In October 2005, our BIG BUILDER column noted that we expected demand to slow as rates rise and a third soft landing unfolds in the housing cycle. In this article, we outline the mechanics of a softening period and how builders respond to weaker demand and more supply.

YES, I MEAN NO In the fourth quarter of 2005, cancellation rates among the builders averaged 22 percent, up approximately 280 basis points from the end of 2004. Nonetheless, this was still below the 25 percent average reported in the 2000-02 period. As inventory levels of both new and existing homes increase in key markets, we expect cancellation rates to rise toward historical highs. They will likely plateau by the end of this year.

As demand and traffic slow, builders use incentives to drive sales. Although the advertised incentives may seem aggressive, up to now, these big discounts apply to a limited number of unsold homes. Often, these homes have fallen out of the backlog because of investment buyers walking away from a deposit, or because buyers are unable or unwilling to sell their current home at a softer price than a few months ago. Since the builders often hold on to these deposits, we do not expect margins to get hurt much.

ATTACHMENTS Public builders are offering more attached housing to combat rising land costs and constrained affordability. In 2005, 17 percent of D.R. Horton's deliveries were from attached units, up from none just 10 years ago; management expects that attached homes could eventually represent as much as 25 percent of closings. Attached housing expands builders' buyer base to include move-down active adults and first-time buyers looking for an urban environment.

Although many of the builders have already implemented permanent cost-cutting initiatives, we believe these efforts will gain increased traction in a more moderate demand environment. There's anecdotal evidence of more favorable terms on land purchases, including longer take-down periods for option purchases, smaller required deposits, and less frequent use of profit participation for land sellers. Similar patterns are likely among raw material suppliers and subcontractors. Since their peak in May 2005, lumber prices are down 25 percent. Large builders will gain leverage over both suppliers and subcontractors, which should result in more cost reductions.

We expect that a more difficult operating environment could drive an increased rate of consolidation, as big builders increasingly leverage their competitive advantages over smaller builders. These advantages include:

DIVERSIFICATION By addressing a larger market, including multi-family and active-adult buyers, builders can continue to grow by better matching buyer demand. In addition, with operations in multiple markets, the public builders are less exposed to weakness in one locale. Over the last three years, strength in California, Florida, and Arizona has offset exposure in weaker markets like Colorado, Texas, and the Carolinas.

LEVERAGE, PERIOD As the industry further consolidates, the remaining large builders can gain leverage over suppliers and subcontractors. We believe builders can unlock significant value in these relationships by focusing on improving inefficiencies in the building process.

Improved credit ratings have led to greater access to the capital markets, where public builders are financed with longer-term and lower-cost capital. The benefits are: 1) access to land that smaller players do not have the resources to pursue; 2) a lower cost structure, which allows profitable pricing below what smaller players can afford; and 3) the ability to buy out private companies at more attractive prices as the small companies realize that the choices are to sell or slowly be squeezed out of business.

Margaret Whelan is an analyst with UBS Investment Bank.