Homebuilders: When Will Things Turn Around?
In light of the ongoing difficult operating environment for U.S.-based homebuilders, investors have raised several questions about S&P Ratings' views on the sector's credit quality over the next several quarters— and the probability of more rating actions. Here, we present our responses to key questions:
We're nearly three years into a housing downturn that is already longer and more severe than many anticipated. When do you expect the cycle to bottom?
Calling a bottom to this severe, and in many ways, unprecedented housing cycle is certainly challenging. Single-family starts have already fallen as sharply and as broadly as any time since World War II. The road to this point in the cycle has been difficult. First, many investors abruptly exited the housing markets, which contributed to pockets of oversupply. Then, prices began a downward trend as each successive round of price cuts by builders further softened consumer sentiment and demand. Deflating home prices pushed mortgages underwater, which contributed to rising delinquencies and foreclosures. And, finally, mortgage financing abruptly tightened for many willing buyers.
Now with the economy likely in a recession and lenders under pressure, the road ahead appears rough. The one encouraging sign we can point to is the fact that new single-family construction has already slowed considerably, to roughly one-third the 1.7 million unit cyclical peak in 2005. Our base-case scenario now assumes that starts will finally bottom out in the third quarter of this year, and we expect to end the year at a little over 600,000 single-family starts.
Prices, however, will continue their downward trend in our view. Our chief economist expects that home prices will continue to fall, perhaps by another 10% through the middle of 2009. Since the S&P/Case-Shiller price index is already down 18%, we're looking at a 25% to 30% peak-to-trough correction. Furthermore, home prices in the "bubble states" of Florida, California, Arizona, and Nevada will likely continue to fare worse relative to the nation as a whole.
This is particularly problematic for many rated homebuilders and building products companies because those states accounted for a significant piece of business at the height of the housing boom. Therefore, while the broader housing market may begin showing signs of firming next year, under our base-case scenario many rated homebuilders and building products companies will continue to face challenging conditions into 2009.
What principal metric will indicate that conditions are finally starting to improve?
We are looking for a sustained, positive absorption of inventory. There's currently a very large, 11-month supply of both new and existing homes for sale, while equilibrium between supply and demand has historically been closer to six months. We don't believe that the current supply estimate fully captures the large shadow supply of inventory and believe that there are a lot of potential sellers who are sitting on the sidelines. When conditions start to improve, those homeowners are more likely to put their homes on the market. In addition, there is uncertainty regarding the effect of foreclosures, particularly regarding the mix between those homes currently owned by investors (and already on the market) and those homes that are owner-occupied (but may ultimately go into foreclosure).
How will the strategies and actions of builders during this housing cycle factor into rating deliberations once the market rebounds, particularly regarding the "fallen angels" and their prospects for returning to investment grade?
Every cycle presents opportunities for companies to recast their business model and emerge more competitively positioned. For example, during the last downturn, NVR (NVR) (S&P credit rating, BBB-) was saddled with too much debt and too much land. The company filed for bankruptcy in 1992, but ultimately emerged with a balance sheet featuring a low degree of leverage and a "land-lite" business model, controlling virtually all of its land through nonrecourse option agreements. This strategy resulted in a more flexible cost structure that has enabled NVR to remain profitable even in the midst of perhaps the most severe housing downturn in 50 years. We expect that most of the large public companies will manage to avoid NVR's earlier fate, mainly because they had less debt entering the downturn. But we may see some meaningful casualties.
Heading into this cycle the conventional wisdom was that the large production builders would shut down land purchases, liquidate inventory, generate cash, and pay down debt. In practice, very few did. In fact, many companies continued to invest in real estate as the markets slowed. Some were in pursuit of market share, others saw only a short, shallow downturn ahead. Regardless of the reason, most eventually faced pressures on covenants in their debt agreements when they were forced to take impairment charges on overpriced land holdings, or they experienced canceled sales that turned into unintended inventory that they also had to write down. Demand basically fell much faster than homebuilder operating platforms could be adjusted to suitable levels.
Looking forward, large on-balance-sheet land and inventory positions will likely negatively affect creditworthiness. We continue to believe that the more lowly leveraged companies, and those with modest exposure to off-balance-sheet joint ventures, are likely to perform better than their peers in these market conditions. In addition, we will incorporate into our analysis assumptions that reflect current market conditions in this cyclical industry. These assumptions will likely affect a company's ability to reach an investment-grade rating.
Given your bearish stance on the homebuilding sector, are we likely to see more downgrades?
We've lowered 25 homebuilder ratings so far this year and, currently, 19 of the 23 rated homebuilders maintain negative outlooks. So it is reasonable to expect that creditworthiness will deteriorate through the balance of the year. We could lower the ratings on the three investment-grade homebuilders if they can't generate positive earnings at lower production levels, or if they use their presently ample financial flexibility to prematurely bulk up on land or repurchase shares.
We believe that the fallen angels (former investment-grade credits that have fallen to junk status) and other companies in the BB category are vulnerable to further downgrades if they continue to take large impairment charges and are compelled to seek additional waivers and amendments from their banks. A few companies in this group, including Lennar (LEN) and KB Home (KBH), are also exposed to troubled off-balance-sheet joint ventures. Large capital calls from these ventures would likely cause us to review our ratings on those builders.
In the B and lower categories, where most of the builders are rated, our analysis focuses mainly on liquidity. We've seen some companies, including Hovnanian Enterprises (HOV) and Standard Pacific (SPF), successfully execute liquidity-enhancing capital markets transactions to help them bridge this downturn. But these transactions have been very expensive, and we recognize that other builders may not have the capacity to meet financial obligations, particularly if the market continues to deteriorate.