Credit Suisse is out with a report today that puts to rest some long-held assumptions about the building industry. The business of building homes, it turns out, is the same as it ever was, at least it was during the past 30 years.
"The amazing part is that so many people think that it's much better now," said Ivy Zelman, managing director of the housing sector for Credit Suisse in New York. "There's a lot of misconception about what the true returns on equity are over a building cycle."
Zelman and her team gathered data going back to 1980 on four of the largest builders in the industry – Centex, KB Home, Pulte and Ryland – and used it to construct a virtual "proxy" builder that would be representative of the industry at large. Next, it excluded all lines of business not directly related to home building.
Among the more counterintuitive findings contained in the report are:
- The group as a whole has never lost money from their home building operations, excluding impairments.
- From 1989-1991, home building net income for the proxy builder (excluding impairments) decreased 76 percent from peak to trough. Based on these estimates, the Credit Suisse housing team expects home building net income to decrease 79 percent from the peak in 2005 to the trough in 2007, suggesting the risk premium for the group (low historical multiples) should remain.
- The industry should earn a 15 percent return on its equity, which after factoring in growth opportunities, the volatility of the model and capital requirements, resulted in a valuation of roughly 9 times earnings and 1.35 times book.
This differs from some current estimates, based on data going back to 1989, which put the average return on equity as high as 17 percent.
"It's not an accurate reflection of what a true return is," said Zelman.
Specifically, the proxy builder generated a median and average home building return on equity of 14.1 percent from 1980-2006, according to the report, which is entitled "Broadening the Picture – A Near 30-year Analysis of Homebuilding." Ample evidence of the boom was found in the years 2003-2005, with ROE in 2003 at 23 percent, 2004 at 27 percent and 2005 at 29 percent, which each exceeded any prior peak.
Based on that analysis, Credit Suisse concluded that "a builder with operations diversified across the country should generate operating margin in the 8 percent range, and assuming a leverage ratio of 44 percent can return an average of 14 percent to equity holders and 10 percent to total capital holders per year, over the full cycle."
All of which led the team to the following conclusion: "In general terms, the only way a builder can differentiate itself enough to garner a higher multiple relative to the pack is to grow faster, without taking on additional risk via leverage, or to grow more profitably, without investing additional capital via land. In our opinion, the reasons multiples have been so tight in this industry, is that the market is too homogeneous and the product is viewed too much as a commodity to support this differentiation."
Another key finding of the report is that home pricing is the single most significant contributor to ROE. Over the next several years, Zelman said, "I think that we're going to be dealing with the excesses of a boom market." And, she added, "Without pricing [upward], ROEs will be negatively impacted."
Just like the early '90s. "From 1989-1991, home building net income forour proxy builder (excluding impairments) decreased 76 percent from peak to trough," the report states.
"Based on our estimates, we expect home building net income to decrease 79 percent from 2005's peak to 2007's trough."