A Housing Recovery: Not So Fast

Stocks of homebuilders have had an impressive run recently, thanks to a stream of improving macroeconomic data, including home sales and consumer confidence, climbing an average of 38% since March 9. But will the recovery last? Recent gains in long-dated U.S. Treasury yields augur rising mortgage rates, while the likelihood of increasing foreclosures could further bloat the housing supply in the months ahead.

New sales of single-family homes came in at a seasonally adjusted annual rate of 352,000 in April, down 0.3% from a downward-revised 351,000 in March, but 34% below the April 2008 estimate of 533,000, according to the U.S. Census Bureau and the Housing and Urban Development Dept.. But new home sales are down from 362,000 in February. The median sales price of new houses sold was $209,700, down almost 15% from a year ago.

One reason for the month-to-month improvement in the housing numbers for a couple of months earlier this year was the moratorium placed on foreclosures by many banks from November through February, says Robert Stevenson, an analyst at Fox-Pitt, Kelton Cochran Caronia Waller in New York. But since then, foreclosures have continued to rise, causing home sales to plateau.

Some of the positive data points have proved not to be sustainable, he says. "You haven't seen as many sales as you would like coming out of the spring homebuying season and the very low mortgage rates and some of the tax stimulus," he says. Still, homebuilders are feeling more optimistic. The National Association of Home Builders' housing-market index, which measures both current and future sales conditions, climbed two points, to 16, in May after a five-point increase in April.

The "Better Areas" Are Going to Get Hit

Economists would like to believe the recent data indicate that the housing market has touched bottom, but prices have further to drop to reach some analysts' peak-to-trough estimates of 43%. John Burns, a real estate consultant who advises major homebuilders, believes the median home price will fall an additional 5% or 6% and that will be the end of it. "The worst areas have been hit very hard" since that's where most of the distressed selling has been, he says. "It's the better areas that are going to get hit over the next 12 months" as foreclosures mount in those areas.

In Phoenix, which has experienced one of the worst drops in home prices from their peak of any U.S. city, sales-office traffic jumped 55% in the three months through the end of April after 11 consecutive quarters of decline, according to Jim Belfiore, president of Belfiore Real Estate Consulting, a market research firm in Phoenix. Traffic is a leading indicator of where home sales are headed, he says.

Builders' sales in that area have at least tripled in the past 30 days, due to a big drop in prices from January through early March that narrowed the premium over prices of foreclosure properties to just 15% in most local sub-markets, says Belfiore. Meanwhile, the latest S&P/Case-Schiller data show prices of foreclosures on Phoenix's multiple listing service up an average of $5 per square foot over the past 30 to 40 days, with demand currently outstripping supply.

Phoenix is being looked at as an indicator of what the nationwide housing market could look like 12 to 18 months from now, he says. The land and lots that most of the publicly traded homebuilders own in and around Phoenix comprise a significant portion of their total holdings, he adds.

Bottom-Fishing in Phoenix

Stevenson at Fox-Pitt characterizes most of those buying homes in Phoenix as "bottom-fishers" who are taking advantage of the supply glut that's pushed prices to bargain levels. Other reasons the market has attracted buyers: Phoenix is likely to produce one of the higher levels of job growth over the next 10 years, and its climate makes it a preferred retirement destination, he says.

Belfiore concedes that a large percentage of the recent sales has been by investors rather than people planning to move in immediately, and most are resales of foreclosure properties. The majority of new-home sales have been by first-time home buyers, motivated by the federal tax credit of up to $8,000, which is set to expire in November.

The expected increase in foreclosures over the next few months will force homebuilders to lower prices on new homes to be able to compete. Builders who own the land end up building a house and selling it at a price that results in a negative margin just to get the money out of the land, says Stevenson. Normally, however, rather than build at a negative margin, companies will take an impairment charge, marking down the value of the land to where they can afford to sell the houses for less without killing their margins.

Generally, the bigger homebuilders are still reporting impairment charges between $100 million and $400 million per quarter this year, including the cost of walking away from options on land they don't own and goodwill remaining from past acquisitions, he says.

more foreclosures than new homes

Metrostudy, a national housing market research firm in Houston, is still projecting 490,000 U.S. housing starts for 2009, below the 520,000 to 550,000 forecast by many general economists. Brad Hunter, chief economist and national director of consulting at Metrostudy, recently cited three reasons for the low level of starts: the inventory overhang builders are trying to work off, denial of credit by some builders' banks even if they're current on their loans, and the depressed price levels that make it hard for some builders to sell homes profitably.

Housing inventory fell to 10.1 months of supply from 10.7 in March and was well below the peak 13 months of supply, After a couple of strong months, there was a lull in purchases of homes priced between $150,000 and $200,000, which had had the strongest growth, Goldman Sachs said in a May 28 research note. The key to further paring excessive housing supply is a slowdown in foreclosure filings, which Goldman doesn't see as likely. In March, foreclosure filings were 15% higher than the total inventory of new homes for sale, Goldman said, citing RealtyTrac data.

Do stock-market pros like any names in the battered industry? D.R. Horton (DHI) is one of the stocks favored by James Wilson, an analyst at JMP Securities in San Francisco, who rates it as outperform. He said he expects the company to be among the first to return to profitability starting in fiscal year 2010. "Over 50% of its customers are first-time home buyers, who will be the first, in our view, to enter the market as prices begin the bottoming process and sales start to pick up in certain markets," he wrote in a May 6 research note.

D.R. Horton had $1.5 billion in cash at the beginning of May and said it was terminating a $275 million revolving credit line due to lack of anticipated need, and as a result saving $3 million in annual non-use fees. The company generated $161 million in operating cash flow in the second fiscal quarter and $978.6 million for the first six months of fiscal 2009. "This puts Horton in a very favorable position to capitalize on attractive land deals as banks and private builders begin to unload assets on the cheap," Wilson said in his note.

While the company said it's trying to work down current inventory and is not considering any joint-venture deals, at some point land will become too cheap to ignore, Wilson said. After two straight quarters of impairments below $60 million, the company is nearing the end of its impairments, he said. He expects an additional $65 million in impairments for the current fiscal year, which should bring Horton's assets close to being in-line with current market values. However Credit Suisse analyst Daniel Oppenheim is less optimistic about the stock, which he rates as underperform, citing risk from mounting foreclosures.

Wilson reaffirmed his outperform rating on MDC Holdings (MDC) on May 11, citing the company's strong balance sheet and much lower-than-expected impairments in the first quarter. With MDC perhaps $30 million away from the end of its impairments, he lowered his net loss forecast for fiscal 2009 to $2.25 from $2.75 a share, but reduced his estimate for fiscal 2010 from breakeven to a loss of 50¢ a share based on lower revenue from a lower-than-expected backlog plus higher corporate overhead costs.

Pressure on Margins

Even though MDC slashed it speculative sales by 173 units from the fourth quarter of 2008 to the first quarter of this year, its remaining 648 spec sales are too high compared with backlog of just 629 units, which will put pressure on margins, according to Credit Suisse (CS). In a May 8 note, Oppenheim rated MDC as underperform, saying that with sales, general, and administrative expenses at 29.3% of revenue, the builder needs significant further cuts or higher sales volumes to become profitable again.

Although he sees MDC as one of the best-managed home builders, Oppenheim said he expected weaker sales and lower prices due to greater competition from foreclosures in the short term to put pressure on the stock and also pointed to the risk associated with its premium valuation to its peers.

Oppenheim downgraded KB Home (KBH) to underperform from neutral in April, citing "risks from weak demand, falling home prices, and increased competition from other builders at the low end of the market where KB Home competes with its new lower-priced 'Open Series' product." His $10 target price is based on a 10% premium to his adjusted book value estimate.

While a lot of the data suggest the housing market is close to bottoming out in some ways, there's really no recovery on the horizon, says Burns. That's because mortgage rates are being held artificially low for now and are going to trend up in the months ahead, which will prevent a strong recovery. Meanwhile, any pent-up demand from renters who want to become owners will be overwhelmed by the rising number of foreclosures. "It's going to take a couple years to work our way through this [inventory]," he says.

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