Real Estate

A builder breakdown

There’s a building hope of an imminent resurgence in home construction across the nation.

The Standard & Poor’s homebuilder index is up more than 50% from its early October low, casting a shadow on the roughly 20% increase in the S&P 500 in the same period; homebuilder confidence is at a four-year high; and housing optimists are arguing that single-family housing starts are beginning their multiyear journey back to nearly 2 million starts a year.

But counter to every argument, is another argument.

“We don’t disagree with that premise, but we do disagree with the timing,” says Michelle Meyer, a housing analyst at Bank of America Merrill Lynch. “With slow economic growth this year and a glut of foreclosures, I think it’s too early to get bulled up on single-family construction. Be patient.”

Be patient, indeed.

Homebuilder stock prices began their surge in October based on fading fears of a double-dip recession and some resuscitation of the housing market heading into 2012. The sharp rise, which leveled off since February, analysts say, is partially due to a market correction.

“The market was overwhelmed by concerns that were exaggerated,” according to Stephen Kim, homebuilder analyst at Barclays Capital. “The market incorrectly priced the stocks in October far below what they should have been.”

The S&P homebuilder index reached its lowest point in more than a year on Oct. 4.

Nishu Sood, a homebuilder analyst at Deutsche Bank Securities, agrees.

“I look at it as investors increasingly pricing the probability that housing has begun to recover,” he said. “Homebuilders are a sensitive proxy for that.”

Sood estimates the market has priced two-thirds of the probability that housing is in a recovery into homebuilder stocks, but “there is still a meaningful number of people who believe that housing recovery hasn’t begun and is not likely to in the near term.”

The precipitous decline in housing starts — from 1.8 million in 2006 to 554,000 in 2009 — that occurred through the recession appears over. There were 607,000 single-family housing starts in 2011, and the consensus among housing analysts calls for about 700,000 in 2012. But homebuilding in most areas of the country remains depressed relative to where it stood before the recession and to where it must be to meet the needs of the nation’s growing population.

Kim, who acknowledges that his prediction is off-consensus, says single-family housing starts will shoot to 1 million by 2013. He said the most important trend in recognizing the housing recovery is the stabilization of nondistressed home prices despite a high share of distressed activity.

Home prices fell 4.7% in 2011, according to CoreLogic. Excluding distressed sales, prices decreased only 0.9% annually.

“That’s a very different way of looking at the housing market than I think people are using, and I think that these times call for something different because housing demand is not something that is easy to predict, particularly now when you have a lot of pent-up housing demand,” Kim told HousingWire. “Trying to predict when that’s going to be unleashed is very difficult. You need different ways of looking at the market.”

The dramatic decline of household formation, particularly among young adults, as a result of foreclosures and a weak economy, is suppressing single-family construction. The lack of substantial mortgage lending, perpetual low demand and excess supply are at the core of the suppression. Initially this was caused by overbuilding, but is now a function of distressed properties.

Analysts at UBS Investment Research concur that accelerating household growth is paramount for owner-occupied demand over the long term. However, they say the benefit from the acceleration will accrue mostly to the rental market, as limited mortgage availability will remain a significant constraint.

“This trend began in 2011 and we expect it to continue in the coming year,” they said.

Homebuilding is the largest and most dynamic way in which the housing sector creates activity for the national economy. Yet, the housing sector is not as stimulating as it once was. Although analysts expect residential investment in 2012 to double the rate of gross domestic product, residential investment has contracted from contributing 6.3% to GDP in 2005 to about 2.2% in 2011, dampening the sector’s influence on the economy’s revival.

The strength of that influence depends greatly on homebuilders.

“Unless homebuilders are building, it’s very unlikely the overall housing sector will generate much economic activity,” says Paul Dales, a housing economist as Capital Economics.

Five of the nation’s largest homebuilders by volume — D.R. Horton, Lennar, PulteGroup, Toll Brothers and KB Home — are encountering spiritless consumer demand for their products and a shrinking supply of quality land. And there are also the millions of existing properties that will permeate the market as the nation’s backlog of foreclosures loosens. Some 6 million homes are at least 30 days delinquent or in foreclosure, according to Lender Processing Services.

Meyers expects the flow of foreclosed properties to peak in 2013 and then slow.

“That’s going to be a very attractive time for homebuilders to come back in and take market share,” she says.

The stock prices of those five homebuilders surged an average of 102% since Sept. 30 and are all at least one-third higher than a year ago. We’re also in the midst of the spring selling season, which is a key measure of the health of the homebuilding sector.


In a January conference call, D.R. Horton Chief Executive Donald Tomnitz said his personal goal is to close 50,000 units per year by 2017 — a figure the homebuilder hasn’t reached since 2006, when it set the industry record. The Fort Worth, Texas-based company is the nation’s largest homebuilder by volume, closing 16,695 homes in its fiscal year ended Sept. 30, a 20% drop from 20,875 homes closed in fiscal 2010.

Returning to 50,000 units a year is a robust growth trend, one that would require D.R. Horton to increase housing starts by 25% in each of the next five years when analysts at BofAML predict a 15% annual growth rate for the industry during that period.

“That tells you what I think the possibility is for us in this industry,” Tomnitz said.

Like most builders in the downturn, D.R. Horton incurred the pain of having too much land at too high prices, resulting in a $712 million loss in 2007 after years of robust earnings (the company reported a loss of $2.6 billion the following year). In 2010, it returned to profit, reporting income of $245 million and then earned $71.8 million in 2011.

D.R. Horton could benefit substantially from a deferred tax asset reversal as early as the fourth quarter, meaning it could apply the aforementioned losses from previous years to this year’s tax expense.

“I think that they will be the first builder who will get to reverse its DTA, so I could see a scenario where the stock could be even higher by the end of the year,” says Alex Barron, analyst at Housing Research Center in El Paso, Texas.

Ted Wilson, principal at Dallas-based homebuilder consultancy Residential Strategies, said it was wise of the company to strategically acquire distressed lots back in 2009 and 2010. The move, along with acquiring existing homebuilder companies, created advantages for D.R. Horton not found in start-up operations such as established land positions and inventories, and existing relationships with municipalities and landowners.

“They were one of the first ones to step up and acquire some of the really best assets in the market at good prices,” Wilson said.

The scramble to find quality locations on which to build is universal within the industry, and Miami-based Lennar has combated that by creating an alternate revenue stream. After repairing its balance sheet, shielding itself from a heavy joint venture exposure and slashing expenses, Lennar raised  $700 million in 2011 for its Rialto Investments unit, which focuses on distressed real estate asset investments.

“Because of those moves, we believe Lennar is on the verge of significant, profitable growth with solid cash generation,” said Stephen East, director at St. Charles, Mo.-based International Strategy and Investment Group.

“I think that Lennar should be applauded for trying to create an additional revenue stream that’s highly lucrative by moving into distressed real estate,” says Robert Wetenhall, analyst at the Royal Bank of Canada, which has upgraded its outlook on the homebuilding industry to neutral from bearish.

For the fiscal year ended Nov. 30, Lennar reported the highest income in 2011 out of the five largest homebuilders, earning $92.2 million, down from $95.3 million in 2010. Lennar’s revenue rose to $3.1 billion from $3.07 billion in fiscal 2010, and had new orders for 11,412 homes in fiscal 2011, up 4% from the year before.

Among other things, Lennar “improved its ability to generate net income even as the majority of its peers continued to rack up losses,” said analysts at Moody’s, which in February upgraded the company’s corporate debt rating.

Barron sees D.R. Horton’s and Lennar’s stock prices ascending throughout 2012 based on their balance sheet. Each company holds about $1 billion in cash, with the former doing so even after paying down $2.3 billion in debt over the past three years.

As for the other three: “I don’t expect their earning per share to be as impressive,” Barron says.


Meyer questions the upswing of the improvement in stocks, pointing out their insignificance compared to the stocks’ collapse from their 2006 peaks. She said it more likely has to do with a rationalization of the industry than a recovery in demand as builders aggressively bring inventories under control.

“A fair reading of the recent improvement is that it puts prices near the top of a depressed trading range,” Meyer said.

KB Home appears to have the highest hill to climb out of the five homebuilders, as it has been savaged by outsized debt.

Even though KB’s stock shot up 131% from its October lows, the Los Angeles-based homebuilder issued $250 million of debt earlier in the year to reduce $193 million and $465 million of debt maturing in 2014 and 2015, respectively. The firm jump-started order growth in the second half of 2011 and should experience at least two more quarters of large annual percentage gains, analysts at ISI say, providing the basis for improved operating margins. 

However, meaningful work is needed on gross margins, while even more is needed on the debt side, according to the analysts. It’s a significant impediment to KB Home’s efforts of reaching normal margins, which East says the homebuilder will hit in 2016.

In September, Fitch Ratings issued a negative outlook for KB Home, downgrading the homebuilder’s senior unsecured debt to B+ from BB- because of its underperformance relative to peers in certain operational categories, over-exposure to the credit challenged entry-level market and cash-flow pressures from a joint venture in Las Vegas.

“While KB Home currently has adequate liquidity to fund working capital and debt service, this cushion is likely to erode in the next 12 to 18 months,” Fitch said at the time.

KB Home’s cash and cash equivalents at the end of 2011 totaled $415 million, down 54% from $904 million 2010, mainly due to legal matters surrounding the joint venture and repayment of maturing debt.

“Until more progress is made on the income statement and balance sheet, we find it difficult identifying a stock specific catalyst that moves the equity usefully higher,” East says.

Barclays Capital agrees, saying KB Home’s capital constraints will inhibit growth relative to its peers, particularly if expected homebuyer demand improves this year. At Dec. 31, KB Home’s debt-to-capital ratio was 72.5%, roughly twice its peer group.

For the past few years, the actual and potential supply of single-family homes has greatly exceeded demand. The elevated number of vacant homes versus owner-occupied reflects the imbalance. According to the Federal Reserve, about 1.75 million homes are unoccupied and for sale, and while the figure declined slightly during the past few years, it is up dramatically from the first half of the 2000s, when readings of about 1.25 million vacant homes were the norm. In Florida, where one of the five largest homebuilders resides, the homeowner vacancy rate averaged 3.2% in the third quarter, when the national average was 2.4%.

And builders feel the excess. For 2011, PulteGroup reported a loss of $210 million because of its bloated land supply, which demolished returns and generated massive impairments. But Pulte significantly narrowed its loss from $1.1 billion for 2010. Of the five homebuilders, it has the second highest land position, owning 7.3 years worth of supply, trailing Toll Brothers, according to ISI. Most builders prefer owning two to four years worth. Management is selling excess land, but the sheer size and asset-impairment ramifications make it a feeble exercise.

However, the company can continue trimming supply for the next several years, particularly as the industry picks up. Net new orders for Pulte in 2011 held steady from 2010 at about 15,200.

Pulte’s stock price surged 41% over the past year and 148% since the end of September. Despite that massive move, the Bloomfield Hills, Mich.-based builder still trades at a significant discount to the other four on most valuation metrics, according to ISI analysts, who expect normalized earnings to return in 2015.


Horsham, Pa.-based Toll Brothers is indicative of the homebuilding industry’s difficulty in discovering superior land. Analysts predict the firm will return to normal profit margins in 2015. Part of the extended period before normal profits is due to the inability to find quality land deals for faster growth. About three-quarters of community growth is from new land deals, with one-quarter coming from mothballed communities.

In a February conference call, Chief Executive Douglas Yearly said his company is “absolutely looking for land, and it is very difficult to find ground in both Northern and Southern California. We’re very frustrated.”

Executive Chairman Bob Toll said asking prices in the Golden State area were “too high and unreasonably so from our point of view,” adding that it also contained less attractive parcels.

Toll Brothers is unique in that it’s the only public play on the luxury market, has a well-respected management and is based in the Northeast — 60% of its business occurs between Washington to Boston. For its fiscal year ended Oct. 31, Toll Brothers earned $39.8 million after losing $3.4 million in 2010. For the first quarter of fiscal 2012, the company lost $2.8 million on lower revenue. But in general, higher-end consumers have fared better than lower-end consumers during the economic recovery.

Big public builders are seeing sales orders grow more rapidly than housing starts, an indication of the market share grab by some of the big builders. Toll Brothers, which in its first quarter reported annual order growth of 45% in dollars and 19% in units, beating Barclays Capital’s estimate of 18%, is taking advantage of opportunities to grow by utilizing access to capital.

“Most of our competition, since we’re at the luxury end, is not the big public builder, but the small regional builder, and they’ve been destroyed because they were dependent on local and regional banks who stopped financing them,” Yearly said in a February interview with HousingWire. “We are absolutely taking advantage of market share gain”

Wilson, from Residential Strategies, said Toll Brothers has been “extremely aggressive” in the Dallas-Fort Worth market, especially toward neighborhoods previously earmarked for custom builders who failed, buying lots at discounts.

“The urban metro New York City market remains very strong,” Yearly said on the call. “We are also encouraged by the continued health of the Washington, D.C.-to-Boston corridor, along with Houston, Dallas, Raleigh and more recently southern California. We are even seeing some recovery on the east coast of Florida and in the suburbs of Detroit and Phoenix.”

However, major economic indicators reflect the infancy and fragility of the market’s apparent return to normal. NAHB’s survey of builder confidence is growing, but remains depressed and is outpacing the hard data. New home sales in January remained flat compared to December and a year earlier. And mortgage purchase applications declined from December through February, reversing their rise last fall.

Applications are the most significant predictor of new home sales and demand, as the majority of buyers of newly constructed homes use financing. But mortgage applications are coincident rather than forward looking, Meyers says, which is why you shouldn’t dismiss the NAHB survey.

“We should keep a close eye on mortgage purchase applications to see if the gain in homebuilder sentiment shows through in greater home sales,” Meyers said.

“A lot of people are stuck in negative equity or have very little positive equity in their home, which means they’re really going to struggle to qualify for a new mortgage,” Capital Economic’s Paul Dales said. “That’s a constraint that’s not going to disappear soon.”

The fundamentals for single-family housing construction do not suggest an imminent turn. Dales agrees with other economists that housing starts and prices won’t rise to previous norms until at least 2015 — at the earliest.

The good news is that builders have been successful at reducing inventory, bringing new supply to six months, meaning that any increase in demand will warrant housing starts. If the economy recovers more quickly this year than widely assumed, single-family housing starts will receive a boost.

From a macroeconomic perspective, housing is likely to remain a drag on the recovery, particularly through its impact on consumer borrowing and psychology.

“While homebuilder stocks have had a nice run, the tailwinds for this sector should fade as the economy slows and competition from foreclosed homes picks up again,” Meyer says. “A real rebound in housing will come, triggering a stronger economic recovery, but not this year.”

“I expect housing starts to return to the historical trend by 2017,” she says. “I feel confident that we will eventually see a snapback in housing starts because the market undershot for such a long period of time. There is a light at the end of the tunnel.”


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