Rising To The Challenge

Many companies were still going great guns (buying land, developing communities, and building more and more houses) until they finally saw visible signs of market distress. Consequently, once things turned, they were stuck with a lot of land bought at peak prices.

In the fourth quarter of 2006 alone, the top 10 builders reduced the number of lots they owned and controlled by 26 percent from their peak holdings, which occurred between the third quarter of 2005 and the first quarter of 2006, according to Margaret Whelan, managing director for home building and building products at UBS.

SITUATION CRITICAL

At the crux of the current housing downturn is low affordability, fueled by price run-ups over the last several years (from a new-home median price of $195,000 in 2003 to $245,000 in 2006) along with increasing mortgage rates, both fixed and adjustable.

"Most of the major markets in the U.S. have affordability challenges because of the run up in home prices over the last five years," Centex's Eller says.

Reed Porter, president and CEO of Phoenix-area builder Trend Homes, saw entry level home buyers priced out of even the most basic homes over the last two years. As sales lagged in 2006, Trend offered incentives, from a free pool to other free options, but buyers didn't bite, because they still couldn't afford the price, Porter says. So, in 2006, Trend cut home prices an average of $50,000-and on some models as much as $100,000. That required reworking house plans to scale back on features, as well as renegotiating with subcontractors and suppliers, Porter says.

Trend, which fell from 75 to 85 on the Builder 100, saw its closings drop from 1,108 to 926 in 2006. But with several projects delayed from last year, Trend is looking for business to pick up in 2007, and affordable, entry-level product is a big part of its plans.

"We needed to bring the price of the homes back to where our profiled buyer could afford them," Porter explains. "There's still a demand for that entry-level housing, if it's priced appropriately."

Astoria Homes, a Las Vegas-only builder, saw its closings fall 40 percent, and its Builder 100 ranking decline from 80 to 113, dropping it into the Next 100. Astoria president Tom McCormick saw first-time buyers priced out of the Las Vegas market during price run-ups over the last several years and move-up buyers wanting more house than the entry-level models being sold at move-up prices. Astoria decided to go in another direction. Instead of building more entry-level homes, Astoria is opening a luxury-home division. He doesn't expect any luxury closings before 2008, but McCormick is hoping his strategy helps carve out a niche for his company alongside the big home builders in Las Vegas.

TROUBLED WATERS AHEAD

Though Ft. Worth, Texas-based home building giant D.R. Horton predicts it will again top 50,000 closings in 2007, company CEO Don Tomnitz conceded during the Citigroup Industrial Manufacturing Conference in New York on March 7 that such a goal is "going to be really tough to achieve."

Credit Suisse analyst Ivy Zelman projects the company will see "a 25 percent-plus decline in closings" in 2007, which would drop D.R. Horton back to just over 40,000 closings.

Pulte's Dugas also foresees selling and closing fewer homes and generating less revenue in 2007 than it did last year. How much less, he's not sure, but "it won't be insignificant."

During the Citigroup conference, Tomnitz let slip his thoughts on 2007. In a moment of unguarded honesty, Tomnitz said, "I don't want to be too sophisticated here, but '07 is going to suck, all 12 months of the calendar year."

The moment after Tomnitz offered his outlook for 2007, it was plastered on plasma screens across New York, from hotel elevators to Wall Street offices, fueling all-day television news programs. The Dow Jones Industrial average, which rallied the day before, closed March 7 down 15.14 points or 0.12 percent in the wake of Tomnitz's projections.

The proclamation marked a sharp contrast to Tomnitz's previously stated views on how his company would fare in even the worst of markets. During a 2004 earnings conference call, Tomnitz boasted that the only thing that could keep D.R. Horton's earnings flat, much less force a decrease, was "the great depression."

Clearly, things have changed. The year ahead offers challenges to all segments of the home building industry, from mortgage bankers to subcontractors, suppliers, and builders of all shapes and sizes. Issues range from tightening mortgage standards that could keep some potential buyers out of the market, to a further flood of inventory that could come by way of bank foreclosures and sales by investors. And builders will have to cut costs in order to sell homes at prices buyers are willing to pay, all while maintaining margins. The year ahead promises to be challenging for even the mightiest builder.