Despite strides to improve their odds of staying above a down cycle, big players learn they're not immune to its pain.

Source: BIG BUILDER Magazine
Publication date: 2006-09-01

By Lisa Marquis Jackson

At least eight weeks before the end of 2005, David Hill worried publicly that the new-home market had peaked. He'll be the first to confess now, however, that not even he could see what was going to happen in the first half of this year.

Like many of his big builder colleagues, the CEO of Kimball Hill Homes may have been deceived by the mixed signals of a new-home market gone slightly haywire after a mind-boggling run of record-setting years that kept defying economic precedent. Even accounting for the hyperbolic arc of growth that was unsustainable and for a cathartic purge of “flipper” buyers, the market forces that cause natural demand for new homes to increase appeared to be healthfully at work.

Ironically, the market's quirky behavior of the past few years set up most big builder executives to expect another pleasant surprise. Even as investors bolted and inventory fever-charted to new heights, deep down they believed demand would continue to prevail as it had the year before, and the year before that. After all, a litany of positive forces still fueled the home-buyer pipeline: job formation, income growth, immigration, existing home obsolescence, aging baby boomers, the emerging Generation Y adults, and more. So why not go ahead and predict another record year—and to hell with the greedy flippers?

But then June's numbers came to light. It was clear the mojo was all but gone.

In what should have been the most prolific sales month of the year, new-home sales dropped 11 percent versus June 2005 sales. What's more in June, the number of for-sale homes increased 20 percent over the previous year. Cancellations, a normal business phenomenon, suddenly leapt to menacing rates in many of the highest-voltage markets of the past three years.

“If you look at the inventory, we started to see it back in March,” Hill admits. “But why so many smart people did not factor it in, and why people didn't cut back on starts to be more in line with sales until early May, is because you have such a seasonality of the sale. You could always say, ‘Of course, we're ahead. Of course, we're building up inventory.' But, we're going to sell them all and deliver them all in April, May, and June like we always do.”

In fact, April sales inched upward, a decoy that got many thinking, “here we go again.” However, by May, every company with operations in what had been the country's best new-home markets found itself caught in gravity's downward grasp. “I think the period of realization for most CEOs was either the end of April, [or] certainly by the end of May. Everybody was sure that there was something really surprising happening,” Hill says.

In the last major residential real estate downturn of the early '90s, the NAHB estimated nearly 15 percent of the country's 385,000 home building companies went out of business after the Financial Institutions Reform, Recovery, and Enforcement Act became law in 1989. The new standards limited the amount of money an S&L could lend to any one builder or developer and put a serious pinch in the industry's primary financing methods. These companies are among the most memorable bankruptcy filings from that era. NVR, of course, made an impressive return from the clutches of oblivion:

Surprised they were, but not in a good way. Now large-scale builders find themselves combing their markets for a sign, a measure, an indicator: anything that might offer them an iota of visibility, a business term that means, “what's going to happen next.” They want, no, they need answers soon to two questions about this downturn. How deep? And how long?

Meanwhile, there are thousands of homes to sell, which are harder to sell today. And, there are big operations set up to design, market, and complete them on schedule.

Land supplies stretch from months to decades, depending on how fast companies can build, sell, and close houses. That's all scary stuff considering no one's privy to how deep or long the current residential real estate downturn will be.

Despite the great cloud of economic unknowing, what big builders do now and over the next several months, individually and as a group, may materially impact not only the answers to those two questions but also the answer a more basic question: Will my company be okay?

How the 200 companies that build two out of every five new homes in the United States behave and perform over the next 12 months may actually play a role in the depth and duration of the market pull-back. Why? Because they represent 40 percent of new homes, a critical link in the chain of residential real estate investment, which accounts for 6 percent of the gross domestic product (GDP).

Projection Conjectures- Though no one knows for sure about the length or depth of the current real estate downturn, economists predict there will be a decline in the new, single-family home sales environment this year. We polled top economists at NAHB's, Frank Nothaft, Freddie Mac, and the National Association of Realtors, who all agree on sales for 2006. The long-range sales projection shows a slight decline and then stabilizing through 2008.

Statistically, 6 percent of the GDP is significant enough, but psychologically, home prices and values have an even greater importance when it comes to consumer spending, which accounts for two-thirds of the U.S. economy.

For better or worse, lacking true visibility into the ultimate depth and duration of the current down cycle, home builders tend to be optimistic.

The widely held belief is that today's challenge is simply to reduce the supply of standing inventory of unsold homes, doing whatever it takes.

“This is really a supply-driven correction,” Centex Corp. CEO Tim Eller told analysts in a July quarterly earnings conference call, echoing the sentiment that many builders and even some economists are expressing. “As the supply moderates, the cancellations will slow, and then everything else will come in line.”

Are they overly optimistic?

One may be inclined to assume that after burning through the excess inventory, the housing market will return to business as usual, but that conviction may prove to be too simplistic. Price and interest-rate trends have merged into a major affordability inhibitor in many markets. More apparent, a variety of other factors add up to trouble for the demand side of the new-home equation, reminding big builders that they're not merely in the business of manufacturing houses, but of putting gold into the American dream.

“The long-standing bubble is in the process of popping,” predicts Christopher Thornberg, a former economics professor at UCLA, who is now a principle at the California-based Beacon Consulting. “We have not seen, by any stretch of the imagination, the end of this. We are in the process of seeing this market go.”

Because the depth and length of the downturn remain the key questions to which no one has the answers, one fact does appear to be clear. With professional management teams in place, stronger balance sheets, and less risk in land holdings, the nation's largest builders believe they're better positioned to thrive than their smaller competitors—no matter how much the market eventually shrinks. The ability to leverage size and scale will give big builders big opportunities to consolidate market share during a downturn and to pounce on weak or struggling competitors.

The next six months will stand as a testament to the fact that today's big builders truly are well-managed companies, says Hill. “It's choppy seas right now, but these are very sound boats. They will get through the choppy seas and still make forward progress.”

So what should you know about the key factors driving the industry today, and more important, what should you be doing to respond to them?

Blindsided by the swift and mighty depth of the downturn, both builders and industry analysts shared overly optimistic views of earnings per share (EPS) potential for 2006 and beyond. Among the Top 10 public home builders by market cap, eight offer guidance. Since late last year, 2006 guidance for those eight, on average, has been lowered by nearly 25 percent. Within a 90-day period earlier this year, analysts recalibrated their own dramatic forecasted drops: lowering expectations nearly 20 percent on average for 2006 and over 35 percent for 2007.

SOURCES: COMPANY REPORTS AND CURRENT ANALYST AVERAGE FORECASTS AS REPORTED BY YAHOO FINANCE FOR EACH COMPANY ON AUGUST 11. AVERAGES ARE DERIVED FROM THE COMPILATION OF ANALYSTS FOLLOWING EACH COMPANY.NOTE: TOP 10 BUILDERS BY MARKET CAP INCLUDE: PHM, LEN, DHI, CTX, KBH, TOL, NVR, MDC, RYL, HOV. AVERAGES WERE CALCULATED USING ONLY THE EIGHT BUILDERS OFFERING GUIDANCE

From a national standpoint, when interest rates dropped in 2001, demand increased. But the true effect of the rate drop was local. Where there was a tight supply of housing or lots, the shortages immediately sparked price increases, and, in turn, spurred investor interest, many of whom sought respite from the stock market.

“People were just buying, and they didn't care where, because they thought eventually they'd just flip it to some bigger dummy,” notes Alex Barron, vice president and senior analyst at JMP Securities. “Now all of that stuff is catching back up to them, and we're caught with a bunch of excess inventory.”

In fact, today the inventory of unsold new homes is roughly 560,000, representing about six months of supply. That's up from 450,000 this time last year and 380,000 in 2004. It's no surprise that the NAHB confidence index plummeted to a 15-year low in July. Housing starts have fallen about 14 percent since peaking earlier this year. New-home sales are down about 9.7 percent from the July 2005 peak for sales. The reality is, builders must find a way to unload existing inventory as they try to stabilize starts and sales in an uncertain future.

Builders, such as Pulte Homes and KB Home, announced in the middle of the spring season they planned to cut volume by nearly 20 percent going into the year. “They said, ‘Look, our orders are going to be down, and we are going to go with quality over quantity. We aren't going to compromise the value of homes in communities that we have already sold. There is the value of the backlog, the value of the dirt on our balance sheet, and we are going to manage through that,'” notes one home building industry analyst.

If the answer were as simple as trimming 15 percent to 20 percent of starts previously selling to investors, then perhaps a normalized level lies just ahead.

But an equally viable scenario says that as buyers used more exotic mortgages and watched affordability plummet, they acted under duress to get into a home while they could. And with home-ownership levels at an all-time high of nearly 70 percent, the industry may have prematurely lured in some of its future home buyer pool, rather than having expanded the total market of home buyers.

Joel Prakken, chairman of Macroeconomic Advisers, a private consulting firm in St. Louis specializing in forecasting housing and other macroeconomic issues, predicts that the number of housing starts in 2007 will still be “very strong and very healthy” at 1.6 million. That still represents a 25 percent drop from the 2.1 million starts from last year. Who's ready to give up one in four of their closings? No big builder worth his mettle.

So how do big builders ascertain the real level of demand, and where do they fit in its force field?

Scrutinize the difference between a sale and a contract. Not to look a gift horse in the mouth, but it's prudent to analyze why any buyer in today's market is handing over a reasonable earnest money check.

“In the '70s and '80s, I was operating in the Rust Belt, and we did an analysis on the quality of every sales contract,” Hill recalls. “We asked ourselves, ‘Was it contingent on mortgage? Was it contingent on mortgage and a house to sell? Was it contingent on this or that?' And now we are going back to some of the analysis right now to make sure that the sales are for real.”

Monitor the velocity of quality sales. “If you are priced at one level and you have one sale where you needed four, that's obviously too weak of a velocity,” observes Hill. “You are probably overpriced in today's world. You price to real demand.”

Adjust pricing, but avoid the discounting spiral. Today, this is where builders and investors are still finding themselves stuck, both mentally and financially. The “soft landing” mindset believed prices would have to stop escalating, but now economists and analysts are predicting prices must drop somewhere between 20 percent and 30 percent in order to clear the market of excess inventory. “In the markets, where we saw the huge [run up], we are only talking about giving back one year of appreciation,” Barron notes.

Still discounting also can be a slippery slope as investors flood the market with inventory, hoping to get out while there is still something left of their investment. “The problem I am envisioning comes if builders don't allow this inventory to clear,” Barron says. “How is any builder going to compete against the desperate flipper who just can't take the pain any longer? Just because Lennar drops its price $50,000 or $100,000 one weekend, [can it compete] against the guy who says, ‘I had better lower mine $200,000 before I lose everything?' Where does it stop?”

Affordability plummeted in the last three years as appreciation skyrocketed in the country's high-flying markets.

SOURCE: HANLEY WOOD MARKET INTELLIGENCE * THE AFFORDABILITY RATIO IS THE PERCENTAGE OF HOUSEHOLDS THAT CAN AFFORD THE MEDIAN PRICED DETACHED HOME, ASSUMING A 20 PERCENT DOWN PAYMENT AND A 30-YEAR FIXED MORTGAGE. THE CALCULATION IS BASED OFF OF MEDIAN HOUSEHOLD INCOME FOR THAT MARKET.

Unlike many of the managers, contractors, and executives engaged in the home building industry's fortunes over the last five years, the average worker didn't see his income escalate nearly 20 percent to 30 percent each year. Problem is, home prices in many markets did.

It's great for builders, who certainly rode the tide to higher margins. It's great for the investors who got in and got out before escalation came to a screeching halt. But it is bad for the average wage earners who never bought homes and will never be able to purchase homes unless prices revert to the levels seen before 2004.

“Clearly, what's affecting the demand in a number of our markets is simply, we've depleted the pool of affordable buyers by escalating real estate prices,” remarks Don Tomnitz, CEO of D.R. Horton during his company's third quarter earnings call on July 20.

Tomnitz notes that his company tracks affordability very closely and responds by adjusting product. The affordability ratio refers to the percentage of households that can afford monthly payments on a median priced detached home in a market based on median-income levels, assuming a 20 percent down payment on a 30-year fixed-rate mortgage. As California's affordability ratio dipped into the low 20 percent levels, “we started doing more high-density homes, more condos, and podium projects,” Tomnitz says. “Then it dropped down [near] 18 percent. Now, I don't even think it's in the teens.”

According to Hanley Wood Market Intelligence (HWMI) data, affordability dips even lower in some markets. By creating a weighted average across the 16 large markets it covers, HWMI estimates the average the affordability ratio to be in the range of 26 percent. By comparison, in San Diego, which has proven to be one of the country's toughest big builder environs over the last six months, the affordability ratio after the first quarter of 2006 was a stunning 4.7 percent, based on the applied criteria and a median home price of $848,330—plummeting from a 17.8 percent ratio five years ago. Outside of California, other markets with widening affordability gaps include Las Vegas, Phoenix, and Washington, D.C.

Although much has been made of the fact that interest rates rose over 400 basis points in the last two years, even after 17 consecutive hikes, rates are still hovering at historically low levels. So although the increases may prove to be a minor aggravation to first-time buyers, after the Fed announced a pause in its rate hike campaign on August 8, a projected stabilization should keep the overall impact to a minimum.

“Interest rates don't have a hill of beans to do with our business in a large way,” Tomnitz says. “If you look at a 30-year mortgage rate, it's still one of the lowest it's been in the history of the United States. So it's not the fact that a less-than-7-percent, 30-year mortgage rate is not available out there.” Still, when you add dollars to each month's payment in an interest rate increase, and factor in fuel prices and other inflationary trends, it all adds up pretty quickly for people counting every penny.

So how are home builders closing the gap between what workers can afford and what they are charging for homes?

Cutting margins. After enjoying enormous margin expansion over the last several years, some builders have resigned themselves to net less in order to get home prices down and move through inventory. “Builders have cut margins,” says Robert Schottenstein, president and CEO of M/I Homes. “That's big, and the cuts have been significant.”

Tony Avila, managing director at JMP Securities, acknowledges that while nearly everyone will see their margins erode to a degree, it's imperative to set a stop-gap. “It's the first thing that happens, but those who can work on maintaining, or at least trying to hold the line, will be much better positioned.”

Value engineering. Clearly, to help balance the affordability factor, price has to come down, but it may have more to do with product offerings and a movement toward an increased use of higher density. “We have to work our way through existing inventory, then redesign the product, put in some more efficiencies, [and] pull out some of the costs,” Tomnitz says. “Then go back out there with a different product and price offering.”

As in other industries, high-volume home builders face the new kind of economy, a global one, creating complexity that economists have not seen the likes of before. Unlike the early 1990s, when housing starts fell to 800,000 during the recession, the economy is growing, and jobs are rising. Interest rates are low and inflation is relatively in check.

Still, a number of dynamic variables in today's world could immediately change the playing field. “It's not a pretty picture,” Barron notes of the market contraction. “What's scary is that we are in the midst of a pretty good economy and this is happening. You can think of a lot of really bad scenarios that make what we are seeing now look like a piece of cake.”

Enter the consumer confidence quotient: “When people are feeling good about where things are, that translates into feeling good about the economy. That translates into being more likely to buy. If they are feeling pessimistic, they are less likely to buy,” says David Krane, vice president of Rochester, N.Y.–based Harris Interactive. The company's poll regularly asks the public if they are feeling confident about the future, and the latest results are telling. According to its July findings, six out of 10 people are not feeling confident. With the Middle East crisis escalating by the hour, the Iraq War costing $7 billion a month, and gas prices surging past $3 a gallon, it's no wonder consumer confidence is rattled.

But as quarterly results were reported late in July, one thing became abundantly clear—the economic uncertainty is not just a housing problem. As companies across all industries report their earnings, big names like Target and Caterpillar are missing sales. GM posted a $3.18 billion net loss for the second quarter amid costs related to its restructuring plan. “It's not just housing specific,” notes one housing analyst. “The economy itself is slow.”

“The slowing of the housing market may restrain other forms of household spending as well,” Federal Reserve chairman Ben Bernanke told Congress in recent testimony. “With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past.”

In fact, as BIG BUILDER went to press, signs were emerging that the effects of the housing market contraction were beginning to fray the edges of the country's overall economic fabric. The GDP numbers issued at the end of July show the economy growing at a rate of 2.5 percent in the second quarter compared to 5.6 percent in the first quarter as consumers and businesses cut their spending.

And that's exactly how the housing industry's executives are seeing it play out. “Large numbers of potential buyers are moving to the sidelines for what they see is a riskier market,” acknowledges Richard Dugas, president and CEO of Pulte.

To thrive in the morphing environment, builders are going to have to find a way to address the psychological shift. “I don't know if discounts are the only thing that will drive a change in trends,” remarks Rick Murray, an equity research analyst with Raymond James & Associates.

So what can big builders do now to position themselves for the upside?

Focus on systems, training, and controls that will be able to gradually differentiate themselves in an increasingly competitive environment, according to one industry analyst.

“I think that's what it all comes down to—creating a sustainable competitive advantage,” says Jamie Pirrello, former COO of Annapolis, Md.–based Mandarin Homes, calling to mind Harvard University business guru Michael Porter. “In tight markets—where the size of the market is limited and you have to fight—if you're better than the competition, you're going to get your fair share of the market. And really, that's what everyone is trying to do,” Pirrello says.

No matter how you slice it, residential construction accounts for a solid percentage of the country's gross domestic product.

Directly ... According to the U.S. Commerce Department's Bureau of Economic Analysis, residential construction makes up 6.11 percent of the overall U.S. gross domestic product.

And indirectly ... According to the National Association of Realtors, “economic activity in housing” accounts for one-fourth to one-fifth of the gross domestic product.

<i>What's worst-case guidance for if not a baseline of expectations?</i>

When times are good on Wall Street, investors clamor, for more. When times head south, their call changes to “More data!” Information is money, and getting enough of it from public home building companies is now a source of investor frustration.

Public builder chief executives each took their turn to deliver grim quarterly news to the investor community late this summer. And after years of well-deserved chest-beating, humility and candor were in order as market conditions show their cycle-resistant strategies to be full of holes.

Still, despite concessions to fuller disclosure, many analysts believe that the market will continue to get worse, that public builder CEOs recognize it, and, for the most part, that they're not yet admitting it to the investment community.

As they rode the new-home wave, public builder managements touted the ways they'd become different from their private-company peers and from home builders of the past: They'd brought in professional management teams, strengthened balance sheets, reduced the cost of their capital, and lessened land exposure through options on lots.

Now, they have had to show that, despite their efforts to stand apart, they aren't performing as promised. So, how should the publics best manage the confidence of all their constituents as skepticism and sensational media headlines crop up around them?

Certainly, companies are caught between a rock and a hard place when it comes to transparency. Being completely open and forthright carries its own risks. There are employees to consider, and no company wants to rattle internal confidence. As Main Street and Wall Street collide, admitting a shaky climate affects customers, and certainly no one wants to jeopardize the confidence of potential buyers. And of course, there is the ever-fickle investor community, where the ramifications of grim news are that no one will buy a company's stock and/or that analysts will inflict a punishing downgrade. In other words, “there is just almost no upside to telling anybody the truth other than getting some respect for it,” notes one analyst.

Most public builders have chosen to tread lightly, guiding down multiple times. The downside to the tactic: “Every three months, every time they open their mouth, it's like ‘Oh, we have a lower guidance again. We are disappointing you again,'” one comments. “Do they not know what is going on, or do they just not want to tell us?”

In stark contrast, D.R Horton did a complete turnaround in its July 20 call, surprising the investment community by laying out the floor on their company's diluted earnings per share guidance for the year-ending September 30, 2006.

No matter what degree of transparency builders decide to employ, analysts agree that there is no way to please everyone. “I don't think there is a consensus view on what Wall Street wants,” says Ivy Zelman of Credit Suisse First Boston. “You can ask 10 different investors and you'll get 10 different answers.”<i>—Lisa Marquis Jackson</i>

There is a strong correlation between consumer confidence and mortgage rates, according to the data for both. For the most part, when rates are low, consumer confidence is generally strong. And when rates are higher, confidence dips.

SOURCE: UNIVERSITY OF MICHIGAN CONSUMER CONFIDENCE SURVEY. MORTGAGE RATES FROM FREDDIE MAC

On the Rise- The number of new for-sale homes* in June was 24.5 percent more than new homes on the market in June 2005. It is the largest number of new for-sale homes since Hanley Wood Market Intelligence started tracking new-homes data in August 1998.