Builders Start to See Light at the End of the Tunnel

While new home sales are still very weak, they are expected to begin a slow rebound next quarter. Fitch Ratings and the National Association of Home Builders point out that sales are likely to pick up slowly as customers come back into the market and as new home sales continue to compete against existing homes and foreclosed homes.

Fitch estimates that new home sales for 2009 will be down about 30%, with the worst comparisons being in the first half of the year and then picking up. "This is a very tentative expectation of something close to a 20% increase next year off of this cyclical low. But it's still early in the game," said Bob Curran, managing director of corporate finance and lead homebuilding analyst at Fitch Ratings. "The economy has to cooperate or be in recovery next year, interest rates not be very much higher than where they are now, the general affordability scenario has to be good, and consumer confidence would have to be positive."

Most new homes sales will translate into deliveries. It may be in the next quarter that the market sees clearly that new home sales have bottomed, Mr. Curran said. "There are a lot of moving parts. We're still in a recession. The first quarter was very weak in terms of the economy. The second quarter is supposed to be in negative territory although not as depressed as the first. We've had mortgage rates move up fairly sharply from the bottom of last year. That hurts affordability to some degree, obviously to the degree that if rates move up more, that could be a bit of an issue."

Revenues and profits are still under pressure. A number of companies will be unprofitable for the full year, and Fitch's outlook for 2009 on homebuilder financials is still negative.

In its spring homebuilding quarterly update, Fitch is estimating public builders could see a drop of 44% in revenues. And for those builders who are profitable, even before real estate charges, earnings could fall 60%. As a result of these various moving parts, Mr. Curran said next year there is the potential for half of the homebuilders to move into the black but with still quite low margins.

David Crowe, chief economist and senior vice president at the NAHB, says earnings will be slow to recover because builders are competing against foreclosure and bank REO. "The oversupply of homes on the market puts pressure on prices and builders must reduce prices to be able to attract buyers," Mr. Crowe said."The result is a very tight squeeze on profits."

The recession is certainly a contributing factor to the growing foreclosure problem as well as the possibility of future job loss. The rate of properties going into foreclosure has picked up momentum following the removal of government moratoriums, adds Mr. Curran.

"Foreclosures compete with existing home sales, there's no doubt about it. They are being bought by everybody, from first time homebuyers living in rental apartments to investors, some who are long-term investors or short-term in nature," he said. "It does siphon the demand in the market that might otherwise go to newly built homes."

Many, including Mr. Curran and Mr. Crowe, are leery to say when robust growth will return to the home building market. "Robust is a relative term," declares Mr. Crowe. "I expect 2010 starts to be 25% greater than 2009, which is a much faster growth than we have seen for many years."

The homebuilder industry will not return to true full production, i.e., production that satisfies underlying demographic demand, until late 2012, predicts Mr. Crowe.

Speaking to the industry as a whole, Mr. Curran strongly believes the country has to get out of recession and into economic recovery before things get better. Builder confidence, not only consumer confidence, needs to come back in order for builders to achieve a healthy number of homes. "They are conservative now in what they are building, because they know they can get into even more financial difficulty if they are building a home and there isn't a customer for the product. And that's assuming the consumer can get financing."

Industry wide inventories must decrease further, including the foreclosures. "It's important for the foreclosure element to sort of trail off somewhat. There will always be foreclosures, but it's way above normal trends," he said.

"And, for there to be robust growth, it will be important for all customer segments to be participating in the housing recovery, not just entry-level. You'll hear from conference calls the suggestion that the major customer - the people who are buying are entry-level buyers who have been renting and don't have a house to sell. But we need those trade-up customers to participate in the market as well for it to be a robust recovery.

Mr. Curran is hopeful interest rates will not rise to a level that cuts into affordability. "I'm not sure I'd expect robust growth in 2010 but perhaps in 2011."

According to Mr. Crowe from NAHB, limited builder capacity is most concerned with access to capital right now. Small and medium sized builders are struggling to get bank financing for buying land, developing property and building the homes. "Without financing, builders will not be able to respond to the increasing and pent up demand. This capacity problem is very real and could dampen the economic recovery as it suppresses builder response to consumers returning to the market."

Mr. Curran agrees. Going forward, a year or two off the bottom, builders will be on the lookout to replenish their supply of land. They need to get financing to buy the land and certainly to buy homes. "That land should be lower priced. Banks will have to price-to-market in order to move it," he said.

He is not expecting a dramatic increase in labor demand over the next few years. "Your labor capacity can be rebuilt fairly quickly. A lot of those people are illegal aliens. It's not like there are a lot of other areas that pay as well as that. Some have part time jobs in the retail food area. Some have migrated back to their home country, probably Mexico," said Mr. Curran.

"Once things ramp up again in terms of demand and communication gets out, I think you'll get a lot of those people back to the marketplace again. There could at times be some shortages of labor, or we could get price inflation in terms of labor, but it doesn't look like a built in squeeze that is going to be a big deal."

Many smaller builders have gone out of business or are going to go out of business before all is said and done. So, when the industry sees the pickup, it will probably be more evident in the larger builders who have secured lines of financing, who have a better conduit to that labor than the the average small builder who builds 35-40 homes a year.