If stock prices represent a reliable indicator of fundamental trends, one would be led to believe that the outlook for home builders is quite rosy. Since the start of the year, major public home builder stocks have appreciated nearly 40 percent on average, versus the broader market which is down 7 percent. I have heard many reasons for the market’s optimism, most notable of which is the theory that a government bailout of foreclosed homeowners, higher loan limits on government-sponsored mortgages, a tax credit for buyers of new and foreclosed homes, and a four-year tax-loss look back for builders will stabilize the housing market and ultimately lead to an earlier-than-expected recovery. Despite the apparent optimism, I continue to believe that the fundamental outlook for the industry remains extremely challenging, and more pain is on the horizon. I expect the glut of home inventory, weak absorption rates, turmoil in the mortgage markets, and a deteriorating job environment to pressure pricing downward.
Given this dynamic, I expect new-home prices to continue to decline approximately 10 percent to 15 percent through 2009. I expect existing-home prices to fall even further, declining through 2010 or 2011, as existing-home prices have been stickier than new-home prices on the way down. These price declines should further pressure land values, which I estimate are already down approximately 40 percent from peak levels for finished lots and down as much as 80 percent in some former investor hotbed markets. Raw lot prices have plummeted even further, with an average decline of 60 percent from their peak. In many markets throughout California, Arizona, and Florida, finished lots are now worth less than the cost of development.
While many industry participants believed that Lennar’s bulk land sale in November 2007 at 40 percent of book value was artificially low in order to generate tax refunds, subsequent deals by M/I Homes (at roughly 30 percent to 35 percent of original purchase price) and Centex (approximately 15 percent to 20 percent of purchase price) demonstrate the recent free-fall in land prices. I expect builders to take additional impairments over the coming quarters as land values deflate further.
The wild card remains the banks and how they will deal with all of the non-performing real estate loans on their balance sheets. According to data from the Federal Reserve, at the end of 2007, real estate–related loans represented 53 percent of total loans for commercial banks versus a historical exposure of 41 percent. Smaller, commercial banks are even more exposed, with 71 percent of loans related to real estate, 46 percent of which is in the commercial real estate bucket, which are primarily loans for acquisition, development, and construction. While performance on these loans has begun to weaken somewhat, I believe we are in the very early innings of this game.
Although the banks have finally awakened to their woes and become aggressive in re-margining assets or, worse, foreclosing on properties, I believe we are only in the early stages of this capitulation. Banks have begun talking to investors about selling bulk loan packages, but the bid-ask spreads are still way too wide. Therefore, no significant transactions have taken place yet. The magnitude of downside in home and land values will likely be contingent on the regulators and how much pressure they apply to the banks in the coming months.