Flickers of life once again pulse in Sacramento's new-home market. Housing analysts say that California's state capital isn't quite out of the woods, but after some painful readjustments, it may well be on the way to recovery.

Once dubbed one of the fastest-growing markets in the nation, experts observe signs that the market is improving modestly, if only because conditions haven't continued their decline.

TOO EARLY TO CALL: When discussing the Sacramento housing market, consultant John Burns says, "I will wait until builders are selling four homes per month per community without increasing incentives before I say the market has bottomed out." Getty One In retrospect, the market—like Phoenix, Washington, D.C., and Fort Myers, Fla.—was an early warning indicator of how out of whack the hot markets had become, and how quickly big builder expansion strategies would have to shift to survival tactics. With the imbalance of pricing, investor buyers, and new-home oversupply, Sacramento was a microcosm of the rapidly deteriorating housing trends that swept through the entire country.

Now big builders believe they've stopped the bleeding in Sacramento, and they're hoping it again will serve as a leading indicator, this time toward recovery. Still, they're going to have to be realistic about when and how strong the next wave of demand might be.

“I don't believe the Sacramento housing market is making a comeback today,” says John Burns, president of Irvine, Calif.–based John Burns Real Estate Consulting. “[However] I believe it will be one of the first markets in California to recover and will be one of the best markets in California over the next 20 years. Sacramento was one of the first markets to experience heavy investor activity, beginning in 2001, and thus has a huge affordability problem that is quickly correcting, but is not finished correcting.”

Burns acknowledges that tiny improvements are taking place. “Falling interest rates, coupled with recent rapid price reductions, have spurred some activity,” he notes. “I will wait until builders are selling four homes per month per community without increasing incentives before I say the market has bottomed out.”

The bottom line is that all good things must come to an end. “The market needed to have a correction take place,” says Greg Ocasek, vice president of land at the Sacramento division of the land brokerage company O'Donnell Atkins. “The market had to readjust and go through a normalization period.”

Market Triage

How did builders adjust to the changing environment? Painfully. Some builders launched massive incentive programs to lure buyers; others offered straight price discounts. Net prices have taken a dramatic turn south.

What's more, in trying to keep costs in sync with lowered prices, builders have changed their product lines, sought approvals to increase project density, and some walked away from tracts of land they had intended to—and sometimes put deposit money down—to acquire.

In the end, the market very likely will have conceded nearly 25 percent in price, while sales will have taken a 40 percent hit. Compared to the market peak in 2005, and you're looking at a loss of millions of dollars in high-margin revenue among leading builders that had penciled in Sacramento profits for years to come. Stephen Smiley, a principal at Hanley Wood Market Intelligence (HWMI), anticipates that prices will level off in 2007 and absorption will improve by approximately 10 percent.

True to housing cycles, after a sustained period of run-up, a market overcorrects before finding its way to equilibrium. Builders had to react fast last winter as the bottom fell out of the market. And they did.

Shea Homes revised its incentive program to deal with the changing market, resulting in lower net pricing for the buyer. “On top of that, we had to really focus on our core business of offering an exceptional experience for our guests and buyers,” says Adam Watkins, Shea's Sacramento division vice president of sales and marketing.

Launching more incentive programs is helping builders get rid of standing inventory—at least a little bit of it. Sacramento saw its standing inventory drop to 422 units in September 2006, down from September 2005's 460 units, according to HWMI.

But add under-construction inventory to those standing inventory numbers, and the picture for the total speculative category is scary. In September 2006, total speculative inventory units stood at 2,364, a 37 percent jump from the same period a year earlier. Among existing homes, 17,299 for-sale units were on the market in September 2005; by September 2006, 21,303 existing units were waiting to be sold, a 23 percent leap.

“The good news is that, with incentives, builders are getting through their inventory and should continue a good clip,” says Smiley.

Another tactic helping to bring Sacramento back: builders walking away from optioned land holdings. Sean Rawson, a senior associate at O'Donnell Atkins, says it hasn't been an uncommon reaction—walking away is one way to mitigate the risk of being saddled with property that might not turn a profit.

Learn more about markets featured in this article: Los Angeles, CA.