Citi sees homebuilder stocks winning as housing inventory stays tight

A lack of existing homes for sale and robust demand are fueling a rally in homebuilder stocks, according to Citigroup.

The sector gauge outperformed the S&P 500 Index last week, rising as much as 3% compared with a 1.4% decline in the broader gauge. Both indexes slipped about 0.5% on Monday as traders weighed the Federal Reserve's next move on interest rates this year. The housing supply shortage is lifting homebuilders, despite a strong May housing starts that led investors to wonder if the market is in the early stages of overbuilding, Citigroup said in a note on Monday.

Single-family inventories are still down 19% in April, below pre-pandemic levels, and under-building after the global financial crisis has caused a significant deficit of more than 1 million homes in the U.S., Citigroup analysts led by Anthony Pettinari wrote. As it currently stands, most measures suggest "the market does not have a path to close the housing deficit in the near-term," the note said. 

Adding to the crunch, current homeowners are locked into their lower mortgage rates, and it doesn't appear they'll be "unlocking" from that anytime soon, according to Citi. Tight resale inventory is in part due to a large group of potential move-up buyers opting not to sell their current properties, as to not lose their highly favorable mortgage rates. 

The tight supply "may provide a multi-year tailwind for builders," the note said. The bank remains positive on homebuilders, with buy-ratings for PulteGroup Inc., D.R. Horton Inc. and Lennar Corp., citing favorable net order growth as a near-term catalyst in the second half of 2023.

Citi estimates that benchmark Fed interest rates would have to fall to about 5% before total supply could reach pre-pandemic levels, and rates would need to fall to roughly 3% before supply could reach pre-global financial crisis average levels. The analysts view the latter scenario as highly unlikely. 

Last week, the Fed unanimously voted to hold the benchmark rate in the target range of 5% to 5.25%, its first pause since it began aggressive rate hikes in early 2022.

"We expect that as mortgage rates fall, some of this pent-up supply may come to market; however, it would require a significant decline in benchmark FRM rates before supply normalizes to pre-pandemic levels," the analysts wrote.