Why the Homebuilders Will Crash and Burn
[Analysis by RodgerRafter]
I listened to the MDC conference call Thursday morning and picked up some interesting information about the housing sector. As I've thought about it over the weekend, I've come to some conclusions about what lies ahead for homebuilders and real estate "investors."
MDC's execs tried to paint a rosy picture of the industry by focusing on profits and declining to give any guidance for future quarters. The analysts on the call seemed to all be thinking that the bubble was bursting, but were polite in the way they phrased questions.
One analyst asked about the effects of increased cancellations. The MDC response was that sometimes cancellations help the company because when housing prices rise the company is able to resell a house at a greater profit. On the other hand, when prices fall they end up having to boost incentives to unload a house. Therefore, in general, cancellations were really a wash.
[My Comments: Some may have been a wash when the bubble was inflating, but now and going forward, cancellations are a bad thing.]
They spoke very vaguely about the troubles in the Las Vegas market, saying that they thought the problem would just take a few quarters to work itself out. Most of their cancellations were in Vegas where there were something like 12,000 homes up for resale. Meanwhile, the company was speeding up development in Vegas and bringing new developments online.
[My Comments: They hope the slowdown is a temporary thing, but if all the builders are rushing to bring new developments online, it will get much worse from here. Speculators in real estate are in a race against time because property taxes and mortgage costs steadily eat away at profits. In a way, the big builders are speculators as well.]
They admitted that sales have slowed down from the hot pace of Nov 2003 to Oct 2004, stating that they are now at the more normal pace that existed before the frenzy.
[My Comments: They are making an unjustified assumption that things won't get worse from here.]
The company greatly increased the amount of lots they own during the year, from 16,351 to 20,760, and the lots they control through options, from 12,251 to 21,164. It costs them an average of $3,000 (per year, I assume) to keep those lots under option. They said that their goal was to own and control enough land to meet their demands for 2 to 2 1/2 years.
[My Comments: Of course they own and control enough land to meet their needs for more than 3 years based on 2004 closings, and more like 5 years based on the recent rate of sales. If things slow down further, they could get in trouble for owning far too much land.]
They mentioned that the average selling price doesn't reflect the the underlying profit margin in a region. At one point in time, Arizona was their most profitable region even though their selling prices were the lowest in the country in AZ. Now AZ is a very hot market, but the cost of land has gone up as well. Demand in California, meanwhile, has dropped off. While they were selling 10 homes per month in an average development at the peak, now its down to 6, which is still well above their national average. They are opening up a bunch of new developments in California.
[My Comments: In California, they've been paying a lot for land, probably too much, and now they have no choice but to open up the developments and try to sell the lots. A lot of builders are probably in this same competitive trap. They lose money by sitting on the land. Putting new developments on the market could hurt sales at their existing developments, but if they don't, other builders will still cut into their sales anyway. From a selfish standpoint it makes sense for each individual builder to rush those developments onto the market ASAP, which will only contribute to the oversupply problem. Like the Airline industry, the homebuilding industry is too competitive to remain profitable for long.]
More personal observations and comments:
Living in the San Francisco Bay Area, I've seen 3 main types of housing developments go up in recent years:
1. The majority have been former farmland and cattle grazing land way out on the periphery that has been converted into suburbs full of McMansions. These are for the poor suckers who are willing to face 2 hour one-way commutes in order to live in a big home that the builder's in-house lender tells them they can afford.
2. A smaller number of developments have been neglected little patches of land closer in that somehow escaped development over the past 20 years as sub-divisions shot up all around them.
3. The last big source of developments has come from former industrial sites where old factories have shut down and the buildings have been demolished, or on top of landfills where people figure that the toxic goo below the surface is now relatively stable. There are huge toxic mess issues related to development on these sites, but many homebuyers don't seem to care. These are sometimes single unit homes, but often are highrise condos. (I suppose the higher up you are, the less the smell will bother you.)
Here's an amazing article about one big proposed development along the Bayshore:
mindfully.org
A friend of mine actually inspected the site in some official manner and said it was another "Love Canal" waiting to happen.
google.com
I've been studying 20 major homebuilding companies and have found that most of them seem to be developing in the same hot areas. This behavior is much like that of mutual fund managers in the late 90s who would all rush into the same hot stocks. Buying up more and more shares of these hot stocks pushed up stock prices and boosted their NAVs and the fees they collected from customers temporarily. This then led to huge crashes when the market eventually broke down and led to huge losses for mutual fund customers.
When these developers rush into an area (as they are doing in Arizona now) it drives up the cost of land and creates a sense of excitement and urgency among homebuyers. Most of the builders have their own in-house lenders who are willing to make questionable loans on overpriced homes to boost sales. If the cycle continues for awhile, the builders increase their gains on early homes by pushing up land values with the purchase of additional land. However, once property values peak and the market is saturated, the builders get stuck with too much land and too much debt (which is happening now in CA, NV and possibly CO). It's like the way mutual funds got stuck with too much Lucent, Global Crossings , WorldCom, etc., except that it is even harder to be the first one out of the market when real estate starts to decline.
One regional company that does not build in the hot markets is Dominion Homes (DHOM). They reported their 4th quarter sales after the close on Friday and sales were down 33% year over year. I believe this would be the case for most builders if not for the bubble mania in all the hot markets because DHOM's markets are subject to more normal market forces. The hot markets will end up crashing much harder because conditions are so extreme now and prices are far out of touch with long term trends. The CA and NV markets are already heading downhill, and the rate of decline should steepen as builders force more homes on the market while the bubble mentality fades and higher interest rates cut into consumers' buying power. AZ is still on the way up, and Florida, Texas and the DC area may still be rising as well (Virginia is hot because it is supposedly harder to get approval for construction there). Eventually those markets will crash like CA, though. Perhaps new markets will take off (Chicago?), but it'll be harder to get them going with rising interest rates. William Lyon Homes' sales figures give an indication of the way things were going at the end of 2004:
.........................................................4th Quarter..........Annual
Number of net new home orders:.....2004...2003.......2004...2003
..............................California.............330....539......2,112..2,357
..............................Arizona................100.....78........677....389
..............................Nevada..................63....144........582....697
................................Total..................493....761......3,371..3,443 |
