As Quantitative Tightening measures aimed at squashing inflation began in early 2022, residential construction companies initially underperformed the market. This spread was driven by expectations that higher mortgage rates would reduce consumer demand.

However, as interest rates continued to rise, these forecasts proved incorrect; demand remained robust. Despite a six-month period of underperformance starting in late 2021, the residential construction industry has since outpaced both the market and the consumer cyclical sector over a three-year period on an equal-weight basis, with positive spreads exceeding 50% and 100%, respectively.

Fig 1: Performance 1YR Horizon

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Fig 2: Sales Growth [1YR Rolling]

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Now, as the easing cycle begins, the key question is whether supportive macro dynamics will persist, or if there is an emerging opportunity for change. At the onset of the pandemic, a shift in consumer patterns triggered unprecedented demand for residential homes, leading to elevated prices and record margins for construction companies.

In the face of rampant inflation, these higher prices provided firms with the flexibility to navigate soaring mortgage rates, which exceeded 7%.

New strategies, such as offering “mortgage rate buydowns” that reduce rates by up to half for an upfront fee, further bolstered demand. Meanwhile, low inventory and limited price sensitivity in the resale market reduced competition for homebuilders.

Additionally, in contrast to the broader consumer cyclical market, operational efficiency improved significantly among companies in the residential construction industry, leading to quarterly earnings that exceeded analyst expectations. To mitigate the impact of rising interest rates, companies in the industry have progressively reduced their debt loads.

Fig 3: Operating Margin [1YR Rolling]

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Fig 4: Free-Cash-Flow To Sales [1YR Rolling]

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The industry's debt-to-equity ratio has nearly halved from pre-pandemic levels, while it has remained stable in the broader consumer cyclical sector. Although gross profit margins have seen moderate improvement, operating and net income margins have nearly doubled from pre-pandemic levels.

However, with new home inventories at their highest since 2008, national home prices at record highs, and affordability at a two-decade low, the fortunes of the residential construction industry may soon change as macroeconomic conditions deteriorate.

Fig 5: Net Income Margin [1YR Rolling]

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Fig 6: Performance [1YR]

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Fig 7: Dividend Yield

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Fig 8: Net Debt To Ebitda [1YR Rolling]

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