Lending standards and capital rules saved lenders and builders from themselves. By David F. Seiders
The recent economic cycle was characterized by a massive inventory cycle in the manufacturing sector that helped drive the economy into recession and then helped kick-start the recovery that began early this year. In the past, large swings in inventories of new homes were part-and-parcel of such a cyclical pattern. But this time was different, and there's plenty of credit to go around.
Single-family housing production remained robust in the latter stages of the economic expansion that peaked in March 2001, but the unsold inventory did not increase at all--in sharp contrast to earlier expansions. As the economy slid downhill over the balance of last year, both home sales and single-family starts came off their expansion highs. The inventory balance deteriorated a bit in the process, but no old-style overhang developed. Now that the economy is in the recovery phase of the cycle, housing demand and supply are once again moving ahead at a coordinated and healthy pace.
Good planning and conservative management by single-family builders undoubtedly played a part in the maintenance of inventory balance in recent years. A recent NAHB survey showed that more than two-thirds of homes built are pre-sold. The average deposit was 5 percent of the sales price, and only 3 percent of builders said they required no earnest money deposit from their buyers.
Most builders, of course, like to have some standing inventory for marketing purposes and meeting immediate buyer demand. For many, the normal cancellation rate takes care of that requirement. Our survey revealed a median cancellation rate of 3 percent of initial sales contracts. The cancellation rate varied from only 1 percent for small companies (starting fewer than 25 units per year), which often build custom homes on customers' lots, to 7 percent for large companies (100 or more units), which do larger-scale projects on lots that they own.
Market forces and regulations
While builders deserve some credit, strong market forces also helped account for maintenance of good inventory balance. Indeed, exceptionally strong demand for single-family homes, coupled with severe constraints on supplies of skilled labor and building lots, made it virtually impossible for home builders to overbuild their markets in the years leading up to the recession.
New-found discipline in the markets where most builders and developers get their credit also prevented development of an old-style inventory cycle. In the wake of the "thrift crisis" of the early 1990s, federal regulators put in place a uniform set of real estate lending standards for commercial banks and thrift institutions, including limits on allowable loan-to-value ratios for construction and land development loans. Risk-based capital rules now also give depository institutions a break when construction loans are for pre-sold homes. The lending standards and capital rules have helped save both lenders and builders from themselves.
Inventory cycles in the housing market are not necessarily behind us, and speculative building looks quite attractive when home prices are rising briskly. But limits on labor and lot supplies, along with the current rules at depository institutions, should help keep inventories under control as the current economic expansion builds momentum. Builders should be able to thrive in this environment.