Why Interest Rate Cuts May Not Boost Housing as Much as You Think

Every interest rate cycle seems to bring the same emotion out of investors, thinking that certain sectors will automatically outperform and do well in the months that follow the decision to cut rates from the Federal Reserve (the Fed). However, this cycle might be different in how it affects one particular space in the economy.

The real estate sector, which has historically done well during low interest rate environments due to their positive effects on mortgage rates and demand, has already priced in most of the growth that could be had in the following quarters, including the new interest rate cuts. For reasons that will become clear for investors shortly, it would be wise to stay away from homebuilder stocks like Toll Brothers Inc. (NYSE: TOL) in this market.

That doesn’t mean ditching all of the sector, though. There could be new opportunities in other areas of real estate, such as apartment and multi-family housing. Taking advantage of the weakening single-family space, stocks like Mid-America Apartment Communities Inc. (NYSE: MAA) and even the broader Vanguard Real Estate ETF (NYSEARCA: VNQ) might be a worthy place to look into for this cycle.

Uncovering the Weaknesses in Toll Brothers Stock

According to Goldman Sachs analysts, the S&P 500 will trade at a forward P/E ratio of 18.0x in the next 12 months, which means any stocks or sectors that trade below this benchmark valuation could be in trouble. Markets typically have a good reason to discount certain names; unless driven by manias, they are usually right.

In this case, Toll Brothers stock trades at a forward P/E ratio of only 10.5x, which is well below the expected for the S&P 500, and also underperforming peers like D.R. Horton Inc. (NYSE: DHI), which has a 13.7x. The reasons for the discount can be found by breaking down the fundamentals of the real estate market today, particularly in home building indicators.

Economic data like building permits and housing starts typically serve as the main gauges for investors to gauge the state of the housing market, so a proper look into their trends is called for. Both of these indicators have been down over the year and show no signs of bottoming soon.

But that’s all to do with future expectations; what about where the market is sitting today? Investors can note the mortgage market index and its current low, which has not been revisited since 1996 to show markets how little interest there is in buying new homes today.

One final check is done in Toll Brothers directly, through the company’s latest quarterly earnings report, showing that backlog values went down by 10% on the year, meaning the future of home values is facing potential downside.

More than that, home sales gross margins were down slightly to 27.4% from 27.8% a year prior, not much, but still a trend helping Wall Street analysts land on a new bias. That new bias include a consensus price target of $145 a share, which calls for a net downside of 4.3% from where the stock trades today.

With Renting on the Rise, These Two Stocks Stand to Benefit

According to these indicators, new demand for homes won’t be here any time soon, so the alternative becomes renting. This is where real estate investment trusts (REITs) focused on rental units, like Mid-America Apartment Communities, come into play.

This could be why Stanley Druckenmiller (responsible for George Soros’ returns) bought into this stock, expecting inflation and rental demand to work in his favor in this REIT. There is enough strength in this company’s portfolio for management to keep up with a 3.6% annualized dividend yield offered to shareholders.

Now, that’s one way to beat inflation, but here’s the best part. Analysts at Goldman Sachs decided that there is enough bullish evidence to boost their price targets on this REIT, so they landed on a $187 per share valuation as recently as September 2024.

To prove this new view right, Mid-America Apartments stock would need to rally by as much as 15% from where it trades today, bringing the potential upside to nearly 20% when investors account for the dividend payout and its further growth.

Some people are uncomfortable letting their capital ride on a single stock, which is why the Vanguard Real Estate ETF might be a better pick. That fund’s top holdings include other rent-focused REITs like Realty Income Co. (NYSE: O) and Simon Property Group Inc. (NYSE: SPG).

Considering that the ETF now trades within 5% of its 52-week high, investors can safely assume the market is rewarding this other branch of real estate with better—and more bullish—price action for good reason. So, despite interest rate cuts, it isn’t property values that could rise but rental income, something investors cannot let pass.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.