View from the Corner Office
March 29, 2007
CEOs from the country’s 10 largest homebuilders recently convened in New York City to collectively discuss current conditions and future expectations for their industry. Their plans for responding to market trends and economic fluctuations provided me with great insight into the current state of the industry.
Four issues clearly dominated the conversation:
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Cancellation rates
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Sub-prime mortgages
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Lot position
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Cost containment
Cancellation rates. This statistic has become the key barometer of the current downturn and prospective recovery. Cancellations have depressed earnings and undermined buyer confidence but will likely have the opposite effect as they revert to normal levels. Cancellation rates raced higher in 2006, reaching twice the historical average before appearing to peak in the third quarter when they exceeded 50% of gross orders. For most builders, cancellation rates moderated slightly in the fourth quarter and improved through January and February 2007.
Sub-prime mortgages. The high profile demise of sub-prime mortgage brokers pointedly raised the question of how sub-prime lending practices impact new home construction. While only small portions (less than 5%) of the public home builder customers are considered sub-prime borrowers, this development damages the industry in two ways: 1) foreclosures adding to the inventory of existing homes for sale; and 2) tighter lending practices to those with solid credit backgrounds.
Lot position. By shedding land positions - primarily option contracts on larger land purchases - national homebuilders collectively generated over $4 billion of charge-offs in 2006. Most are driving towards a four-year lot inventory, half owned and half optioned, as measured against a trailing 12-month period of closings.
*Meritage Homes Corporation, Citigroup 20th Annual Global Industrial Manufacturing Conference, March 6, 2007
Jack Welch cost management. Margins expanded as house prices rose rapidly throughout the past three years. In most markets, this inflation pushed the envelope of affordability. Going forward, earnings growth will come from containing costs incurred during the production process. Builders have targeted a 10-15% reduction in direct construction costs and a 20% reduction in development costs.
Eventually, the conversations returned to the topic of long-term industry fundamentals, which paint a much more attractive picture.
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Consumer confidence
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Population growth & household formation
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Mortgage rates & Job growth
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Lot supply
Consumer confidence. Having fallen precipitously from mid-2005 through 2006, confidence ticked up strongly in January and February 2007 to the highest levels in three years, according to survey findings from Reuters/University of Michigan. Ironically, the incentives and discounts that builders offered stimulated homebuyers’ to sit on the sidelines until prices bottomed. In markets where builders implemented even slight price increase, buyers moved to contract out of concern that higher prices were eminent.
Population growth & household formation. Most population estimates show the U.S. population rapidly growing, soaring from 300 million in 2006 to 400 million by 2040. The Joint Center for Housing Studies predicts household formation over the next decade (14 million+) will outpace the past 10 years (12 million+) by millions of new households.
Mortgage rates & job growth. While mortgage rates have ticked up from historic lows, they remain compelling with 30-year fixed financing at 6.37%. As reported in my January newsletter, the economy continues to grow and remain robust, particularly in the Sunbelt where new home construction is concentrated.
*Freddie Mac, Primary Mortgage Market Survey
Lot supply. Supply of lots will remain constrained or become even more difficult to secure as the approval process lengthens in the most attractive markets. The time required to convert agricultural land into entitled lots now runs in terms of years, rather than months or quarters.
Conclusions
Operational. As one CEO said, “The time to worry in homebuilding is when no one’s worrying. Once bad news is out, the fix is already apparent and typically being executed.” Most CEOs foresee a period of moving sideways, lasting through the year, while the inventory overhang is worked down. With much of 2007 spent mopping up the oversupply, the stage is set for a robust recovery in 2008 and beyond.
Capital Markets - Dry Powder & Consolidation. As one would expect from this contraction segment of the cycle, most public homebuilders are generating significant amounts of cash. Some have entirely paid off their billion-dollar working capital bank facilities and are sitting on solid 9 figures of cash. Consolidation remains a primary objective for the larger builders in the premier markets. When markets strengthen, PCE looks for the public companies to deploy significant amounts of capital in the growth markets either through acquisitions or land purchases.
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