Tuesday, March 08, 2005

Will 7% Mortgages Hurt Pulte?

By Lawrence Meyers

Homebuilders have been on a tear during the housing boom. Look at the five-year charts of Pulte Homes (NYSE: PHM), Centex (NYSE: CTX), D.R. Horton (NYSE: DHI), and Lennar (NYSE: LEN), and you'll see pretty much the same thing: stocks that have become eight- or 10-baggers over that period.

Investors who saw the demand for houses rising in the late '90s wisely targeted the homebuilding industry for their funds and have done quite well. But, as I wrote about earlier, the big question on everyone's mind is: How long can the party last? Granted, this is the question people have been asking for years, even as home prices continue to defy gravity and grow 20% annually in places such as Southern California.

Pulte Homes CEO Richard Dugan said in a recent interview that mortgage rates could hit 7% this year. What would that mean for homebuilders? It's hard to predict with any accuracy, of course, but Mr. Dugan did point out that mortgages hit 8.5%-9% in 2000, and the industry still did well. He opined that homebuilding would be soft in the Midwest this year and strong on the coasts, even with these higher rates, because more people would find their way into adjustable-rate mortgages.

That's usually how it works when rates climb. People who have been priced out of homes usually apply for adjustable-rate loans, which have lower initial interest rates than fixed loans, to make the purchase happen. If rates rise, that trend is likely to continue.

But at the same time, stock investors should take note. The Fed has pumped the interest-rate gun six times in the past year, and despite Pulte Homes' recent price cuts in its Las Vegas market, it still reported great earnings. Sooner or later, those rising interest rates will cause demand to slow and hurt the homebuilders. If this should coincide with a pricing collapse in the housing market, investors will be in real trouble.

The lesson is to keep an eye on trends, and not just in your area. Even if you've pulled in some stellar homebuilding returns over the past few years, now may be the time to re-evaluate.

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