Hovnanian Enterprises last week ran a three-day “Deal of the Century” sale at its communities nationwide offering discounts of up to 30 percent on certain homes. The big New Jersey-based home builder said it generated sales of 2,100 homes — 10 times greater than its weekly sales average over the past three months.

Ara K. Hovnanian, president and CEO of the company, said, “The high level of traffic we saw … convinces us that there are interested buyers in the market today. However, with all of the negative publicity about the housing market, many home buyers were hesitant to buy because they worried that even lower prices might be offered later.”

Home buyers aren’t the only ones who should be hesitant. For investors reading this news, it’s a good reminder of why builders’ shares have consistently traded at a low price-to-earnings (PE) ratio relative to the overall market. According to Standard & Poor’s, during the past several years the S&P 500 Index has generally been priced in the range of 17-20 times earnings while home builders have traded at a multiple of only 6-9 times earnings.

Wall Street has given this discount to home builders’ shares because the industry has historically been cyclical and we are currently in one of the worst down cycles ever. The problem is that home builders tend to be optimists. They consistently overbuild, inventory increases, and the large discounts required to move that excess inventory reduce or eliminate company profitability.

Many builders like to highlight the fact that they start construction only after the home is under contract with a buyer. The problem is that cancellation rates can quickly skyrocket if consumers believe that the house or condo’s value has fallen far enough that it’s better to forfeit their deposit than close on the deal. Consumers can also hire a lawyer to try to get their deposit back, as many are now doing. Some home builders are experiencing cancellation rates in the mid-30 percent range, meaning more than a third of contracted homes come to market without a buyer.

While the cyclical nature of the industry won’t change, in the future home builders should be able to reduce their earnings variability by eliminating their forward price risk. The start of long-duration derivatives trading (based on the S&P Case Shiller and Radar Logic RPF indexes) last week will finally provide the tools necessary for builders to hedge their inventory price risk. It will take several years for these markets to develop and become both broad enough and deep enough for major builders to efficiently hedge their price risk. During that time, the current housing downturn will probably run its course.

I’ll want to be a long-term shareholder of these stocks when I hear company management say they have fully or substantially hedged their forward price risk, not when they announce that they have successfully dumped a lot of inventory in a margin-killing fire sale. Yes, a hedging program entails substantial cost, but Wall Street consistently puts a higher multiple on the stocks of companies that have superior earnings visibility.

For years Southwest Airlines stock has enjoyed a higher earnings multiple than its competitors because it was consistently profitable even during industry downturns. The company hedged its fuel costs and could better forecast its future earnings.

The silver lining of this housing market cycle is that the home builders that survive may be more highly valued by real estate investors if they can take advantage of evolving property derivatives markets.

This article was also published on Inman News.

Last week futures contracts and options based on the S&P/Case-Shiller U.S. National Home Price Index with durations of more than 12 months began trading on the Chicago Mercantile Exchange.  Based on prices for contracts expiring during the next several years, investors expect deep housing price declines to continue. Investors expect the ten-city composite index to be down almost nine percent by September 2008 and over 11% by September 2009 before beginning a slight upturn for 2010 and 2011.  The ten markets on which CME contracts are currently traded are mostly coastal — except for Chicago, Denver and Las Vegas – so the composite is likely showing a deeper downturn than would a more national index covering stronger markets like Seattle or Raleigh-Durham.  Investors expect the worst performing market to be Miami with a breath-taking decline of over 29% by September 2011.  San Francisco is also expected to decline more than 20% and San Diego and Las Vegas just short of 20%.  Chicago is expected to see the smallest decline which is natural since that market also experienced relatively limited price appreciation compared to coastal markets. 

Are these expectations reasonable or the narrow perspective of a small set of panicked investors?  The Los Angeles market began its ascent in April 1996 and climbed steadily before hitting its peak in September 2006. Over that more than 10 year period, housing prices increased about 275%.   Since hitting its peak, the LA market has declined by 4.8% as of July 2007, the most recently published S&P Case Shiller index value.  CME futures investors expect a further decline of almost 15% by 2011, for a total decline of just under 20% over a period of more than five years between the market peak in July 2006 and September 2011.  The prior downturn in the LA market lasted almost six years from June 1990 to March 1996 and the decline from peak to trough was over 27%.  On that basis, investor expectations seem reasonable, at least for Los Angeles.

The Miami market began its last upturn in September 1992 and peaked in December 2006.  During that period housing prices increased about 262%.  Again, put in that context, current investor expectations don’t seem unreasonable.  As many folks who joined the industry in the past few years are discovering, the real estate market — like other markets – doesn’t move in just one direction.

 Note: Future price expectations are reflected in the difference between the current index value (most recently published for July 2007) and the prices of contracts expiring at future dates.  Contracts expiring in November are based on the index value with a two month lag so price expectations for September 2008 are reflected in the contract expiring in November 2008. The contract prices above are as of 9/25/07.

 This article was also published in Inman News.

One of the most commonly referenced statistics in the real estate industry is the median sales price of homes. Many articles are published in newspapers the day after the National Association of Realtors releases its quarterly Metropolitan Area Existing-Home Prices report with conclusions about the healthy or unhealthy state of the local real estate market. Unfortunately the median sale price is frequently taken out of context and misinterpreted.

Even someone who slept through most of their math classes will remember that the arithmetic mean and median statistics are different for the same data set. The average is the sum of the numbers divided by however many numbers you started with. The median is the number in the middle, when the numbers are listed in order.

The reason that the mean or average sale price for a market area can be misleading is intuitively obvious and that’s why it’s rarely cited. A few sales in the extreme luxury segment of a market — think $30 million or more in Bel Air — can push up the average for the entire local market area.

The median sale price can also be misleading particularly in down markets. Let’s consider the San Francisco market. The median home price reported by NAR in the first quarter of 2007 was $748,100. In the second quarter it was $846,800 — a jump of more than 13 percent. Wow, that appears to be a sure sign of a healthy market. Or is it?

To get a truer picture of market conditions, let’s consider a few more statistics: price indexes (using a repeat-sales price methodology), the number of sale transactions, price reductions and inventory growth. From April to June 2007, the S&P Case Shiller Home Price Index showed a decline of just less than 1 percent, not an increase of 13 percent. Likewise the home-price index published by OFHEO showed a decline of just less than 1 percent for the second quarter. The S&P Case Shiller index covers only resale transactions while the OFHEO data covers multiple sale types but only for conforming loans.

FIS Data Services reports that sale transactions increased about 25 percent between the first and second quarters, which is to be expected given that period corresponds to the spring selling season. However, according to Altos Research data, the market inventory level increased almost 40 percent during the second quarter and the percentage of houses listed with a price reduction increased from about 33 percent to 43 percent.

So what actually happened? Sales transactions increased with a greater proportion on the high end versus the previous quarter. There appears to have been little actual appreciation as evidenced by the Case Shiller and OFHEO numbers, while inventory increased and prices of many listed properties were reduced. So next time you read that median house prices have increased in your area, don’t celebrate prematurely. Conduct more research before you reach a conclusion about market conditions in your area.

This article was also published in Inman News.

Long-duration derivatives based on two competing housing price indexes began trading this week. These new contracts with expirations between one to five years will allow investors, developers, builders and other market participants to express a long-term view on U.S. housing prices.

Contracts based on Radar Logic’s Residential Property Index (RPX) will be available through licensed dealers including Morgan Stanley & Co., Lehman Brothers, Merrill Lynch, Pierce, Fenner & Smith Inc., Deutsche Bank Securities Inc., Goldman Sachs & Co., and Bear Stearns & Co.  These indices cover 25 local market areas.

Futures contracts and options based on the S&P/Case-Shiller U.S. National Home Price Index with durations of 12 months or less have traded on the Chicago Mercantile Exchange since May 2006. Contract months extending out 18 months will now be listed on a quarterly cycle of February, May, August and November. Contracts listed 19 to 36 months out will be available on a biannual schedule of May and November contracts. An annual November listing schedule will apply to contracts listed 37 to 60 months out into the future.

Contracts based on the S&P/Case-Shiller indices trade for 10 markets: Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York City, San Diego, San Francisco and Washington D.C. 

Investors that own large portfolios of mortgage-backed securities may be some of the first customers for these products. According to Rich McKinney, head of Residential MBS Trading at Lehman Brothers, “Investors holding securities sensitive to mortgage credit and prepayment performance … now have a powerful tool in managing their residential real estate risk.”

The importance of housing prices for holders of residential MBS securities was recently highlighted in an article from the forthcoming Federal Reserve Bulletin that analyzed loan data from 2006 collected under the Home Mortgage Disclosure Act. The data comes from 8,900 lenders that account for an estimated 80 percent of home lending nationwide.

The study found that the best predictor of future loan performance on a county level was not the unemployment rate, per capita income or population growth. The most important predictor was house-price appreciation. And conversely, risk to holders of these securities comes from house-price depreciation or – as it is often referred to oxymoronically in the industry – negative price appreciation.

This article also was published in Inman News.

The Federal Reserve recently released an article from the forthcoming Federal Reserve Bulletin analyzing loan data from 2006 which was collected under the Home Mortgage Disclosure Act. The data comes from 8,900 lenders that account for an estimated 80% of home lending nationwide.

One of the conclusions of the article may seem obvious but its implications are worth considering carefully.  The study found that the best predictor of future loan performance on a county level was not the unemployment rate, per capita income or population growth.  The most important predictor was house-price appreciation.

Again, this may seem like a statement of the obvious.  If house prices are rising, and a borrower can’t make their loan payments, they just sell the house and payoff the loan.  Even if the property had a high LTV ratio when the loan was originated, equity has accumulated due to price appreciation and the loan(s) can be paid off in full.

 Of course the problems occur when house prices are declining.  If the borrower took out a piggyback or went with some other low-downpayment program, there is little or no equity.  The borrower can go upside-down quickly.  And if that borrower was an investor, they aren’t going to be too concerned about having a roof over their head.

 This problem will be particularly acute in states like California.  Why?  Several factors:

- High home prices mean buyers need jumbo loans which are expensive right now.

- A high percentage of loans originated in the state have been of the low doc and/or high LTV variety during the past several years.

- Falling house prices.  Often oxymoronically referred to in the industry as ‘negative price appreciation’.

- And lastly, California is a deed of trust state.  That means foreclosures are faster and cheaper for the lender since they generally are subject to non-judicial proceedings.  It also means that the lender can’t come after the borrower for any loan losses.  For many borrowers (and especially investors), it may seem better to take the hit to their credit score and throw the keys across the table than to struggle to make payments on a property whose value is plummeting. Why throw good money after bad?

This time around, I think we’re going to see a lot more problems with loans in upper credit tiers. As price depreciation continues, even borrowers with means may decide to default rather than try to keep up with an ARM payment that keeps rising.

 In the future, mortgage lenders may want to change their risk management policies to more directly consider home price trends and not just rely on borrower financials and property appraisals.  Markets with relatively high price volatility should be approached with caution in good times and bad.

And for how long?  I’m frequently struck by various industry analysts that don’t expect a real estate market recovery until ‘next year’.  Brokers, builders and many economists, all say that we can’t realistically expect the recovery until then.  OK, but why then?

Let’s take a look at the Los Angeles market.  According to the S&P/Case Shiller index, this market begans its ascent in March 1996 and peaked in September 2006.  That’s an up cycle of more than 10 years.  During that time, the price index increased over 270%.

Prior to that long bull market, Los Angeles had been mired in a downturn which started in June 1990.  That down cycle continued for almost 6 years and prices declined by a cumulative total of 27% during that period.

Since September 2006, prices have declined by just 4.3% (as of the last published index value for June 2007).  So why is the recovery coming next year?  If the past is any guide to the future, the recovery might be several years in the future and prices have a lot further to drop before it arrives.

Below are closing prices for CME Futures contracts as of Friday September 7.  Longer duration contracts for only two markets - Chicago and Las Vegas - have traded so far.  Investors continue to take a very pessimistic view of these markets, expecting all to decline by the August 2008 expirations.

The worst is a 10% decline expected in Miami.  This is pretty dramatic when you think about it.  The median home price for the Miami market published by NAR for the 2nd quarter was $384,400. Most home buyers put down 20% or less to purchase a home.  A decline of 10% would wipe out about $38,000 in equity.  If you did an 80/10/10 mortgage program, all of your equity would be gone within 12 months and, with closing costs, you would be upside down on your financing.

 The only way for home buyers to protect themselves would be to buy at a very deep discount to the current market price. And of course that kind of mindset, if held widely, would only add downward pressure on prices.