How to Play Shaky Homebuilder Stocks

Homebuilding stocks have a rough go of it so far in 2018, with the SPDR Homebuilders ETF down some 15% since the year began. Here's how I'm playing things. First, you should recognize that despite decent U.S. housing-market activity at the moment, there are myriad reasons for Wall Street's increasingly negative sentiment on the sector, including: Rising Mortgage Rates Mortgage rates move in almost lock-step with the 10-year U.S. Treasury yield, which recently broached the key 3% level. As result, the average 30-year fixed mortgage rate rose to a seven-year high of 4.61% in the latest Freddie Mac weekly survey. That's potentially bad news for home sales. Higher Building Costs Lumber prices are up some 30% so far this year, as well as approximately 60% above where they stood a year ago. This will impact homebuilders' margins given their heavy dependence on wood. The industry also continues to face a shortage of skilled craftsmen such as carpenters, which could add to labor costs. Unfavorable Taxes and Regulations The new Trump tax-reform package limited the federal mortgage-interest deduction to just the first $750,000 borrowed on loans taken out after Dec. 14, 2017. That's down from a previous $1 million cap. The package also capped consumers' ability to deduct state and local taxes (including property taxes) at just $10,000 a year. This will likely hurt the home-building industry -- especially in the luxury segment, and particularly in high-tax states like Illinois, California, New York and the rest of the Northeast. California's recent move to require solar panels on all new homes built as of 2020 will also add another $8,000 to $12,000 to housing costs in a state where affordability is already beyond a challenge for most people. Taking a Toll on TOL (and Other Names) You can see all of these challenges already hitting homebuilders' stock prices. For example, luxury builder Toll Brothers took a nearly 10% hit in trading Tuesday after reporting results that fell short of earnings expectations. The company also reported a higher-than-expected cancel rate for future orders. (Read Jim Cramer's take on TOL's woes here.) Meanwhile, home-improvement retailer Lowe's missed expectations when it reported earnings earlier this week, while rival chain Home Depot reported mixed results last week as well. I'm seeing these negatives not only in the stock market, but anecdotally as well. I've been looking to possibly acquire a secondary home outside New York City and am seeing what had been $10,000 to $25,000 price drops at 2018's beginning morph into $50,000 to $75,000 reductions today. How I'm Playing Things I still have a decent position in homebuilding stocks, but have hedged almost my entire stake by writing just-out-of-the-money covered calls against individual names. One play I'd recommend is to accumulate an initial stake in LGI Homes -- my favorite homebuilder stock -- via a so-called buy/write order. That's where you buy a stock and immediately write a covered call against your position to lower your cost basis. LGIH currently trades right around $58.50 a share. That means you can fashion a buy/write order using November $60 call strikes that offer about a $6 premium per contract. This will give you LGIH shares for about a $52.50 net cost basis -- your $58.50 stock price minus the roughly $6 options premium that you'll receive. This mitigates some of your downside risk, but still sets you up for a more-than-solid potential return for the less than six months remaining before your covered call expires. I'm also lightening up on homebuilders like Toll that have substantial exposure to the luxury segment and/or a significant footprint in the high-tax states mentioned above. Such names will likely see the greatest negative impacts from tax reform. On a brighter note, homebuilders should continue to enjoy positive effects from the Trump reform package's sharply lower federal corporate tax rates. A strong U.S. jobs market should also boost housing demand. However, until mortgage rates stabilize, it's hard for me to feel as sanguine toward this sector as I'd been over the past few years.

How to Play Shaky Homebuilder Stocks

Toll Brothers fell some 10% Tuesday, while the overall sector is down some 15% year to date.

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