Within two weeks of it becoming clear that the passage of the housing bill would become a reality, public home builder stocks rallied 15 percent on average, while the S&P 500 gained 5 percent. While the broader market rally has also been driven by a pullback in oil prices, I believe that the builders’ outperformance has likely been propelled by optimismthat the housing bill will stabilize both pricing and demand.Furthermore, the recent rally has also been supported by improving existing-home sales in select MSAs, which many have interpreted as a sign of market stabilization. While I believe that any improvement in sales is a positive, much of the current resale activity in these markets has been driven by distressed sales such as REOs and short sales, which have contributed to the significant home-price deterioration witnessed in many former hotbed markets.
Despite the strong stock performance, feedback from our private builder contacts indicates that market conditions in July took another significant leg down with continued deterioration in sentiment, absorption trends, pricing, and margin. In addition, surging foreclosures, the pending elimination of seller-funded down-payment assistance, rising mortgage rates (compounded by the GSEs’ reduced appetite for loan purchases), and the continued contraction in the availability of bank capital all foreshadow additional pain on the horizon, in my opinion.
While many public builders have argued that foreclosures do not directly compete with new homes given the quality differential, 64 percent of our private builder survey respondents believe that they are losing market share to foreclosures. While I am unsure of how many of these buyers are primary users versus investors, I believe that a significant amount of these foreclosures are being purchased by investors; this has led to significant incremental price declines that become the comps for the market, shattering many potential transactions as appraisals for primary buyers fall well below asking prices.
In our most recent private home builder survey, 29 percent of contacts believed that pricing had reached a bottom. Many of these respondents cited improving affordability (i.e., price-to-rent, price-to-income) as their primary cause of optimism. While affordability has historically been an accurate way to predict a potential bottom in pricing, I believe there are two reasons these metrics may not be suitable this time around: First, banks continue to slash prices on the huge overhang of REO inventory, pushing appraisal comps lower; and second, there is an unprecedented level of over-levered consumers who do not have the ability to make a down payment or qualify for a loan in today’s tightened mortgage market.
In my opinion, incremental price deterioration will also be partially driven by rising competition from foreclosure sales, which have grown to represent 50 percent to 90 percent of resale activity in markets such as the Inland Empire, Las Vegas, Merced, Calif., and Sacramento, Calif., to name a few. I expect national new-home prices to fall at least another 8 percent over the next 18 months, with declines of 15 percent to 20 percent expected on the existing-home side due to rising foreclosures.
For market participants looking for a possible inflection point in the housing downturn, I believe that actions taken by the banks will prove to be the best indicator of future trends and conditions in the new-home market. As land values continue to deflate and regulators put more pressure on banks to reduce their exposure to construction loans, I expect this to lead to a significant contraction in capital for home builders and developers, ultimately pushing many to the brink of failure or forcing these builders to fold-up shop as the economics no longer justify building the next incremental unit. While these builder failures will likely result in additional land deflation as assets are liquidated, I believe that this will create a longer-term opportunity for well-capitalized builders.
Learn more about markets featured in this article: Las Vegas, NV.
