Homebuilders: A Hard Slog Ahead

S&P remains negative on the sector, citing bloated inventory levels and margin pressures

Despite the recent pronouncements by some commentators that the housing slowdown may have stabilized or reached a bottom, Standard & Poor's maintains its negative outlook on the group.

The expectation for declines in both home prices and unit volumes will exert margin pressure throughout the industry well into 2007. Moreover, builders with large land surpluses could find themselves with an overhang of land if unit orders fail to pick up. Investing in the sector, in our view, remains speculative until the supply-and-demand imbalance moves closer to equilibrium, and builders are able to reduce their current high levels of inventory.

Declining Further

The downturn in the U.S. housing cycle accelerated in the second half of 2006. Preliminary fourth-quarter disclosures from several larger builders show signs of further deterioration, as new orders continue to decline significantly and cancellation rates spike. As it becomes abundantly clear that one of the greatest booms in the U.S. housing market is fizzling fast, builders are rapidly pulling back by limiting production of new single-family units and decreasing their land portfolios.

Because inventory levels are well past their comfort zones, most builders have had to step up incentives offered to buyers; this has pressured profit margins. Many builders are walking away from land options struck during market peaks in 2004 and 2005, while the value of land they own is providing far less of a kick to their margins than it did at the height of the boom. This puts more pressure on margins, while land-impairment charges erode book values.

Past housing downturns were driven in part by job losses and recessions. The current downturn stems from investment and inventory imbalances. Higher interest rates have exacerbated the drop in sales, contributing to deteriorating affordability for home buyers. Rapid home-price appreciation also has outpaced household income. Speculators, who had underpinned the purchase investment market, also were stung by higher borrowing costs; they have played a key role in the rapid fall in new orders. This first link in a chain of lost buyer confidence created a feedback loop in which other buyers think better deals will be available in the future if they put off purchases now.

Affordability at Issue

Besides bloated home inventories, builders face an added problem: housing for some prospective buyers has become less economical. The Federal Reserve raised short-term interest rates 17 times from June, 2004, through June, 2006, pushing the key lending rate for overnight loans from 1% to 5.25%. During the recent housing boom, 30-year fixed-rate mortgages averaged 5.83% in 2003, 5.84% in 2004, and 5.87% in 2005, according to Freddie Mac, the government-sponsored enterprise. Fixed rates for 30-year mortgages were as high as 6.76% in July, 2006, before falling back to 6.33% as of early November.

While fixed-rate mortgages remained low on a historical basis throughout the housing boom, sharply higher home prices presented another hurdle for affordability. New single-family home prices rose by more than 20% from 2001 through 2005, according to the Joint Center for Housing Studies of Harvard University, based on figures from the Census Bureau. Part of the sticker shock has been cushioned by new adjustable-rate mortgage (ARM) products that incorporate interest-only, or payment-option, features. But the popularity of these so-called nontraditional mortgage products could begin to wane. In September, 2006, U.S. regulators issued new guidelines for these products, requiring greater scrutiny from lenders.

Home prices are still high in terms of their relation to family income. The average home was selling at 3.3 times household income in the third quarter of 2006, down from 3.46 times in the prior-year period but still above the historical average of 2.65. This ratio has contributed to the affordability deterioration and is expected to fall further if home prices decline. S&P (which, like BusinessWeek.com, is a unit of The McGraw-Hill Cos. (MHP)), sees a total fall of 7% for the median existing home price on a national basis in 2006 and 2007. This would mark the first national drop in U.S. home prices since the 1930s.

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