During our third quarter portfolio update, we profiled portfolio holding, NVR (NVR). Below is a replay of our live commentary on the company from our quarterly portfolio update webinar and an excerpt from our QUARTERLY LETTER.
In his presentation, Todd referred to our previous webinar profile on NVR from January 2021, which can be found here.
The US housing market has been unstable so far this year, as rising mortgage rates and higher housing prices have rapidly reduced affordability. Fortunately for existing homeowners, most of whom own their houses outright or have locked in low, fixed mortgage rates, rising rates have not directly impacted their finances unless they have an outstanding variable-rate home equity line of credit.
Homebuilders, who rely on incremental demand for housing, have seen demand dry up in response to declining affordability. Single-family home building permits have plummeted in recent months back to pre-pandemic levels.
That’s the bad news. On the bright side, the building materials supply chain, which delayed construction and increased the cost to build a home, is rapidly improving. This bodes well for homebuilders like NVR with a track record of cost discipline. In other words, even if NVR’s average selling price declines, it can maintain attractive gross margins if they simultaneously control costs.
According to the National Association of Home Builders, the ten-largest builders’ market share increased from 8.7% in 1989 to 34.2% in 2021. There are various reasons for this steady trend toward industry consolidation, but two factors – land availability and cost control – are near the top of the list. Critical to any home builder’s profitability is securing cheap yet attractive land, which is getting harder to come by. Smaller, independent homebuilders don’t have as many financial and operational resources to obtain sufficient amounts of cheap and attractive land knowing that demand to build on that land may not materialize for a few years, if ever.
Similarly, larger builders like NVR can source materials more efficiently and spread costs among more jobs than smaller builders. This makes it difficult for smaller builders to generate attractive cash flows that can be used to reinvest in their businesses. Naturally, then, large builders have an advantage that should increase in down markets when smaller players get shaken out of the industry.
We believe NVR remains well-positioned when it comes to having communities in attractive locations and having affordable price points. Relative to other major homebuilders, NVR has greater exposure to the exurban (beyond suburban) areas and second- and third-tier cities like Richmond, Virginia and Cincinnati, Ohio, where housing tends to be more affordable compared with major cities or “hot” real estate markets like Boise, Idaho and Austin, Texas. Further, to the extent that remote- and hybrid-work arrangements remain relevant – we believe they will – NVR’s locations away from city centers should be attractive to new home buyers. Longer commutes become more palatable if they don’t have to be done every day.
It’s important to remember that NVR’s markets don’t necessarily have a strong positive correlation with what’s going on in the national housing market. NVR operates in a specific region of the United States, all east of the Mississippi River. So even if housing prices in high-growth areas in the western half of the United States are sharply declining, NVR’s markets may be holding up relatively well. Some of NVR’s markets, particularly its home region of the Mid-Atlantic and the Northeast, tend to be more mature. While growth is more limited in those regions, they are also less vulnerable to house price declines.
It’s worth reiterating NVR’s two-pronged business model – first, be asset light and second, maximize local market share. On the first point, NVR only uses option agreements to control land until there’s present demand to build on the land. NVR pays landowners a premium for the right to purchase the land by a later date at an agreed-upon price. If demand doesn’t materialize, the most NVR loses is the premium paid to control the land for a certain period of time. Using options in this way frees up NVR’s capital to be deployed in a manner that management considers prudent.
Other homebuilders make greater use of outright land ownership where they buy the land and keep it on their balance sheet, hoping to one day build on the land. Owning the land works really well in a robust real estate market where affordable, shovel-ready land can be in short supply. On the other hand, it does not work well when demand doesn’t materialize, and the home builder has to carry the land on its inventory. If the home builder also carries substantial debt – which many do – they may get into a situation where they need to sell the land at a steep discount to service their debt.
Unlike its major homebuilding peers, NVR has a net cash balance sheet, meaning it could pay off all its debt today and still have plenty of cash leftover. As such, we believe NVR’s asset-light, cash-rich balance sheet is a distinct advantage during downcycles in the housing market. This was on display following the housing crisis when NVR moved into new markets like Florida and Ohio, which subsequently became attractive growth markets for the company. In the event of a prolonged weak housing market, we expect NVR to make similarly opportunistic investments to grow the business.
The second prong of NVR’s business model, to maximize local market share, is also designed to help the business be resilient in down markets. NVR has seven manufacturing centers, in which the company receives bulk materials and pre-fabricates parts of the home – panels, interior stairs, etc. – before sending the sections to the job site. The more communities that NVR develops around these manufacturing centers, the more efficiently and quickly NVR can turn its inventory. Greater local market share also allows NVR to maintain sub-contractor relationships across housing cycles, as sub-contractors know there will always be business working with NVR.
We chose NVR over other homebuilders because we think they are best positioned to capitalize on what we believe to be a long-term secular tailwind for US housing activity. Research group Evercore recently stated that it would take a decade of 2 million annual housing starts to make up for the deficit in housing activity incurred after the housing crisis of the late 2000s. In September, the president of the Philadelphia Federal Reserve stated that, despite the Fed raising interest rates, “The bottom line is this: We need to build (homes).” There will inevitably be up-and-down cycles in the housing market while these ends are pursued. We believe NVR has the most resilient business model and is led by the best capital allocators in the homebuilding industry. As such, we expect NVR to take share from both smaller competitors and its larger peers during down cycles and come out stronger on the other side.