The Paradox of the Homebuilders

Back when the housing market started to crash in 2007, the focus began to shift to analyze which homebuilders could get lean fast enough – walk away from land contracts, get partially built homes finished and sold, then radically downsize by laying off most of their staff, selling raw land, lowering prices to sell existing inventory, downsizing existing home models, etc.

This is all still true in 2010, and will probably still be true in 2011. The few home builders who could differentiate themselves by unique business models have been rewarded in the bond market. The so-called Cadillac of homebuilders, Toll Brothers, had for a long time charged customers a rather large “earnest money” fee which would be forfeited if the order were cancelled. This proved to be golden in the crash, since not only did Toll Brothers actually collect some hefty cancellation fees, but the fees discouraged enough would-be-cancellers that they went through with plans more than a typical cohort of wavering buyers for other homebuilding company homes.

My belief is that the hunkering down phase is not enough to keep spreads tight for homebuilders any more. It has always been about the shadow inventory and how with the slightest provocation, more and more inventory shows up, often in the form of foreclosed homes for sale. The homebuilders overbuilt in precisely the areas of the most shadow inventory – exurbs in the Sunbelt, in which people had not sufficiently established the neighborhoods long enough and with enough “roots” to make the far-flung tract viable. Florida’s Fort Myers Beach is the poster child for such a community.. Although nominally old enough, in reality the huge majority of the homes were built since 2000, and with little supporting infrastructure (schools, parks, retail) so that when it crashed, there was a tangible drop in the morale of the town, and existing homeowners face the “prisoner’s dilemma” – why keep up your house when so many on your street are boarded up, or gangs are moving in, or the weeds are growing high, etc.? As a consequence the prospect for recovery is dim – the progression of home prices there goes something like this: 2000: $200,000; 2003: $400,000; 2006; $800,000; 2009: $180,000!

Given the moribund state of markets which previously had been so critical to homebuilders (Fort Myers Beach and a few other similarly-afflicted major Florida developments almost sank Hovnanian), one would expect their spreads to still be wide, and they are. But not wide enough, in my opinion. Survival is one thing: moving back to a modicum of prosperity is quite another. To me, these weak credits are only surviving until the next real estate setback, which may be beginning as we speak.

The quoted level of housing starts, slightly over a half a million annual rate, is misleading because multifamily has come up strong (not surprisingly). However, most homebuilders don’t make nearly as much money, is they indeed make any significant amount of money, off multifamily (apartment) building. For one thing “change orders” which in good times represent a big chuck of homebuilder profit, would logically be virtually nonexistent when dealing with rental property. For another thing, the land homebuilders have bought is probably not ideal for the more urban or at least closer-in suburban renter, who of course doesn’t care about cheap real estate taxes at the perimeter, which has generally been the driving force for the march of the exurbs to ever-farther rings around the metro area.

So why should the market continue to reward homebuilders for building a paltry few homes and just spending all their time trying to move old inventory? It may make sense from a short-term perspective, but longer-term many homebuilders will have to exit the business or find a buyer as Standard-Pacific did. There still appears to be far too many single-family-homebuilders out there for the minuscule amount of homebuilding actually required by the market.

Consider this: in the sharp recession of 1980-1982 (technically two recessions), homebuilders and forest-products companies were moaning that the end of the world had come with housing starts falling to slightly under a million! We’re now half that, maybe worse (adjusting for the higher percentage of multifamily lately), and what’s more, the sharp recovery of 1983-1986 seems less likely to happen with unemployment being so stubbornly high. High unemployment, as all analysts agree, is the single biggest long-term driving force for weakness in the housing market.