It may not seem like it now, but housing activity will improve. Phase one of the cycle has been in place for a few years now. Housing starts are down from over 2 million in 2005 to 587,000 in 2010. Restricting supply is a major step in the right direction. In 2005, houses were being built on the assumption that houses were now like cars -- a household had to have more than one. Current housing starts are well below the natural rate of household formation of around 1 million per year.
The problem, however, is that more and more households are opting to rent rather than own, because the current costs of renting are equal to or more attractive than those of home ownership. That dynamic between rent and mortgage is a huge factor today, because of the lack of consumer confidence and high unemployment. So while it may be great to see the number of housing starts come in below household formation, that alone may not be enough to get the job done.
As long as renting costs are equal to or lower than home ownership costs, housing demand will remain depressed. Home price appreciation is what made home ownership more attractive than renting, even if costs between the two options were equal. Housing prices don't appear to be appreciating at the moment, so folks will continue to rent.
Phase two of the cycle is that over time, as rental demand grows, costs of renting will rise, spurring households to own instead of rent. Low interest rates and attractive real estate prices will serve as additional catalysts in promoting home ownership.
When exactly that will happen is the question. The Fed seems to believe that mid-2013 is appropriate, given the central bank's intent to keep rates low until then. The unemployment rate will be a good indicator, as lower unemployment will spur consumer confidence, which is what needs to happen to motivate folks to buy homes. For investors, however, markets are anticipatory, so those businesses that are leveraged to a housing recovery will likely be trading higher over the next few years in anticipation of a recovery.
If that happens, then investors in these stocks can expect returns that will likely be in excess of 100%. Builders FirstSource (BLDR) is one of the largest suppliers of building materials to homebuilders. It does not compete with Home Depot (HD) or Lowe's (LOW). Shares trade for $1.79, for a market cap of $168 million. Back in 2006, shares traded north of $20. I don't expect real estate activity to reach 2006 levels for many, many years, nor do I expect shares to come close to 2006 levels. But a modest stable housing recovery could push shares above $5 in two years.
Mueller Water Products (MWA) is another highly leveraged housing play. "Leveraged" is the key word here: Mueller has a market cap of $331 million and net debt of over $600 million. The business currently generates annual EBITDA of over $100 million with annual interest expense of about $65 million. In the fiscal third quarter of 2011, its net loss was $2.7 million, compared with $3.8 million a year earlier. Mueller is a century-old business, and many of its water infrastructure products command the No. 1 or No. 2 market share. Shares trade for $2.13. EBITDA could easily approach $150 million to $160 million with improving housing activity. Apply a 4x multiple to that EBITDA, and you get a market cap over $600 million, or a share price near $5.
Housing-related stocks have hit rock bottom. And most companies have adjusted to leaner, more efficient operations. The only catalyst they now need is some tangible evidence that housing is recovering. Because these companies' businesses are so levered to a housing recovery, any signal of improvement will very likely send shares prices up significantly, in most cases 2x to 4x the current stock price.