If You Build It, They May Not Come

With inventories rising, investors have soured on big builders' expansion plans

Sprawled across the desert near a town called Surprise, the Arizona Proving Grounds are flat, dry, and featureless -- perfect for testing automotive endurance. Now homebuilder Toll Brothers Inc. (TOLL ) has targeted this desolate land -- 35 miles from downtown -- for the next expansion of metro Phoenix. Last month the Horsham (Pa.) builder and two partners announced the purchase of the 5,500-acre DaimlerChrysler Corp. (DCX ) facility for $312 million in what the Arizona Republic called the most expensive land deal in state history. "This particular parcel is a highly coveted site," Toll Brothers Chief Executive Robert I. Toll crowed.

But with inventories of unsold homes rising, the days when investors cheered homebuilders' expansion plans are over. Wall Street began to sour on builders last summer, even before it dawned on most homebuyers that the market was topping out. Most homebuilders' stocks are down 15% to 25% since last July. The prices of Toll, Centex (CTX ), Pulte Homes (PHM ), Lennar (LEN ), D.R. Horton (DHI ), and KB Home are only about six times this year's projected earnings per share, much lower than the price-earnings multiple of 15 for the Standard & Poor's 500-stock index. Toll Brothers has lost almost half its market value since its summer peak. The latest blow: On Feb. 7, Toll announced a 21% drop in the value of contracts for new homes signed in its first fiscal quarter, ended Jan. 31, compared with a year earlier. The stock fell $1.73 to $29.47.

The Street's distaste is understandable. Builders made huge profits when the value of the land they owned soared. But now, as the Arizona deal demonstrates, they're having to replenish their land banks at high prices. At the same time, housing demand and prices are moderating. On Feb. 7, the National Assn. of Realtors predicted that new-home sales would fall 8.5% this year from last year's record, while construction would fall 9.3%. Depressing the demand for new homes is the inventory of unsold existing homes, which the Realtors group said was 26% higher in December than a year earlier. Goldman, Sachs & Co. (GS ) economist Jan Hatzius estimates that house prices nationally will have to stagnate for the next three to five years to correct an average overpricing of about 15%. David M. Rosenberg, chief North American economist of Merrill Lynch & Co. (MER ), argues that housing probably peaked last summer. "The impact is starting to show through right about now," he said in a Feb. 7 report.

Builders say what's happening is no more than a lull. They argue that they're better positioned for a soft market than in previous slumps, such as in the early 1980s, when many went bankrupt. They're less indebted. They build fewer homes on speculation. And much of the land they control is under option, so they don't have to buy it if they don't want to. In a conference call with analysts on Feb. 7, Robert Toll sounded mildly annoyed that investors aren't buying his company's optimistic story. He said Toll Brothers buys land such as the Arizona parcel with the intention of earning 25% to 30% a year on its investments.

If investors believed the company could really get that kind of return over the long term, the stock would be much higher. Instead, some are urging management to dial back. William R. Mack, an equity analyst for S&P, says Toll controls enough land to last for eight years at the expected 2006 rate of building. Instead of acquiring more land, he says, the company should buy back more shares.

Builders like Toll have enjoyed huge profits, but business can dry up quickly if customers lose faith. The Arizona Proving Grounds, which once tested the endurance of Jeeps, may soon try the stamina of homebuilders.

By Peter Coy

    Before it's here, it's on the Bloomberg Terminal.