Housing Downturn has Silver Lining for Builders

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.

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