Homebuilders: Hitting Bottom at Last?

One industry player says the low point for the housing market is "very near." But credit problems and other issues have many contemplating further gloom

It is, according to homebuilder Hovnanian Enterprises (HOV), the "deal of the century." The builder wants to unload 1,000 new homes in a weekend sales promotion Sept. 14-16, cutting prices on some houses by up to $100,000.

Aggressive sales tactics such as this are a sign of how desperate homebuilders are to unload their excess inventory. The sales, discounts, and extra incentive put the spotlight on a key question both for the residential construction industry and for all Americans who own their own homes: How much further will prices fall?

Hovnanian Chief Executive Ara Hovnanian said Sept. 14 that while a full recovery for homebuilders might take until 2009, the end of price declines may be coming soon. "I think the bottom is very near," he told Bloomberg TV.

An end to falling prices—along with a boost in sales—is certainly what he and other homebuilders are hoping for. Home shoppers hesitate to buy now if they think homes will be cheaper in a few months. Hovnanian said his sales offices are seeing plenty of traffic, but potential buyers aren't putting down offers because "they're worried that they're not getting the very bottom of the marketplace."

'Ugly' Sales Data Due

In markets such as California, where home values started falling first, those declines have slowed recently, says James Diffley of research firm Global Insight. "Home prices are clearly falling, but [the declines] don't seem to be accelerating," he says.

But the most recent data on home sales isn't very recent. It predates the recent stock and credit market troubles that began in the middle of the summer.

As a result, home sales data for August and September is likely to be "rather ugly," A.G. Edwards (AGE) analyst Gregory Gieber wrote recently. "A liquidity crunch is the last thing that an industry already overburdened by an inventory glut needs."

Before the credit problems began, the housing market was already burdened by home values that were out of whack by most measures. Global Insight, along with National City Corporation (NCC), looks at fundamentals such as interest rates, income, population density, and other factors to determine just how over- or undervalued home prices are.

In the 1990s, Diffley says, home prices didn't keep pace with incomes and were actually undervalued. But values had caught up by 2003 and kept accelerating in the next few years. In the second quarter of 2007, the total value of single-family homes was 25% too high compared to fundamentals, according to Global Insight; 14% of U.S. single-family homes were overvalued, according to results released in mid-September.

The Credit-Crisis Effect

That suggests home prices have a lot further to fall before the housing bubble is truly popped. But Diffley says a sharp drop is less likely than a long period of slow growth in the next 5 or 10 years, as incomes and other fundamental factors catch up with home prices.

But could recent credit problems trigger a more rapid decline?

The problem is that mortgage lenders suddenly find themselves unable to resell many mortgages on the secondary credit markets. Many lenders have gone out of business. Others, such as the U.S.'s largest, Countrywide Financial (CFC), have slowed down not just subprime lending (to people with low credit scores), but also other kinds of nontraditional lending hit hard by the crisis.

Even if those loans are issued, the interest rates are often much higher. For example, large mortgages—so-called jumbo loans—have gotten much more expensive for home buyers.

"Potential home buyers are losing access to credit beyond what is being reported in the headlines," Morningstar (MORN) analyst Parrish Glover wrote in mid-September.

Sharing the Pain

So far, housing trouble has been the worst in key markets, especially those in California and Florida where home values skyrocketed this decade. But credit problems could be spreading the housing pain elsewhere.

As an example of how much credit problems are contributing to the fall in home values, look at Houston. The fundamentals in Houston look good, Deutsche Bank (DB) analyst Nishu Sood wrote recently: The economy and job markets are strong, and homes are still affordable. A starter home can be found for $75,000.

The only issue for Houston is that subprime lending accounted for 32% of home purchases in 2006, vs. 22% nationwide. "The subprime effect in relative isolation has been significant enough that prices are down 5 to 10%," Sood wrote, "even though prices were never meaningfully out of equilibrium to begin with."

Sood lowered his price targets for homebuilder stocks due to the chance a U.S. recession could make things even worse. "A faltering economy could undermine what little demand support the builders still have," he wrote.

Let's Make (an Even Better) Deal?

Thanks to all the worry, homebuilder stocks already are trading at bargain prices. The S&P 500 Homebuilders Index is off more than 50% so far this year, so even a little good news can help revive shares. Hovnanian's stock was up 9.67% to $11 on Sept. 14 on hopes for its big sale. Larger homebuilders such as D.R. Horton (DHI), Lennar (LEN), and Pulte Homes (PHM) were also up, and the entire industry rose 3.26% on Sept. 14, according to Standard & Poor's. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

One thing is clear: More big sales like Hovnanian's big weekend blowout may be necessary before Americans buy up the huge supply of homes on the market. In July, there were so many existing homes on the market that it would have taken more than nine months to sell them all off.

If credit conditions take many buyers out of the market, and foreclosures add extra homes to the market, things could get even worse.

"The backlog of unsold homes has reached a level at which buyers are likely to get nasty, insisting on deep price cuts," Charles Dumas of Lombard Street Research wrote recently. That's not the kind of problem that can be solved with a splashy weekend sales blitz.

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