Housing has never seen a soft landing, ever

Mike Morgan at Morgan Florida had some interesting comments on housing and the economy.

It is encouraging when people take a hard look at their own industries and plot the real possibilities rather than the ‘head up the arse’ denial that comes from most anyone tied to the housing industry right now. And to all of you – closing your eyes won’t make it go away…
Vern

From Mike Morgan http://www.treasure-coast.us/

Chicken Little
I’ve been receiving quite a few calls regarding the surge in home builders’ stock prices. Well, first off, I am not a financial advisor. My research and consulting services are purely information for the end user to incorporate into their financial analysis.

I think that what’s going on nationwide in housing will effect the country to levels we have not seen since the Depression. Some of you may be equating me with Chicken Little. After all, Cramer is bullish on the home builders and so is Bill Gates. Well it’s not Bill Gates making the call. It’s his financial advisors that run the foundation that are making the call. Second, even if it were Bill Gates, he’s been wrong more than right for the last few years. Bill Gates is not Warren Buffet. As for Cramer, I have no comments except to say that his show speaks for itself. I think you can read between the lines.

Finally, the market seems to have bought into the "Goldilocks" soft landing theory. Well housing has never seen a soft landing ever and I fail to see how this time can possibly be different given the affordability problems and the disparity between housing prices and rents, not just in Florida, but pretty much nationwide. With that comment, let's now turn our attention to the situation facing the homebuilders.

Catch 22
Following are the three business strategies builders are using to survive the downturn in home building.1) Reduce Inventory

Housing inventory is at the highest level we have ever seen since the beginning of time, and growing daily. Back in early 2005 Centex was the first to realize the market was in trouble. They quietly contacted real estate agents and offered double commissions and huge discounts on inventory that would close prior to their fiscal year end of March 31, 2006. As this program grew, the other home builders initially ridiculed Centex, but in their own board rooms, they quickly started cooking up competitive discounts, incentives and commission bonuses. Now it’s a free for all to see who can leap frog the other on the way down, and who can get more creative with incentives. The Catch 22 here is simple. Margins after all of this nonsense are approaching zero for most builders, and the madness has not stopped. But if builders don’t dump standing inventory now, they will have heavier losses if they continue to carry these homes and watch prices further deteriorate as the competition drives prices down further.

(Catch 222) Monetize Land
As if standing inventory was not enough of a problem, builders have two additional problems. First they have land, some of which is entitled and improved. Second they have thousands of projects that are already started, with roads, sewers and utilities already in place and paid for with lots of debt. They might be able to walk from land options and land that is not entitled, but it is not very easy to walk away from land that is already in the development process with billions of dollars of debt tied up.If the builders move forward with the developments, they are further increasing inventory. If they don't, they face problems with carrying costs of entitled land or shutting down a development that has already started. But carrying costs are not the only problems builders face.

If they have already started the development, they most likely have a time frame with the local government to complete the build out. Some local governments require builders to post a bond insuring the completion of developments. And how many homes do you think a builder can sell in a ghost town of a few spec homes? People want to live in a community, not a construction site.

(Thus we have the second Catch 22.3)
Scale Back
One would think this is the smartest option. When demand drops off, it is usually a good time to cut back on supply. But if the builders scale back, that means lower numbers for Wall Street. We’d see lower starts and lower sales and lower revenues and lower profit. Oh, almost forgot the "bonus factor". We’d also see lower bonuses to the top dogs who greedily reaped in tens of millions of dollars each during a market fueled by irrationally greedy speculators that essentially had nothing to do with their business acumen or experience.

One top builder has already announced they plan to continue building so they come out of this as a volume leader and capture branding. They’re losing money on each sale, but they’ll make it up in volume? That’s pretty expensive branding.

Once again, we have a Catch 22.
If the builders scale back, Wall Street will not see the numbers they want to see. If the builders don’t scale back, Wall Street will see some numbers, but the increase in inventory will complicate the problem with lower prices and bottom line losses will be the only numbers Wall Street will see.

Book Value
In addition to the three Catch 22 issues, Wall Street seems enamored with the low book values of the builders. I’ve got news for you. The book value numbers for this group are as misleading as a deaf and blind seeing eye dog. We’ve seen a few builders take write downs on some land, but if you crunch the numbers, it’s crystal clear that these write downs are not enough.

Homework
Look at D.R. Horton’s (DHI) recent write down in comparison to their land position. Look at Lennar (LEN) and the other builders referenced in the informative piece appearing in the October 2 issue of Barrons. Think about WCI Communities (WCI) and Brookfield Homes (BHS). Is their land old land with value, or is it relatively new land that they paid top dollar for. Finally, take a look at what happened to Kara Homes in New Jersey. A large regional builder that choked on their land and inventory. Choked right into bankruptcy.

This is where it gets tricky. It’s not easy finding out at what prices, where, and when the builders purchased land and/or options on land. For land purchased prior to 2000, the book value will most likely hold. For land purchased in 2005 or later, these guys are in trouble, and much of that land is probably worth 25-50% less than what they paid. For land purchased between 2000 and 2004, there is a grey area as to what the land is worth. The bottom line when it comes to land is that builders bought land just like the flippers bought their preconstruction homes. Price was a secondary issue. The primary concern was getting entitled land.

The crash of the housing industry is only now getting started, as it will spread virally to all of the boats it floated during the rising tide. Housing has touched every single segment of our economy, and it will darken all of those segments as the industry collapses to the worst levels we’ve seen since the Depression. The NAR and other groups producing numbers have been great cheerleaders, but when you’re pumping out misleading numbers, I don’t care how beautiful or loud the cheerleaders are, the situation is a no win catch 22 for the homebuilders no matter how one looks at it.