As previously documented on BRIIDGE, contrary to initial expectations of underperformance in the residential construction industry during the fastest rate hike cycle in decades, homebuilding companies outperformed the benchmark by over 100% on an equal-weight basis over a two-year period.

Despite predictions that higher interest rates would lead to increased financing costs, the impact on both companies and consumers was less severe than anticipated. Companies in the industry, buoyed by strong balance sheets following the pandemic-driven surge in sales, took proactive steps to reduce their exposure to rising interest rates.

Fig 1: Performance 1YR Horizon

BRIIDGE Shortcut: TS Reference Index

Fig 2: Sales Growth [1YR Rolling]

BRIIDGE Shortcut: BRIIDGE FA | BRIIDGE CUSTOM FA

Many lowered their debt burdens in anticipation of tighter monetary policy, as evidenced by a median interest coverage ratio that was seven times higher than pre-pandemic levels at the start of the rate hike cycle. On the consumer side, macroeconomic factors, such as the temporary rise of hybrid work, led to increased demand for additional residences.

Furthermore, companies introduced measures like mortgage rate buydowns to mitigate the effects of higher interest rates, which sustained demand in the residential sector. In contrast, the commercial and office building industries experienced the expected challenges.

Remote and hybrid work models weakened demand for office and commercial spaces, resulting in declining occupancy rates and negative median sales growth during the speculative cycle (Q2 2021). Unlike the residential construction industry, which had reduced its debt in response to the impending monetary tightening, the commercial real estate industry’s debt burden continued to rise, as reflected in increasing debt-to-equity ratios and declining interest coverage ratios.

The absence of the favorable macroeconomic tailwinds that supported the residential sector made the commercial and office real estate industries more vulnerable to rising rates.

Fig 3: Operating Margin [1YR Rolling]

BRIIDGE Shortcut: BRIIDGE FA | BRIIDGE CUSTOM FA

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

BRIIDGE Shortcut: BRIIDGE FA | BRIIDGE CUSTOM FA

As a result, companies in this industry were forced to take drastic measures, including asset sales, to manage the growing financial pressure. Moreover, while the residential construction industry has seen rising net income margins over the past three years, the commercial sector has experienced the opposite trend, with margins declining.

With the current shift towards monetary easing, potential arbitrage opportunities may arise between the residential and commercial real estate sectors.

Fig 5: Net Income Margin [1YR Rolling]

BRIIDGE Shortcut: BRIIDGE FA | BRIIDGE CUSTOM FA

Fig 6: Performance [1YR]

BRIIDGE Shortcut: TS Reference Index

Fig 7: Dividend Yield

BRIIDGE Shortcut: BRIIDGE FA | BRIIDGE CUSTOM FA

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

BRIIDGE Shortcut: BRIIDGE FA | BRIIDGE CUSTOM FA