to manage an apartment building and it's another thing to manage single-family housing.
Deidre Woollard: Exactly.
Jason Hall: Everything is harder. It cost more, you have more land to do, it's a lot less uniformity, right? [LAUGHTER]
Deidre Woollard: Yeah.
Jason Hall: All of those factors. But they've shown you can do it, there's obviously money to be made there.
Deidre Woollard: We've got about 15 minutes left. I want to talk about how people can think about choosing homebuilders because we've talked about Meritage, we've mentioned LGI, NVR is other one that I know you and I both like. The two biggies are probably D.R. Horton and Lennar. Do you think it's better to look at the smaller homebuilders that are a little more nimble? Or what do you think of owning the two giants in the space?
Jason Hall: For me, this is very much a personal preference thing. I prefer the smaller homebuilders myself because I think there are opportunity in this market. Let's be realistic, even with the massive shortage of housing that we have, the percentage rate of growth is pretty low, it's not super-duper high just because we already have a couple of 100 years, really, 75 or 90 years or so of modern homes. We have a pretty large existing stock. Even though we are far undersupplied, the rate of growth is not enormous. For me as a growth investor targeting that growth, I tend to prefer the smaller homebuilders on this list, certainly Meritage and LGI because not only are they smaller so their ability to take more market share as they grow I think is good but because they have the strategies that are focused on where there's the obvious substantial shortage, and that's in the starter properties. But I don't think that means you should look past Lennar or Horton. I think between the two I tend to prefer Horton rate margins. They've been doing this for a long time. We mentioned Fourstar. Whatever happens with that relationship. It means that as a big homebuilder, it's really important to manage that pipeline. The orders of magnitude go up. The importance of managing that pipeline of land becomes even more important, and having a related party that's also a separate entity. Managing that is really helpful in terms of that. But I do tend to think as an investor, I think your chance of better outsized returns lies with buying the smaller companies that are focused on where the need is the strongest, so long as they manage their balance sheets. Well, and that's the key, for example, looking at LGI versus Meritage. Meritage is still larger, they still sell more homes. Their average sales price is significantly higher, so that generate a lot more revenues, great margin profile so their earnings are larger. But LGI Homes actually has a larger inventory of properties now. On one hand that's great if the growth story continues unabated. But the risk is if there's a downturn of some sort, even a short period of downturn, which is probably what my expectation over the next decade, as we might have one or two little blips on the radar. Depending on the timing of those blips on the radar, leverage can completely undermine a successful business and hurt shareholders heart. I think that's the risk you have to manage. I think a basket approach is probably the safest way to invest in this sector. Own 4-5 of the top homebuilders. I think you can position yourself well and you don't have that single factor risk of an LGI that gets out of its skis and as the shareholder you take the brunt.
Deidre Woollard: Yeah. I think that's true, especially because you do watch these homebuilders pursue slightly different strategies. It's interesting because I think a lot of them have coalesced around a couple of different strategies. We talked about some of them leaving the West going to the Sunbelt. It seems like a lot of them are doing that. A lot of them are pursuing entry-level. One of the things I do like about Lennar is I do feel like they are really innovative. They've got their Lennar ventures, it's where they invested a bunch of different things they invented and invested in latch early on. But I think you've got some innovation there. I also like what both Lennar and DR. Horton are doing in terms of floor plans with multi-generational. I feel like multi-generational is going to be something that's huge. I think that it's really, when we talk about aging in place. The bottom-line is, baby boomers are more active than previous generation. But at some point, aging does catch up with all of us.
Jason Hall: Absolutely.
Deidre Woollard: Because home prices are so high, we are going to see more families moving in together. Which is a whether things I find fascinating, because it's a throwback to the way things used to be.
Jason Hall: In the way things still are in a lot of the rest of the world besides the US.
Deidre Woollard: Exactly.
Jason Hall: Yeah. It gets a lot easier with you think about the remote work movement. Now all of a sudden things like that become a lot easier to facilitate.
Deidre Woollard: Yeah. That is a really good point as well because one of the things that we saw during this remote work is it has disproportionately impacted women with caregiving obligations and things like that. One of the solutions sometimes can be to move your parents in. I've seen a lot of my friends have done that and it actually works out pretty well for all concerned.
Jason Hall: Depends on the grandparent. [LAUGHTER]
Jason Hall: Exactly. Just real quick. . Yeah, that was DR Horton, 24 percent of lots are owned and the rest are through purchase contracts. Just saw that in here. But I just think it's such an interesting time right now. You think if the rates of growth some of these companies have reported, it's crazy. I mean, Horton revenue was up almost 80 percent. How much did Lennar grow in sales, 30 percent? New orders were up 32 percent. I mean these are big companies, 22 percent revenue growth for Lennar. Company does 20-25 billion dollars a year.
Deidre Woollard: Yeah, absolutely. Let's talk a little bit about when you look at earnings, what you should be looking for for homebuilders, just because it's slightly different than. We talked about lots you want to find out how many lots they have. You want to find out that ratio of owned to auctioned. You also want to see where they're building a lot of the homebuilders when they do their earnings call, they do pie charts, a little grafts where you can see where they're building now, where they're building next. You want to look at community size and what the inventory is, how they are planning to expand communities. Are they planning to start new communities or are they still filling up homes in existing communities? You want to hear what they have to say about commodities. I mean, everyone is going to talk about the price of lumber and things like that. But you want to hear what their strategy is on the earnings, because some of them talked about ordering things in advance and how they are using that as a strategy. You want to look at net sales orders and you also want to look at absorption rate, which is how much of that inventory is getting taken up and how many homes they have on backlog as well.
Jason Hall: Yeah. I think for me the bigger thing is this just like with any other business or industry, you want to really focus on the trends and do the trends on the earnings statement and the trends on the cash flow statement and the balance sheet match up with what management is telling you is the company strategy. If there is a deviation then does the explanation that management's giving you make sense? Or are they just trying to move the goalposts to where the ball's going [LAUGHTER] to try to get that kick through the goal, even though it's not the original goal or strategy. I think that's really important. To me, the big win in addition to those things, is really understanding the balance sheet. Understanding working capital, which is current assets minus current liabilities. Do they have enough working capital to easily get through periods where there is a downturn. The demand shifts quickly without having to take on more debt. In other words, relying on the generosity of others. [LAUGHTER] You want companies that don't have to rely on the generosity of others to keep their doors open. Then also think about with the debts, understanding if they have secured or unsecured notes. When do they mature? What's the waterfall of those debts? Do they have a lot that's coming up at a certain period of time which means you're going to have to raise a lot of capital, or new debts to retire that old debt. What are the implications? Are interest rates going up? That means that all of a sudden their debt service is going to get a lot more expensive in two or three years. Thinking about all of those things is really important, because these are cyclical businesses that do have leveraged assets that are harder to monetize when they need to monetize them the most, which is when there is a downturn.
Deidre Woollard: Exactly. That service is really important, because when started talking about this, there's a lot of cash right now. Some of these companies are using this opportunity to take a look at what their debt is for the future and trying to figure out how they can position themselves a little better, maybe paying off some things now, maybe positioning things a little further out, so it's not hitting the next 2-3 years, but it's hitting further out. I think there's a lot of that strategy with debt definitely plays into what they deal.
Jason Hall: We only have a few minutes left here. I want to talk about valuations before we wrap. What do you have an next before I go there?
Deidre Woollard: Let's go for it.
Jason Hall: Sweet. I was talking about it earlier about the valuations that we're seeing on a price-to-earnings perspective. I'm going to do a screen share here real quick if I can. I know we have the technology is just whether I can click the button right to do it is another question. Okay, here we go.
Deidre Woollard: Here we go.
Jason Hall: This is PE ratio, price-to-earnings ratio going back about five years. I want to say this too, I'm not going to show it on the chart, but I am just going to say it. A lot of these stocks, the stock price for a lot of these is near all-time highs. It's near all-time highs. Then at the same time, this little period here, this is the coronavirus crash when everything was cheap. By and large, a lot of these companies are trading for similar or even lower valuations than any time over the past five years. As a group, I think homebuilders are cheap. I really do. I think they're cheap. I think this is going to be a mega cycle. I really do. I think this is a super-cycle for housing over the next decade. I think that we're going to see strong results. We're going to see very strong growth over the next three or four years. Then it's going to moderate and then still be pretty steady. There's going to be some ups and downs along the way. For me, I view a lot of these is worthy of holding long-term with the willingness to ride out some tough periods, and the willingness to look at those tough periods as opportunity to add. Because the cycle change is temporary, and if it's a good durable business, that temporary cycle that sends the stock down is a great opportunity to buy. So that's it.
Deidre Woollard: Absolutely.
Jason Hall: That's the story.
Deidre Woollard: We've got a question from Kelly that I want to address about green building in general, saying there's so much interest in tiny homes and green built homes. I wish there were more interest in tiny homes and green built homes. I feel like that's the thing that gets more press than actual demand from what I've seen. I would say that all of these homebuilders to some extent have addressed some of this, some more than others. But in terms of tiny homes, there isn't as much demand I think yet. I think part of that is changing. For example, the State of Maine just changed their rules so that tiny homes, you can basically built them the same as you can single-family homes. Like they changed the square footage requirements. I feel like that's going to happen in more places, but I don't know if there's any specific green builders that I can think of.
Jason Hall: I think a couple of things you've seen, so Meritage Homes definitely has their LiVE.NOW. I can't remember exactly what it's called now, but part of their entry-level offering are homes that are really focused on energy efficiency. They have a deal with a solar company in California, basically new homes have to have solar [LAUGHTER] I think you're going to see maybe the regulatory shift to focuses that. But I also think it's something that younger buyers are starting to demand more. You're seeing some of these companies start to come up with strategies that are more focused on it. But the reality is that virgin timber is the cheapest way to build a house. To build a house reliably and repeat it. There has to be a technology answer to green housing. There's technology that's coming there, but it's just a lot of it it's expensive. [LAUGHTER] That's already a problem with housing, it's expensive.
Deidre Woollard: There hasn't been enough focus in my opinion on construction waste, so I think that to some extent the homebuilders don't have to worry about it until they have to worry about it. I wanted to mention this question that we got. I'm bothered by cookie cutter homes with inferior quality. I wonder what these communities will look like in the future. It seems homes are larger and built to code but not to the skill of those standards.
Jason Hall: I would say, I think a lot of the modern builders are building better homes than were built in the 80s and early 90s. I really believe that's the case.
Deidre Woollard: Definitely agree with that.
Jason Hall: I think it's better because like you look at the existing stock it's coming up on 38 years old on average, and there's a lot of people that have those homes that were built in the 80s that are spending a lot of money on Home Depot to bring them up to standard. I think we're going to have a little bit better durability from the new stock.
Deidre Woollard: I also think to some extent the mergers and acquisitions that we've seen inside homebuilding is good news for that because I think some of that was smaller fly-by-night homebuilders. My mother lives in a community in Florida, every house on her street has had to have their plumbing redone. They're all built during the 80s from one of those smaller homebuilders. There is that advantage to being at scale. Last question from [inaudible 00:58:12] In your opinion, are homebuilders a bedrock buy it and forget a part of the portfolio, or a cyclical sector that requires a bit of vigilance?
Jason Hall: I think more the latter. Just again, because the cycle can turn because they're more leverage businesses, so there's more risk. I don't think there's like a trade on kind of investment, but I think you certainly can do better if you find the ones that are well run of course obviously, and the ones that have their strong balance sheets. Then you look for opportunities when the cycle turns to buy more. You have to be very much more thoughtful about what is your financial goal, and as you get closer to that financial goal, just like with any stock you're exposed to the volatility of something large happening, the consent prices down 10, 20, 30 percent or more very quickly. I think the closer you get to your financial goals the more cognizant you have to be to exposing yourself to losing capital permanently by owning homebuilders at the wrong time. That's my only caveat there is I think you have to buy them with a 10-year horizon, and then the closer you get to that 10-year, you have to be more willing to cut bait to avoid that risk of the downside. But based on more on your financial goals, and then you can build a schedule that makes sense on owning those businesses over that period.
Deidre Woollard: Well, I also think the other thing that is good, perhaps about owning homebuilders is that you'll know because the media covers the market so much, if you're noticing housing at all you'll start to hear about things. It does take a little bit of awareness, but it also isn't something you necessarily have to focus too much on because you can see the larger trends at work.
Jason Hall: You don't have to read every 10-Q from beginning to end and read every earnings call from beginning to end and have your finger on the trigger to hit the sell button every time the National Association of Realtors drops their housing report every month. [LAUGHTER] You don't have to do that. I want to be clear, you don't need to. It's not healthy. If you're interested in it and you love it like we do, yeah, totally. But don't feel like you have to be on a hair-trigger with homebuilders. You just need to stay aware to a Deidre's point.
Deidre Woollard: Excellent. All right. Well, we are at three o'clock.
Jason Hall: I think we've got a recording here. Who's on this one? The Brian's and John Feroldi, the hunt for 10X stocks. We've got that lined up for the next hour. Deidre, this was fun. Thanks for having me on.
Deidre Woollard: [LAUGHTER] Thank you. Always a good time.