Housing's long-anticipated downturn unfolded more sharply than many expected despite healthy underlying demand and low mortgage rates. Constrained affordability—the worst it's been in 15 years—was a key factor. Now, home prices are falling as much as 10 percent to 15 percent from their peak, with wide variances among declines across local markets.
Lower home prices—and a six-tenths of 1 percent decline in mortgage rates since June 2006—have rekindled demand. While inventory on a trailing four-week average declined by 7 percent since peaking in October 2006, new single-family home sales have declined by 23 percent from the top to an annualized run rate of 1 million. Builders responded by cutting supply.
The sharp correction in demand over the last 12 months, coupled with declining average prices, has driven many builders to switch from growth to harvest mode. Relative land positions, calculated in terms of years of supply, have increased to 8.8 years, up from 6.5 years at the end of the third quarter 2005. This is forcing builders to scrutinize their land assets, and many are walking away from optioned lots with the assumption that returns on land purchased later in the cycle will be higher. Consequently, liquidity and free cash yields are improving. On average, the rate of decline in lot positions of 16 percent has exceeded that of home prices, positioning the builders for margin expansion once demand recovers.
As falling demand pressured prices to sink in 2006, the value of land builders control took a downturn. Land they'd secured in the last 12-plus months is especially vulnerable. As expected, home builders aggressively “scrubbed their balance sheets” to recognize impairment their land assets through year-end. We think these charges peaked in fourth quarter 2006, but they will crop up this year, too. They negatively impact near-term profits. But, resetting the land cost base should help drive margin expansion once demand re-accelerates.
Our builders' sales and earnings per share enjoyed a five-year compound annual growth rates of 26 percent and 37 percent respectively—with a concurrent 10 percentage point average increase in return on equity of 34 percent. Something had to give. Besides lower unit volumes, margins are falling as a result of price cuts and increased selling costs to sell standing inventory. We expect cancellation rates to improve in the year ahead from 40 percent to 25 percent. Toward the end of 2007, as inventory diminishes, prices—and subsequently demand—should improve.
We're estimating a 2006 EPS drop of 31 percent year over year. Further, we anticipate a 51 percent decline in 2007. We're assuming operating margins of 11 percent in 2006 dropping to 7 percent in 2007, although margins may vary depending on the extent of further land charges. Normal operating margins are in the 10 percent to 12 percent range; they peaked at 16 percent in 2005. We forecast a 58 percent year-over-year decline in 2007 average net income. Assuming that the majority of net income is accretive to retained earnings, we forecast that tangible book value per share should grow by an average of 7 percent. Unless land prices continue to decline and pressure book value, we expect book value gains in 2007.
–Margaret Whelan is an analyst with UBS Investment Bank.