Battered homebuilder stocks may be primed for a new rally as US mortgage rates look set to drop in 2023, Bank of America says

• Bank of America sees homebuilding stocks pushing higher as housing market conditions improve after a rough 2022.
• PulteGroup, Lennar, and Toll Brothers were each upgraded, and NVR is the bank's top 2023 pick in the sector.

Homebuilder stocks could be gearing up for a rally after a losing 2022 performance, with a turnaround in sight before fundamentals in a slower housing market start improving, Bank of America said Wednesday.

The investment bank said it's cautious about housing demand this year, but it sees a few reasons that point to a "more favorable setup" for the performance of homebuilder stocks. Among them, valuations have already priced in the drop in home prices and weak demand.

Shares of PulteGroup and Toll Brothers rose during Wednesday's session after BofA upgraded them to buy ratings from underperform. Lennar stock also rose following an upgrade to neutral from underperform.

NVR, which runs construction company Ryan Homes as well as mortgage banking operations, is BofA's top pick in the sector for 2023 and has a buy rating.

Homebuilder stocks dropped last year as mortgage rates surged to a two-decade high above 7% from 3% in the beginning of the year, and as demand slumped in the second half.

The investment bank said mortgage rates look set to continue drifting lower after coming down 80 basis points from peak levels logged in October.

"Our structured products team expects the 30-year mortgage rate to decline to roughly 5.25% in 2023 (current 6.44%), as spreads normalize with lower Treasury volatility," BofA equity analyst Rafe Jadrosich wrote.

Mortgage rates surged under the influence of a spike-up in the 10-year Treasury yield and widening spreads. Borrowing costs for home buyers accelerated last year as the Federal Reserve pushed up its benchmark interest rate seven times to tamp down hot inflation.

Also in homebuilding stocks' favor, BofA said it does not see a material risk to book value. "[Most] of the land on balance sheets was purchased prior to 2021 and we expect a home price correction (down 10%) rather than a crash (down 15-20%)," wrote Jadrosich.

Meanwhile, margin tailwinds for companies, estimated between 200 basis points to 300 basis points, should emerge in the second quarter, fed by lower costs for labor and raw materials, especially lumber.

"Macro is a concern, but housing demand and builder valuations are already at recessionary levels, and we expect the inflation and rate backdrop to be more important for stock performance in 2023," BofA said.

US homebuilder stocks were logging a median one-year total return of negative 26.7% as of Jan. 4, S&P Global Market Intelligence said in a separate analysis published Wednesday.