What happened?

Shares of major homebuilders are down sharply today, on news that it's about to get even harder to get a mortgage. Over the weekend, it was reported that JPMorgan Chase (NYSE:JPM) was going to tighten lending standards for mortgages. The bank, which is America's largest by assets, said it would require a 20% down payment and a credit score of 700 or higher. 

Investors have reacted about as you would expect today, sending the biggest homebuilders' stocks down sharply: 

Homebuilder Price Change (Decline) Today
Beazer Homes USA (NYSE:BZH) (11%)
Century Communities (NYSE:CCS) (15.3%)
D.R. Horton (NYSE:DHI) (5.9%)
KB Home (NYSE:KBH) (12.4%)
Lennar (NYSE:LEN) (6.5%)
LGI Homes (NASDAQ:LGIH) (14.6%)
Meritage Homes (NYSE:MTH) (10.8%)
NVR (NYSE:NVR) (7.5%)
PulteGroup (NYSE:PHM) (6.8%)
Toll Brothers (NYSE:TOL) (7.8%)

Source: YCharts. As of 1:12 p.m. EDT April 13. 

So what

While JPMorgan Chase (NYSE:JPM) is the first, it is not expected to be the only lender to raise its lending standards. The U.S. has fallen sharply into a recession as the coronavirus pandemic has shut much of the economy since mid-March and is expected to weigh on it for months to come. 

Banks are hedging their risks at this point, focusing on only the best-capitalized buyers with cash and a solid borrowing history. Homebuilders are one of the most-exposed industries to a recession, and it's a certainty that home sales are going to fall sharply with most of the U.S. population ordered to stay at home, and millions being added to the unemployment rolls weekly. 

Roofer working on a new home.

Image source: Getty Images.

Now what

Unlike past recessions that have been the result of a troubled spot with the economy or a major industry, most expect economic activity to recover quickly once there are treatments and hopefully a vaccine for COVID-19. That should be good news for homebuilders, since there was already substantial pent-up demand for housing, particularly the entry-level single-family properties many homebuilders were prioritizing over the past few years. 

With that said, it's far from clear just how long the sanctions on work, travel, and public gatherings will be in place. It's hoped that the coming summer will provide some respite from COVID-19 cases, and there's already evidence that the worst in the hardest-hit parts of the country is over, and the curve of growing infection rates is being flattened. But there's also tremendous risk to opening things up too quickly, with the possibility that we end up back in the same place with overwhelmed hospitals and thousands of people dying before there are effective treatments. 

Yes, new homebuying activity will recover once we get past the worst of the pandemic, and some of today's beaten-down builders will likely make for market-beating investments. But investors should be cautious. This is one of the most-leveraged industries, as most homebuilders use substantial amounts of debt to acquire the land assets they develop: 

MTH Debt to Assets (Quarterly) Chart

MTH Debt to Assets (Quarterly) data by YCharts.

With home sales likely to crater through the second quarter and potentially even longer, that's a lot of debt that the industry will have less cash flow to service. 

What should investors do? I think NVR is the one homebuilder investors can count on to come out of this crisis in great shape. 

NVR has no debt maturing this year; ended last quarter with more than $1.1 billion in cash; and uses more option contracts to acquire land, which results in far less leverage than its peers. Management is also likely to act aggressively to repurchase shares during the downturn. I think that makes it well worth buying today. 

On the risk/reward side, I'm a big fan of both LGI and Meritage. LGI has a more leveraged balance sheet and $300 million of debt maturing this year, but both are hyper-focused on starter properties, have strong track records of developing desirable and profitable communities, and represent enormous upside gains from here.  

With that said, I think most investors may want to wait until we have some idea how bad the industry is being affected, and how long the downturn could last, before buying. The next few months are likely to see a brutal drop in home sales, and homebuilding will probably come to a near halt. That could send share prices down even further, and (more importantly) could send some of the homebuilders with the weakest balance sheets into serious financial trouble. 
