From today's Contrary Investor:
Last week we had lunch with a friend and client who happens to be heavily involved in the California real estate markets. And we consider him a very meaningful leading indicator in that he is specifically involved in the procurement of land for residential real estate building. He’s personally close to all of the major homebuilders in the state and has a very good sense of not only ongoing activity in land procurement among all of the major players, but is on top of land pricing like there is no tomorrow. There is absolutely no question in our minds that land is the front end of the broader real estate cycle. And what he is currently seeing is two fold. First, land acquisition activity is drying up fast. It’s his estimation that at the current time, the large CA homebuilders in aggregate have enough owned land to build for about five years at the current pace before they would essentially build on their last lot currently owned, so to speak. Of course they will never drain the land inventory well completely dry. But maybe more importantly, he’s witnessing prices willing to be paid for land by the larger builders drop rather precipitously. One has to realize that in many communities here in wonderful California, a builder may have $100,000 or more sunk cost into each lot before a backhoe ever breaks earth to dig a T-footing foundation. Between entitlement costs, city permits, city requirements (parks, open space, etc.), utility hook up, and improvements such as electrical and sidewalks, just getting an individual lot to the point of being able to be built upon is an extremely expensive affair. With home prices no longer rising by the minute here in California, land prices are no longer penciling out as they did even a few short months ago.
But as we look directly ahead, there are a few points from our conversation we’d like to relay to you that we believe are important. First, we know you saw the recent housing starts numbers from a week or so back. We currently rest at highs not seen for well over 30 years.
The important comment from our friend is that the large homebuilders simply cannot stop building on a dime. Financing is in place, land entitled, permits have been pulled and city/county fees have been paid. Remember the easy $100 grand per lot before any building comment from above. When the builders already have sunk costs of this magnitude, the starts continue and the builders ultimately end up in a game of discounting if new home unit demand softens.
But there is yet another angle that perhaps a few folks may not be too familiar. You’ve undoubtedly seen the recent “sales” being conducted by builders like Centex, Meritage, Horton, etc. When incentives are being offered to new potential buyers, the homebuilders have to likewise turn around and offer these same incentives to folks who are already in escrow, but have not yet actually closed. So what a builder thought might have been a profit of “X” when the buyer of a few months back entered escrow, the builder is now looking at a profit number of “X” minus “Y”. “Y”, of course, being the cost of these incentives. So profitability is being squeezed both on new sales and on those already booked that are in escrow. The more this process of discounting continues ahead, the more the double-barreled hit to pro forma profitability occurs. We would expect that since the discounting is very recent, homebuilder profitability over the next few quarters may be very volatile. More to the downside than not.
Despite the fact that most homebuilders are not acting as speculatively as they have in past cycles, the broader real estate and especially new building cycle is characterized by a set of dynamics that does not allow the homebuilders to stop building on a dime if demand were to suddenly and meaningfully stall. In other words, they cannot effect just in time business practices. Most importantly, the builders risk losing entitlement on land if it’s not developed in a certain period of time. And given that the entitlement process itself is so lengthy and costly to begin with, it virtually ensures an excess supply of new homes at the top of every cycle. It’s the simple dynamics of the industry, not any great revelation on our part. And as you know, these dynamics are still yet to play out right before our eyes in 2006.
One last chart. As you'll see, it's new housing permits also at a three decade-plus high point at present. One characteristic common to both this and the new housing starts chart above is that never in the last half century at least have new housing permits and new starts hit current levels without ultimately dropping over 60% at the subsequent bottom to complete the entire housing cycle. Will it be different this time? History says not a chance, although today's homebuilders and real estate agents might have a differing opinion...for now.
You probably saw earlier this week in the January new home sales report that inventories of unsold homes rose to a record high (528,000). The number is up juts shy of 21% from one year ago. Moreover, the month’s available supply rose to 5.2 months, a number not seen for a bit over nine years. And although completed, but unsold home inventories rose 11+% over the last year, a big part of the rise of total unsold homes in January were homes not yet started or currently under construction (yes, these are counted). Unless sales really pick up, and fast, these inventory numbers will continue to head north. One last interesting point. As you remember, incredibly warm weather in January was apparently responsible for retail sales being well above analyst expectations. Unfortunately for the homebuilders, warm weather in January was a complete non-event. Maybe folks were just too busy enjoying the weather to remember to go out and buy a new home, do you think?
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