Warren Buffett's Berkshire Hathaway recently released its 13F holdings report, which revealed that the company made significant investments in three real estate stocks during the second quarter: D.R. Horton (DHI), Lennar Corp. (LEN), and NVR Inc. (NVR).

However, among homebuilders, there is one luxury home builder whose stock price has outperformed these three companies this year: Toll Brothers.

Toll Brothers (NYSE: TOL) specializes in designing, building, marketing, selling, and financing an array of luxury homes, including single-family detached homes, attached homes, master-planned resort-style golf communities, and urban infill projects. The company operates in two segments: Traditional Home Building and Urban Infill (City Living).

What sets Toll Brothers apart from other homebuilders? Here are three key questions to help you understand this exceptional company.

Why did housing builders' stocks rise significantly in 2023?

To understand what happened in the real estate market in 2023, we need to look back to 2020.

The COVID-19 pandemic impacted all sectors of the economy, including the housing construction industry. Material costs rose due to supply chain disruptions, and labor shortages continued to drive up house prices. During this time, quantitative easing policies by the Fed allowed many homeowners to secure low interest rates for home purchases.

In 2022, mortgage rates began to climb due to the Fed's rate hikes. This had an immediate impact on borrowing costs for purchasing existing homes, making it more expensive. About 80% of US homeowners have a mortgage rate below 4%. However, by August 2023, the mortgage rate had soared to 7.23%, its highest level in 22 years. As a result, owners of existing homes were reluctant to sell their properties as buying a new home meant taking on higher borrowing costs. This created a serious shortage of existing homes on the market.

In 2023, sales of existing homes declined significantly compared to 2022. According to Lawrence Yun, chief economist of NAR, high mortgage rates and historically low inventory of existing homes were the main factors inhibiting sales.

However, this shortage of existing homes presented a good opportunity for housing builders like Toll Brothers.

In the second half of 2022, housing builders had to lower prices and offer incentives to boost sales, as concerns over slowing demand due to rising rates grew. After this tough period, housing builders are now raising prices for new homes and increasing production at full speed. In 2023, homebuilders set record after record and reported the best first-half performance in nearly a decade. The industry outperformed the entire market, rising more than 50% so far this year, while the S&P 500 index only rose 18%.

What sets Toll Brothers apart from other housing builders?

Toll Brothers stands out from other housing builders because it caters to high-net-worth clients who are less sensitive to interest rate risks.

Roughly 20% of buyers pay in cash, making them less susceptible to rates, while its remaining customers have an average loan-to-value of 70% and are required to use jumbo loans, which many banks still offer at rates below 4.50%.

Moreover, Toll Brothers currently has nearly 12,000 backlogged orders for homes to be built (equivalent to one year's worth of work), and owns or controls another 70,000 land parcels with locked-in land prices, which combined would provide some insulation against inflation risk.

According to Simply Wall St analyst, Toll Brothers has a return on equity (ROE) of 22%, which is higher than the industry average of 18%. In terms of net profit growth, the company's profit growth in the past five years has been lower than both the industry and market averages. However, as of August 2023, the company's profit growth in the last year far exceeded both the industry and market averages.

Future opportunities and risks

Barclays analysts believe that in the short term, despite the uptrend in their prices in 2023, housing builders' valuations are still not expensive by historical standards. The current valuation of 1.4 times is consistent with historical averages, and there remains further potential for growth. Better mortgage rates, inventory turnover, and significant stock buyback capabilities support the expected rise in return on equity (ROE) for housing builders, which will drive their market valuations upwards.

According to Zucks report, Toll Brothers has limited competition in the luxury residential market and enjoys a unique advantage with greater pricing power than other home builders in an environment of rising interest rates. Building homes according to orders will continue to drive the company's sustained growth.

Looking ahead in the long term, Investor's Business Daily analysts state that the United States faces a persistent housing shortage as new home construction struggles to keep pace with population growth. Since the COVID-19 pandemic, material costs, supply chain issues, and labor shortages have exacerbated this issue. According to the National Association of Realtors, there is currently a shortage of about 5.5 million homes, which would take more than a decade to fill even with accelerated new home construction.

However, along with opportunities come risks. According to Zucks report, as the housing market is a cyclical industry, it is influenced by consumer confidence levels, current economic conditions, and interest rates. Federal government actions related to economic stimulus, taxes, and lending restrictions may affect consumer confidence and spending levels, thereby having adverse effects on the economy and real estate market. Therefore, investors should remain cautious during periods of frequent policy changes.