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Minyan Mailbag - Homebuilders



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent. Please note that at the time of publication, Fil had a position in both Beazer Homes (BZH:NYSE) and Toll Brothers (TOL:NYSE) and nothing in this article is intended as advice.


Something strange has been happening recently: every time I short a homebuilder all my screens simultaneously begin flashing this. Having attained a numbing level of pain, my Pavlovian reaction is to recite the reasons for choosing to be periodically gored by our friendly bovine. It goes something like this:

"Hoofy my friend, I would strongly urge you to slow your run for a second and reaaaaallllly focus on the recent parabolic rise in home prices. I think you have lost track of the fact that from 1989 to the end of 2001, existing single family home prices rose an aggregate of 50% - 4.1% per year. From January 2002 to February 2004 prices increased 19% - 9.5% per year; and for the cherry on the bubble, from March 2004 to June 2004 prices jumped another 14% - an annualized 56% per year. Isn't this ride enough even for a bull of your stature?

The price party is beginning to backfire (can you say Pulte Homes (PHM:NYSE) / Las Vegas?). Four months ago the National Association Of Realtors affordability index fell to its lowest level in 4 years; in addition, just about everyone with a pulse already owns a house, more precisely a cool 84% of households with family income greater than or equal to the median (approximately $64,000). Really Hoof, aiming to sell the typical Beazer Homes (BZH:NYSE) $233,000 entry level dig to someone making less than $64,000 is NOT a good business model.

Furthermore, the "it's-time-to-buy-a-bigger-more-leveraged-house-than-the-Joneses" bash that your friends (and Uncle Greenie) have fueled for the last 3-years, is causing an ever rising number of bankruptcy wrecks. And if that were not bad enough, it appears that more and more of these "innocent" victims of the festivities suffer from a profound bout of amnesia as to the soundness of the financial statements behind their defaulted mortgage loans. That kind of behavior is "unhealthy" and unbecoming of a true bull.

I am hanging from your horns only because I like you Hoofy, and I wanna help you, and if you keep listening to sell-side target-price setters, I really think you're gonna end up in a bad way."

Alas, Hoofy is not paying the least bit of attention to my whining. All he knows is that the "homies" are cheap, cheap, cheap and they have talked themselves into a new paradigm of ever rising sales, prices and market-share taking. He does not want to hear that in the real estate biz, "cheap valuations", be it homies stocks or physical real estate, are the rocks at the end of the siren's call: one better jump ship before the rocks are in sight or it's usually too late. EPS estimates that go up 20% a quarter can come down just as fast, as Dominion Homes (DHOM:NASD) has vividly illustrated over the last 6 months. But hey, why listen to me now when I've been preaching the same mantra last year and the year before? Because this time just might be different:

First, interest rates are now rising. Even the best of homebuilders (read Toll Brothers (TOL:NYSE)) could not escape 50% haircuts when rates rose in 1994 and 1999. And rate rises will be particularly painful this time given that, over the last year, no less than 35% of new homes have been purchased with ARM mortgages.

Second: most trade groups now forecast a decrease in new home sales of 5%-20% over the next three years. Virtually all the homebuilders I follow concede that forecast, yet - according to their managements - none will be impacted because they are all going to take market share. Memo to management: you are all flocking to the same geographies - MidAtlantic, FL, AZ, NV and CA - someone will be left standing.

Third: Merrill recently noted that homes available for sale increased 17% Y/Y to a 6-year high of 404,000 units. Months/supply of homes also jumped from 3.6 in March to 4.2 in August. Not surprisingly, prices in most markets have stalled and in some of the hottest markets (Las Vegas, Orange County, Washington, DC), they have started falling. No problem says Beazer Homes on its last call, "we'll just build more expensive homes and our ASP's, and EPS, will still go up!!" Huh?

This time (bubble) around, the price insanity, has the potential to be a devastating issue. Remember when folks were buying more and more Commerce One stock on the margin created by their Amazon's holdings? ("What's the problem? I am diversified!") Same concept, same likely ugly ending. Thousands have been suckered into believing that it is not the price of a home that matters, it's your monthly payment. If I had not heard this "brain cramp" from a "reputable" talking head on CNBC two nights ago and saw it first hand at a recent condo open house, I'd have a tough time believing it. Line up the class action lawyers for the eventual communal awakening to the concept of "negative equity".

Fourth and last (for now): homebuilders are unanimous on the idea that the lifeblood of their business (absent free mortgages for everyone) consists of jobs and wage growth: on this res ipsa loquitur.

My humble opinion, and never advice, is that the pieces of Boo's puzzle are (finally) coming together. I've lived 2 major real estate booms/busts in my career. The '88-'91 S&L related collapse in commercial and residential real estate, and the 2001 bust in commercial real estate tied to the tech bubble. The latter did not make headlines because it paled in comparison to the equities implosion, and also because, fortunately, the capital structures of commercial real estate are much healthier today than they were in the late '80's.

In neither instances was there a soft landing. Virtually overnight leasing traffic disappeared and rental rates, for whatever tenants one could find, fell 20%-40%. On the residential side, people simply stopped showing up for the Open House parties, and a year later overleveraged homes were being bid in at foreclosure for 50% of the purchase price.

As the saying goes, "booms and crashes in real estate are but shades of the same noise." The truly new paradigm this time around will be the decibel level. So "grizzlies" take heart, for Boo just may be about to get the last laugh.

Thanks kindly,

Minyan Fil Zucchi


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