Builders Brace for a Housing Downturn

Even this typically sunny sector is expecting prices to fall as prelude to a prolonged downturn

NEW YORK CITY (By Peter Coy, Business Week) September 8, 2006 — The housing market is looking sicker by the day. On Sept. 7, the perpetually optimistic National Association of Realtors acknowledged for the first time that housing prices are likely to fall on a year-over-year basis, at least for a time.

Beazer Homes USA and KB Home lowered their earnings guidance. Federal Reserve Bank of San Francisco President Janet Yellen is warning that a housing slowdown will weaken consumer spending, which is 70% of the economy. And economists issued new forecasts showing that a slowdown in housing could reduce growth to barely above recession levels. All that came one day after Hovnanian Enterprises announced a 35% decline in earnings per fully diluted share for its latest fiscal quarter.

Overshadowed by all the bad news was a tidbit that once would have been seen as a big positive for housing: mortgage rates remain quite reasonable. Freddie Mac said Sept. 7 that the national average rate for a 30-year fixed mortgage was 6.47% in the latest week. That's down from 6.72% as recently as late July.

Mountain Football

Mortgage rates. No one's paying attention to the cost of borrowing money these days because it seems trivial next to the risk of losing money by buying high and selling low—catching a falling knife, in the Wall Street vernacular.

Ian Shepherdson of High Frequency Economics, an early bear on housing, said in a conference call with clients on Sept. 7 that the housing market is so far gone that "it's not rescuable anymore. The housing market is beyond the control of the Fed." He compared it to a football game played on a mountaintop. Once the football goes off the edge, he said, it doesn't stop until it reaches the very bottom.

Even the homebuilders, long an optimistic bunch, are all but throwing in the towel on the current market's condition. "We're running our business today as if we're in a prolonged downturn," CEO Ara Hovnanian of Hovnanian Enterprises told analysts Sept. 6.

GDP Bite

In boom times, when home prices were rising 16% a year and many buyers expected that pattern to continue, they could borrow at 6% and, in effect, be paid 10% a year for living in their homes. Now that annual appreciation is roughly 0% and interest rates are roughly the same, says Shepherdson, the real cost of living in a house has increased enormously.

Shepherdson says that housing alone could take 2 percentage points off GDP growth, lowering it to 1.5% from 3.5%. Add in weakness in other sectors, such as autos, and actual GDP growth could briefly dip to zero next year, Shepherdson adds.

"The housing market party is over," economic forecaster Global Insight said Sept. 7. While not as bearish as High Frequency, it's predicting that housing starts will fall 10% this year and 13% in 2007. It predicted that second-half 2006 growth will average just above 2%, with housing being the main negative.

Lowered Horizons

The National Association of Realtors has been reliably upbeat on the market for months, but on Sept. 7, Chief Economist David Lereah said, "We'll probably see prices dip temporarily below year-ago levels as the market works through a build up in housing inventory." He predicted that the national median existing-home price for all housing types will grow 2.8% in 2006 over 2005, and the median new-home price will rise 0.2%. He predicted a 7.6% decline in the volume of new home sales.

No wonder builders are lowering their forecasts. Atlanta-based Beazer lowered its forecast for fiscal 2006 diluted earnings per share to $8 to $8.50, from $9.25 to $9.75. It said net sales through the two months ended Aug. 31 were 49% below a year earlier, and cancellations of existing contracts rose to 50% from 26% a year earlier. Los Angeles-based KB Home also lowered earnings guidance as it said that preliminary net orders for the third quarter were down 43% from the year-earlier quarter.

Red Bank (N.J.)-based Hovnanian, remarkably, maintained its earnings guidance for its full fiscal year in spite of a worse-than-expected quarterly performance. The company said it expects for the fiscal year ending Oct. 31 to earn between $5 and $5.75 per fully diluted common share, compared to fiscal 2005 earnings of $7.16 per fully diluted common share.

"Inexorable Process"

One piece of mildly good news, in Hovnanian's view, is that it believes the rate of cancellation of orders from homes has stopped increasing, at least for now. The cancellation rate was 33% for its third quarter, which was up significantly from 24% a year earlier but barely higher than the 32% rate in the second quarter. But even Hovnanian is being cautious. For example, the company is cutting back on the amount of land it controls when it can't renegotiate deals at favorable terms.

High Frequency Economics' Shepherdson argues that housing could remain weak for another two or three years. "This," says Shepherdson, "is pretty much an inexorable process."