We think housing turnover could remain elevated in the near term, particularly if consumers are given the opportunity to lock in mortgage rates at low levels. Some consumers could attempt to pull forward a home purchase that was being contemplated over the next two or three years to get ahead of rising rates. We expect such behavior to continue to support the stock prices of names like Home Depot and Lowe’s as improvements tend to occur around a sale. As mortgage rates increase over the longer term, the softlines names in our coverage should show more resilience, in our view. Companies like Bed Bath & Beyond
are generally agnostic to the rent-versus-buy decision and should benefit from higher headship rates as millennials move out on their own, independent of whether these consumers rent or buy.
Consumer Well-Being Supports Near-Term Spending
Since the beginning of December 2016, the Federal Reserve has increased its target federal-funds rate twice, with the expectation of two additional rate hikes before the end of 2017. Morningstar forecasts the federal-funds rate to increase to 2.75% over the next five years, implying modest and regular increases from current levels. Despite the rising-interest-rate environment, we do not believe there will be an immediate downside impact on spending in the home improvement category, as mortgage rates are still historically low, bolstering spending on housing.
Harvard’s Joint Center for Housing Studies anticipates 2% average annual growth in homeowner improvement spending over the next decade, rising from $221 billion in 2015 to $269 billion in 2025. This is versus an average annual decline of less than 1% over 2005-15, which is partially skewed to the downside because of the heightened spending before the housing downturn. For furniture, spending levels also remain promising: Wayfair has pegged U.S. home market growth at 4% through 2025. This is versus a compound annual growth rate of spending in the furniture category of 2.7% over the past five years, according to IBISWorld, and 0% in the furniture and home furnishings category on average over the past 10 years, according to the U.S. Census (skewed similarly by the peak spending prerecession; growth of the Census category over the past five years has averaged 4.5%). Granted, all of the categories cover slightly different parts of the home goods industry, but this implies that the perceived pace of spending ahead remains positive.
Moreover, we think there could be near-term spending support in this home improvement category from a number of consumer wellness factors, including a still-improving wealth effect (as indicated by both the equity markets and home prices--existing home prices rose 12% in aggregate between 2014 and 2016, according to the National Association of Realtors), competitive affordability levels, and clean personal balance sheets (debt-service payments as a percentage of disposable personal income have fallen 300 basis points since before the recession, to around 10%), exacerbated by aging national housing stock (the median age of owner-occupied homes is 37 years, according to the American Community Survey).
However, we don’t expect these consumer wellness factors to improve indefinitely, which is the mitigating factor in our long-term outlook. Over time, we anticipate that normalized growth for many of these mature businesses is likely to be lower than near-term growth, making some shares appear more expensive relative to other consumer discretionary stocks at this time. We have faster near-term growth and slower long-term growth embedded in our models to account for this trend.
Our spending forecast across models in home improvement and furniture and home furnishings companies is predicated on the continued elevation of housing turnover. We believe relatively low interest rates should persist through the end of the decade, given that the Federal Open Market Committee’s expectations and Morningstar’s outlook for the federal-funds rate peg the metric at around 3% or below by 2019. This could encourage homeownership among new owners and help facilitate transactions in the existing homeowner base. Elevated housing turnover should boost demand for more meaningful home improvement projects (like renovations) as owners tend to be more likely to fix properties up ahead of sale and amend interiors upon move-in. Even if existing home sales rise only 1% annually through the end of the decade--significantly slower than the 6% over the last decade--we still anticipate turnover will remain at healthy levels, around 7% or better (calculated by dividing existing home sales by owner-occupied units). This represents a long-term peak level if we exclude the housing bubble, when turnover was around 9% (2003-06). Prior estimates by the National Association of Home Builders indicate that the average buyer is expected to stay in his or her home for 13 years, so not only do homeowners benefit from changing the interior of their homes to better match their tastes (allowing them to enjoy their properties to a greater extent), but they also benefit from the potential return on their investment in improving the home, if they choose to later facilitate a sale.
Home Prices and Stock Market Contribute to Wealth Effect
Higher sustained turnover is likely to continue to crimp inventory levels, supporting rising new and existing home prices, helping the wealth effect remain positive. The average existing home price was more than $236,000 in March 2017, around peak prerecession levels ($231,000), and is likely to remain inflated, given the tight 4-month supply of inventory on the market (down from 11 months at the peak of the housing slowdown and lower than the 6-month supply that the country has averaged over the past 50 years). And while homeownership rates are lower than peak rates near 70% prerecession, the share of Americans who own their homes appears to have stabilized above 60% (at around 64%), according to the U.S. Census Bureau. A study quoted in Bloomberg Businessweek
pegged the middle 60% of U.S. households by net worth as having more than 65% of total wealth wrapped in its principal residence. Thus, a significant portion of the population is probably feeling better about its net worth position, given the improving home price environment over the past seven years.
As higher home prices help improve consumers’ perception of wealth, the willingness to spend on generally positive return on investment categories, like home repair and remodel, tends to increase. Over the last 20-plus years, as home prices rose, retail sales in key categories including furniture and home furnishings, electronics and appliances, and building materials and garden equipment have been largely positive, averaging 3%, 4%, and 4% respectively since 1992. As home prices fell, however, spending waned over 2007-09, turning negative across all three categories.
Consumers are feeling wealthier not only from higher home prices, but also from higher stock prices. Since the beginning of 2010, equity markets have risen significantly, with the Dow ticking up 98%, the S&P 112% higher, and those with exposure to overseas markets performing similarly well (the DAX was up around 105% and the Nikkei rose around 80%) through March 31. According to Gallup (2015), 55% of U.S. adults are invested in the stock market (but still lower than the more than 60% prerecession levels). The breadth of exposure to equity markets indicates the scale of impact that rising or falling equity prices might have on consumers’ overall wealth and, in turn, the wealth effect and the corresponding spending in other housing categories. Between rising home and equity prices, we think consumers’ perception of financial well-being is better than it has been since before the recession and bodes well for the likelihood that spending will persist across the home improvement and furnishings category.
Additionally, from consumers’ perspective, affordability remains favorable as median incomes are handily covering median home prices, according to the National Association of Realtors. The Home Affordability Index remains above 150, implying that a family earning the median family income has more than 150% of the income necessary to qualify for a conventional loan covering 80% of a median-priced existing family home. The higher the index, the easier it is to afford the median-priced home. We think even if home prices continued to rise and wages were stagnant (which we don’t see as probable, given tight labor market conditions), it would take some time to get the index back to 100, where a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home. Still, high affordability also could signal that consumers would probably have incremental discretionary income available to make home improvements on their homes (as well as those being bought or sold), bolstering demand for products offered at home improvement retailers, if they actually choose to use only 100% of the income necessary to qualify for a conventional loan they might need.
Furthermore, consumer balance sheets continue to deleverage, and debt service as a percentage of disposable personal income is at its lowest point in more than 30 years (since the metric has been tracked), leaving more discretionary income to be spent on issues outside debt service (including mortgage and credit card payments), at around 10% for the past five years. However, this will naturally rise as new debt is issued at current rates, which are higher than the rates at which previous debt was issued.
We believe consumer behavior has already led to faster spending in housing-related categories. Over the past five years, furniture and household furnishings have grown at a faster pace than overall consumer expenditures, which could continue if turnover remains high and consumer balance sheets remain clean. Over 2010-15, furniture experienced average growth in expenditures of 8%, household furnishings and equipment averaged growth of 5%, and small appliances and miscellaneous housewares averaged 3% growth versus total consumer expenditure growth of 3%.
Declining Affordability Could Mean More Renters, Fewer Buyers
Our long-term concern remains that as prices and rates continue to rise, affordability for the median consumer will change, affecting the rent-versus-buy equation. While headship rates remain lower than in the past, as discussed in "Millennial Households Are Down but Not Out
," we are more interested in what a secular shift in rent-versus-buy behavior would mean for home improvement and home furnishings companies. For those in the millennial and younger demographic cohorts, given the tighter lending standards, higher expense levels (medical, rent, student loans) prohibiting savings for a down payment, and housing price growth that has outpaced wage growth, the economic equation on the ownership decision continues to evolve.
Existing home sale prices continue to rise. Over the past five years (March 2012-March 2017), they have ticked up 44% in aggregate, rising to an average of $238,000 in March 2017 after peaking at nearly $250,000 in June 2016, and around the prior peak of $231,000 in July 2006, before the housing downturn.
Moreover, the ratio of median home price/median income continues to creep back up to prerecession levels, indicating that a bigger portion of income is being spent on housing. The old “rule” for consumers was that total debt payments shouldn’t be more than 36% of gross income, and housing costs, including taxes and insurance, shouldn’t surpass 28% of monthly gross income. At the end of 2015, average median home price/average median income was at 3.9 times. For example, if a person earned the average median income of $56,500 per year, the average home value she or he paid would be equal to around $221,000 ($56,500 x 3.9). With 20% down, the loan value on the mortgage would be $176,800. At an interest rate of 4%, a 30-year mortgage would cost about $850 per month; with another $300 for taxes and insurance monthly, this would total $1,150.
While even with insurance and taxes this places the average consumer within the 28% ratio for housing costs ($1,150 per month x 12 months = $13,800 / $56,500 = 24%), it doesn’t consider the elevated rents or student loans young people are contending with while saving for homes, or the actual cost of the mortgage payment with less than 20% down. With a 10% down payment, the mortgage rises by $100, to $950. Tack on another percentage point to a 5% mortgage rate, and the payment rises to $1,070. With another $300 for private mortgage insurance, taxes, and insurance, our monthly payment of $1,370 represents 29% of our gross pay ($56,500 / 12 = $4,708). As home prices and interest rates move higher in tandem, this equation could continue to move out of sync, providing the impetus for those forming a household to rent rather than buy.
Longer term, if renting becomes more pervasive and a lower homeownership rate (but rising headship) becomes the norm, we would expect the housing softlines companies on our coverage list to benefit, including Bed Bath & Beyond and Williams-Sonoma. Given the short duration of rental agreements (usually one to two years), we’d expect renters to move more frequently, leading to replacement of softlines items such as curtains, bedspreads, towels, and more to better tailor each apartment location to its individual style. We think renters are less likely to spend on material home improvement projects, like bathroom or kitchen renovations, as the return on their investment would not be seen, since renters cannot capture any capital appreciation on properties where they temporarily reside. However, we’d expect landlords to undertake projects that would improve the aesthetics of the units, like paint (benefiting names like Sherwin-Williams ), rather than risk units remaining vacant.
Could Rising Interest Rates Affect Housing Spending and Affordability?
After an extended period with U.S. interest rates at historically low levels, we appear to be embarking on a slow but sustained run of federal-funds interest rate increases ahead; Morningstar’s outlook is for a federal-funds rate that rises to 2.75% by 2021. In the context of the housing market and related spending, this could cause some concern for investors. Admittedly, there are limitations in assessing the possible magnitude of slower spending ahead, as it remains difficult to capture the appropriate amount of profitability data in past rising and falling interest rate environments. Existing home price data is simple to assess over the last 50-plus years, but spending behavior within the category is a bit more difficult to ascertain, as most of the publicly traded companies representing the home improvement category have only been actively reporting business results over a few interest rate cycles, with Lowe’s (as the most tenured) coming public in 1979 and Home Depot tapping outside investors in 1981.
Through assessing the federal-funds rate movements since 1960, we found five rising-rate and five falling-rate periods, where interest rates were sustainably moving in either direction. The only time home prices fell during these changing rate cycles was leading up to and during the Great Recession as the housing bubble burst. Between July 2007 and July 2008, after rates stopped rising consistently, existing home prices began to falter, tumbling more than 8%. In prior rising-rate cycles, home prices mostly continued to trend higher, which we would presume was in order to keep pace with inflation. Additionally, even throughout the housing recession of July 1990 to March 1991, existing home prices were flat from start to finish, after dipping about 6% in the beginning of that period. To us, this means that rising interest rates aren’t necessarily the only predictive factor in a potential decline in home prices and its impending impact on the wealth effect and spending in correlated categories.
Given the more rational behavior of both lenders and borrowers after the last recession, with more stringent lending requirements intact and cleaner personal balance sheets than pre-2008, we would expect housing prices to exhibit more stability than during the last cycle, behaving closer to other periods of economic expansion and contraction, especially given the pent-up demand that could occur from younger generations, like the millennial cohort (75.4 million in 2015), whose size now outstrips that of the baby boomers (74.9 million in 2015). More than 20% of the population had a FICO score of 800-850 in 2016 versus just below 18% in 2006, according to Fair Isaac. FICO scores incorporate credit history, credit mix, credit utilization, payment history, and the duration of a credit profile; more consumers in good/excellent categories (over 700) would imply that consumers are more diligent about how they are using leverage. Nearly 70% of the population was above 700 in April 2016 versus just 54% in 2006, implying overall consumer credit profiles are improving. We think some of this improvement could be a function of timing in the Fair Credit Reporting Act, which mandates that all derogatory payment information must be purged from the credit file no later than seven years after the negative event occurred. The millions of consumers who experienced foreclosure and default during the downturn may be seeing those blemishes come off their credit files.
Additionally, while there could be a timing differential in the rising of interest rates relative to federal-funds increases, we expect higher inflation could lead to rising asset prices (including home prices). The 30-year fixed-rate mortgage has moved closely in tandem with rising rates, at a correlation of more than 80% over the last 45-plus years. If we expect the indexes to remain highly correlated (and we have no evidence to prove contrary), we are likely set to see higher home mortgage rates, particularly after 2019.
We still see some time passing before those higher rates become a real impediment to demand, as indicated by the expected cadence of raises from the Federal Open Market Committee. At the March meeting, the majority of the participants’ outlooks had the federal-funds rate between 2.375% and 3.0% in 2019, inflating from the current 0.75%. While this is a meaningful boost, it remains depressed compared with the long-term average, which was nearly 5% between 1954 and 2016, and the long-term target of 2.8%-3.0%.
Without a long history of publicly listed companies trading through these cycles, it is difficult to ascertain stocks’ true overall behavior driven by profitability, as rates have risen and fallen. On our coverage list, only Home Depot, Lowe’s, and Williams-Sonoma have traded consistently since the early 1980s, and performance across shares of the three names has been predominantly positive over the rising and falling rate periods we have highlighted--with the exception of Home Depot in the early 2000’s, which we attribute to former CEO Bob Nardelli’s value-destructive leadership as the company strayed from its core competencies, hurting economic profitability. We believe strong share performance--reflecting solid profit gains--through different cycles indicates successful competitive positioning, which underlies our wide economic moat ratings on Home Depot and Lowe’s and our narrow moat rating on Williams-Sonoma and is a factor that should allow these companies to successfully weather different economic cycles ahead.
While current mortgage rates remain low relative to long-term historical levels (averaging 5.7% over the last 20 years versus around 4% presently), our main concern if interest rates continue to tick up centers on the fact that historical levels could make ownership seem expensive for many new buyers, including the entire 75 million-strong millennial cohort, who have not lived through a mid-single-digit mortgage rate environment. The first millennials, born in 1980, probably began working around 2002, when the federal-funds rate was sub-2% and 30-year mortgage rates were around 6.5%. While interest rates continued to rise ahead of the Great Recession, the leading edge of the millennial cohort was probably not yet in the home purchasing cycle or exposed to the interest rate environment in a meaningful way, given that the median first-time homebuyer age has increased in recent decades (in a Zillow survey from 2015, first-time homebuyers’ median age was 32.5, while 30 years ago it was 29.6). The first millennials who turned 31 did so in 2011, when the federal-funds rate was near zero and 30-year fixed-rate mortgage rates averaged 4.4%.
Rising Headship Rates Support Demand for Retailers
Given our outlook
for rising headship rates, the demand for products to improve and furnish homes should continue to be supported. Headship rates (the percentage of adults who head a household) stabilized among those aged 25-34 in 2016. Still, improving financial conditions, which include rising wages thanks to tight labor market conditions, should catalyze a recovery in younger headship, buoying adult household formation. After a long period of stagnation, wages are finally beginning to creep up again. Since pre-2008, nominal private-sector average hourly earnings growth had fallen from north of 4% to lows of just above 1%. This trajectory is finally reversing itself, but the rate is still well below historical levels and the Federal Reserve Board’s 2% inflation target, 1.5% productivity growth, and a stable labor share of income, showing that there is a long runway for potential future wage growth.
As we do not believe rising interest rates will have an immediate impact on slowing housing turnover, we expect some time to pass before affordability will substantially worsen, implying that a more favorable rent-versus-buy option has taken hold. While home improvement names like Home Depot and Lowe’s may not be inexpensive, we could see investors remaining interested, given these companies’ significant return of capital to shareholders. Home Depot has repurchased $33 billion and Lowe’s has bought back $20 billion in shares over the past five years, while paying out $13 billion and $4 billion in dividends, respectively.
Over the long term, our concern about Home Depot and Lowe’s surrounds eventual multiple contraction driven by slower EBITDA and operating margin growth. While these companies are able to continually raise debt as EBITDA expands, providing the ability to buy back a significant quantity of shares presently (and ultimately bolster shareholder returns), our long-term outlook for operating margins and EBITDA growth is set to slow from recent levels. This, in turn, should lead to normalized earnings per share growth that is slower than what has occurred over recent years. As growth slows, the ability to finance incremental share buybacks with leverage will wane, slowing earnings growth to a low-double-digit pace, potentially leading the earnings multiple to contract.
However, if interest rates and lending standards eventually crowd out first-time homebuyers’ ability to purchase a home, we believe softlines retailers will do well if renting becomes the more popular choice. In our opinion, if housing turnover eventually slows, the incremental consumers who are squeezed out of home purchases and pushed into renting a house or apartment could be more likely to spend on home goods including towels, linens, lower-priced furniture, and wall decor rather than products that would be used in a major home renovation project. This type of trend would probably benefit retailers like Williams-Sonoma and Bed Bath & Beyond, which are trading at historically low multiples as earnings power has compressed over the past few years. Furthermore, both of these businesses continue to trade at significant discounts to our fair value estimates.
While some pricing pressure from peers could persist, we believe Williams-Sonoma’s evolving real estate strategy, supply chain optimization, and still-growing global reach will help returns on invested capital rise to 18% over the next five years (versus our estimated weighted average cost of capital of 9%). For Bed Bath & Beyond, while we think the cadence of couponing is unlikely to slow over the near term, we believe the firm’s improving omnichannel presence, disciplined real estate expansion process, and improving supply chain processes will help offset its inability to price at a premium, ultimately leading to lower operating margins than in the past (9.7% in 2021 versus a 13% average over the past five years). We believe both of these shares have fallen in tandem with many softlines retailers, as consumers have shifted their spending in recent periods to more durable categories, and have moved in sympathy with overall retail stocks independent of their differentiated offerings over the past year.
Top- and bottom-line growth has stalled for many brick-and-mortar retailers, as consumers have pressed for aggressive promotions to facilitate sales and foreign exchange headwinds have negatively affected results. Sales and earnings growth for Bed Bath and Williams-Sonoma slowed to their weakest pace in the last five years in the most recent period. However, we believe these are trough levels and growth should resume at a more normalized pace over time, as younger cohorts of the population bolster headship rates. These businesses are relatively mature, though, and we forecast top-line growth to reach only a low- to mid-single-digit pace while earnings growth reaches a low-double-digit rate through operating efficiencies and share buybacks. The higher normalized rate of growth over our long-term forecast implies that the shares are inexpensive at current valuations, given the true earnings potential of these companies.