Toll Brothers Inc (TOL), The Home Depot, Inc. (HD): Invest in Housing Without Breaking the Bank

It is no secret that the U.S. housing market is on the rebound. More people are getting jobs, the unemployment rate is falling, and the housing price indexes are increasing. Still, there are hidden risks in the abnormally low interest rates that are fueling consumer demand.

Home builders will face serious difficulties when interest rates return to their historical norms and fewer people can get mortgages. Investing in relatively stable home improvement stores gives upside exposure and limits the downside risks in the event that the bottom falls out of the market.

Case-Shiller Home Price Index: Composite 20 data by YCharts

The Home Builders

Home prices have been rising, but in many markets it is substantially cheaper to buy than to rent. Toll Brothers Inc (NYSE:TOL) is a home builder that focuses on the higher end of market with an average selling price of $573,000 in 2012. Its focus on this market segment is a major strength as it allows the company to benefit from America’s growing upper class. Regardless, financial crises easily scare luxury buyers, as the 2008 crisis showed.

Toll Brothers Inc (NYSE:TOL)‘ debt load isn’t excessive with a total debt to equity ratio of 0.69. Its numbers have come back since the great recession, but its current return on investment (ROI) is only 0.1%. Toll Brothers Inc (NYSE:TOL) is one of the better home builders, but with expected 2014 earnings per share (EPS) of $1.45 and its current share price around $35 it is too expensive.

is profitable and continues to move into multi-generational housing. There are a number of older Americans that cannot afford the costs of assisted living. Lennar’s multi-generational homes are cost effective alternatives between independent and assisted living.

Lennar Corporation (NYSE:LEN) is trading at high valuations with an expected 2014 EPS of $2.47 and a current share price around $43. It currently has a gross margin of 12.6% and a ROI of 8.9%. If interest rates rise, Lennar Corporation (NYSE:LEN) and Toll Brothers Inc (NYSE:TOL) could suffer a sharp fall in margins. The chart below shows how in a couple of quarters home builders can go from being highly profitable to very unprofitable.

TOL Profit Margin TTM data by YCharts

Home Improvement Stores Offer a Safer Path

The above chart shows how home improvement stores didn’t suffer a giant drop in profit margins. All of the companies suffered, but the home improvement stores were able to maintain more of their customer base and keep a tight control on costs.