Beazer Homes Ginsu

falling-knife.jpgYesterday Beazer Homes (NYSE: BZH) published results for the quarter ended September 30th.  The stock temporarily rallied based on Wall Street’s relief that the results of an accounting re-statement weren’t worse. 

Momentarily ignored was the company’s ghastly performance resulting from the recent credit crunch.  The cancellation rate reached 68% either because buyers got cold feet or their financing fell through.  That means the company is largely building ‘on spec’ in the teeth of a fierce housing downturn.

Beazer’s stock price was in the mid-40s at the beginning of the year and is trading at a bit over 9 today.  It’s hard to imagine a stock that better qualifies for the old Wall Street warning about trying to catch a falling knife.  Just because this one traded above $40 bucks a few months ago, there’s no reason it can’t go down $3, $2 or zero.

 In a multi-year housing downturn, there will be builders that survive and there will be those that don’t.


A Look at Past Downturns

The long boom in the real estate market attracted many people into the industry, with the National Association of Realtors’ ranks growing to more than 1 million members. Because the upcycle lasted for 10-15 years in many markets, hundreds of thousands of agents have not experienced a significant down market.

By looking at down markets in the late ’80s and early ’90s, we can make some observations on past real estate declines.

Price declines are relatively shallow. During most downturns, prices tend to decline in the range of 3-6 percent annually with cumulative declines of less than 20 percent. Los Angeles was the exception in recent history, experiencing a cumulative decline of more than 27 percent. Compare this with the NASDAQ index, which was over 5,000 at the height of the dot-com boom in 2000 and is still at only 2,791 seven years later. Of course, because houses are a highly leveraged purchase, a percentage decline even in the teens can eliminate your equity entirely if you bought too close to the market peak.

Down markets can be lengthy. Market observers frequently say that the market will turn up “next year.” This is often wishful thinking. Past downturns have persisted for a number of years, not just one or two. Real estate markets are often characterized as “sticky downwards.” That is, when home sellers don’t get the price they want, they opt to take their properties off the market and wait. While this behavior may cushion the downturn in prices short term, it tends to extend the duration of a market correction.

The big picture matters. Most downturns are a manifestation of larger economic conditions. Generally a national or local recession with substantial job losses drives real estate corrections. The current downturn in Detroit has been the most severe of any major market because of auto industry-related job losses. Many real estate markets declined during the national recession of the first Bush presidency in the early ’90s. In the case of the Los Angeles market decline, the downturn was extended and deepened by an earthquake and race riots.

Market Downturn Start Date Duration
Cumulative % Price Decline Average Annual % Price Decline
Los Angeles Jun-90 67 -27.1% -4.9%
San Diego Jul-90 68 -17.2% -3.0%
Boston Jul-88 43 -16.7% -4.7%
New York Sep-88 31 -15.5% -6.0%
Detroit Dec-05 19 -12.4% -7.8%

Source: S&P Case Shiller National Price Index

So what does this mean for real estate professionals in the current downturn? Be prepared for the weak market to last a fairly long time.

In our view, prices are likely to continue to decline by low- to mid-single-digit percentages annually for the several years in the high-cost markets that had the greatest run-up. The wildcard is a recession. If that happens, we will take another downward lurch before we gradually settle to a bottom and begin the upcycle again.

This article was also published in Inman News.

Assessing the Downturn: A Quick History Lesson

Over the past year, I’ve heard two questions asked on a near-constant basis: How long will this housing downturn last and how low will my market go? The simple answer is: when the inventory stops piling up.

To figure out when that will happen, housing economists study reams of data on building permits, housing starts, mortgage rates, loan resets, affordability indexes, job growth and a host of other factors including consumer psychology. Before you hear the answer from someone’s crystal ball, it’s worth establishing some historical context for your local market.

The most obvious questions are:

How long ago did the market hit its peak? Markets like Seattle, Charlotte and Atlanta are still rising. On the other hand, Boston peaked in September 2005, San Diego in November 2005 and Detroit in December 2005.

How far has the market fallen since hitting its peak? Detroit has fallen the furthest with a 12.4 percent decline as of July 2007, the most recent month for which the S&P Case Shiller indices have been published. San Diego and Tampa have both declined more than 8 percent so far. On the other hand, Chicago and Denver have fallen by less than 2 percent from their peaks.

How big was the run up in prices prior to the market peak? The big California markets all experienced increases of more than 200 percent in the 10-year period prior to hitting their peaks. Miami also soared more than 200 percent. In fact, 10 of the 20 markets in the table below all saw increases of at least 150 percent. The Midwestern markets saw much more restrained price appreciation with a low of 41 percent in Cleveland and a high of 117 percent in Minneapolis.

Looked at in this way, the contrasts are stark. Both the Los Angeles and Cleveland markets peaked in mid-2006 and both have fallen less than 5 percent, but Los Angeles appreciated 267 percent in the prior 10 years while Cleveland was up just 41 percent. You can reach your own conclusion about the desirability of living in Cleveland versus Los Angeles, but the downside price risk in your house would probably be a lot lower in Cleveland at this point.

While local market price direction is largely driven by local supply-and-demand factors, it’s worth considering your market’s recent past before you try to peer into its future.

Market Month of Market Peak 10 Year Appreciation
Prior to Peak
Months into Downturn
(as of July 07)
% Decline from Peak
(as of July 07)
Los Angeles Sep-06 267% 10 -4.8%
San Diego Nov-05 251% 21 -8.3%
San Francisco May-06 223% 14 -4.5%
Miami Dec-06 219% 8 -7.3%
Washington May-06 182% 14 -7.6%
Phoenix, Ariz. Jun-06 179% 13 -7.3%
Tampa, Fla. Jul-06 171% 12 -8.8%
New York Jun-06 170% 13 -4.0%
Las Vegas Aug-06 161% 11 -6.3%
Boston Sep-05 158% 22 -5.8%
Seattle, Wash. 135%
Minneapolis, Minn. Sep-06 117% 10 -3.7%
Portland, Ore. 100%
Chicago Sep-06 96% 10 -1.5%
Denver Aug-06 89% 11 -0.7%
Detroit, Mich. Dec-05 72% 20 -12.4%
Atlanta, Ga. 59%
Charlotte, N.C. 48%
Cleveland, Ohio Jul-06 41% 12 -3.6%
Dallas, Texas* 26%
   *Dallas index compiled only since January 2000
   Source: S&P Case Shiller National Price indices

This article was also published in Inman News.

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.

Forecast Calls for Pain

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.

Damned Lies and Median House Prices

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 Begin Trading

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.