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Smart investors make their name in markets like this. Many growth stocks have fallen 50% or more this year and almost the entire real estate sector is down 30%. And it’s not just because Mr. Market has gone crazy; there are legitimate economic pressures affecting the industry. Interest rates are up, prices are starting to fall, and materials inflation and scarcity are still rising in many parts of the economy.
Investors who can pinpoint the strong companies that will survive and thrive in a market like this will have the best returns a decade from now. The two real estate stocks that we’ll discuss, Howard Hughes Corp. (HHC -3.62%) and Green Brick Partners (GRBK -2.56%), have growth potential and smart investors backing them.
Most public real estate stocks register as real estate investment trusts (REITs) and are required to pay out 90% of their net income as dividends. This restrains their ability to grow because they can’t retain earnings for growth.
When the hedge fund manager extraordinaire Bill Ackman helped split Howard Hughes off its parent company over a decade ago, he made the decision to keep Howard Hughes a real estate operating company (REOC), which doesn’t have the same dividend obligations. This allows the company to retain earnings to grow.
It was a good choice because Howard Hughes specializes in master planned communities (MPCs). It purchases tens of thousands of acres of land and plans a massive community on it. The area includes school systems, houses, apartments, shopping, dining, walking trails, gyms, and even police and fire stations. The company develops commercial property to drum up demand from consumers and then starts to parcel out the land and sell it to residential developers. Those funds are used to further develop commercial buildings.
As the community is developed, it has cash flow from selling off parcels and has a consistent income from the commercial assets that it retains.
Howard Hughes is managed to withstand recessions. It never develops more than the existing demand so that it won’t be caught with empty buildings in a recession, and it has the ability to hold onto land indefinitely. If prices collapse, it can simply sit back and collect income from its existing assets and choose to sell parcels and start up development once the market recovers.
Today, Howard Hughes is Ackman’s second-biggest stock position, totaling close to $1 billion and accounting for 12.4% of his portfolio. Many of the company’s assets were purchased at prices below the current market prices (even after the drop this year) but must be reported at cost on the balance sheet. Yet the stock still trades for less than book value. Investors today get the upside of the stock price if it reverts to its five-year mean book value multiple (1.44), any further upside in the price of land and the commercial buildings that it develops (at a high return), and the inherent diversification in their portfolio from investing in a land bank.
David Einhorn, like Bill Ackman, made his name making big value bets with a little bit of macro forecasting thrown in for good measure. He currently has 25% of his stock portfolio (not including cash) invested in one company: Green Brick Partners.
Green Brick is a land development and homebuilding company that has developments in Texas, Colorado, Florida, and Georgia, with the majority in Texas. It has been hit hard this year, and the stock is down close to 30% year to date.
Einhorn hasn’t lost faith. In a recent shareholder letter, he wrote:
A small tweak in monetary policy isn’t going to resolve the decade-long underinvestment in housing. Green Brick Partners (GRBK), our largest investment, is poised to benefit from this dynamic. It trades at around 7x this year’s consensus earnings estimates.
That thesis makes sense. Home prices skyrocketed in many areas in 2021 for a reason: demand far outpaced supply. Homebuilders raced to increase supply and interest rates have tempered demand, but once interest rates stabilize, the same people will be looking to buy houses, and the poorly capitalized homebuilders could go out of business.
Additionally, there has been a migration since the start of the pandemic from coastal cities to cheaper areas like Texas, Oklahoma, and Utah. This will further drive demand for Green Brick’s properties.
Meanwhile, the stock now has a P/E of just 4.04 and a forward P/E of 10.94. Its five-year average P/E is over 12. That means Green Brick’s current earnings level would have to collapse by two-thirds to make the price level sensible. And that doesn’t even include the long-term growth potential of developing land in Texas.
Mike Price has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Green Brick Partners and The Howard Hughes Corporation. The Motley Fool has a disclosure policy.
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