RX for Recovery

As the new year drawns, A blood-red sun rises on the horizon, warning of even bigger troubles for home builders than they experienced during a disastrous 2007.

Too dire a forecast? Not according to the economists, analysts, and other industry experts BUILDER consulted for this story. Major financial institutions, along with home builders large and small, will be dragged into bankruptcy and some will go out of business before the year is over, the experts say.

“We'll see a number of major builders file,” says David Shulman, senior economist at the University of California at Los Angeles Anderson Forecast. “You have to see that it's part of the clearing out process. It's ugly. We're going to have the mirror image of the joys of 2005 in how depressed people will be.”

Factor in growing economic tumult and increasing chances for recession in the broader economy, and we couldn't offer up a typical forecast for 2008. So BUILDER set out to learn what factors will facilitate an eventual recovery and where the metrics need to be for home building to rebound.

The leading indicator for recovery named by our experts was the reduction of high levels of inventory of new and existing homes for sale. Obviously, demand, as seen through home sales, needs to increase as well. But before it does, home buyer confidence needs a boost, credit conditions need to improve, and home prices (new and existing) need to come down to a point where consumers value affordability over the possibility of prices falling still further, which in turn will cause them to pull the trigger and buy.

At present, one of the greatest challenges for home builders is that their potential customers are struggling to sell their current homes. Some are having difficulty getting the price they desire and some can't seem to find a buyer at any price. Would-be first-time buyers for these existing homes are having trouble getting financing, and those looking to move up to a larger existing home can't sell their current home, many experts say. It's a vicious circle that stymies efforts at all levels.

While some optimists are heralding the end of the housing recession, it appears to some that a bloodbath may be just beginning. Several top home building consultants with access to the financial information of private builders say it looks bad.

“I'm very upset for a lot of my private builders,” says Ivy Zelman, founder and CEO of Zelman and Associates. “There are a lot of builders that are going to run out of cash in March, and there are going to be more foreclosures and insolvencies than I would like to admit.”

Rest assured, however, conditions will change, and consumers will once again start buying both new and existing homes. But that's going to take time, and sales of new homes are not likely to find a bottom until the end of 2008 or 2009 when they hit somewhere close to 600,000 units, say some of our experts. Others see the bottom occurring somewhere around 700,000 units during 2008, with John Burns, president of John Burns Real Estate Consulting, in Irvine, Calif., boldly predicting sales to have already hit bottom in the fourth quarter of 2007.

One of the major factors impacting demand for new homes is the overwhelming abundance of vacant housing units. Oversupply caused by overbuilding is being augmented by foreclosed properties and by houses that builders sold only to have the buyers cancel on them. However, homes that are once again for sale due to cancellation are not accounted for by either new-home sales data from the U.S. Census, or the existing-home data put out by the National Association of Realtors. This has created a shadow inventory of massive but indeterminate size.

“There is substantial vacant unit inventory in both the new-and existing-housing stock,” says NAHB chief economist David Seiders. “That's the legacy of the investor/speculator boom, and that's what we're living with.”

Nationally, the worst inventory troubles are in the very areas where builders have been building the most and continue to build, in the suburban fringe, says Mark Fleming, chief economist for First American CoreLogic, based in Santa Ana, Calif.

“What we need to see, as inventories begin to fall again and the inner core markets begin to stabilize and the prices even begin to rise again, is for demand to push back out to the fringe,” Fleming says. “Once that demand returns, the absorption rates will rise and builders will be able to clear more homes and build more homes. But that's going to take a few years.”

Still, if you were watching one number for an indication of a market resurgence, Karl Case, the Katherine Coman and A. Barton Hepburn Professor of Economics at Wellesley College, says that a decline from an eight month's supply of new homes to roughly six months would signify a turnaround.

FURTHER TO GO: New-home starts have fallen by at least 61 percent from their peak in past cycles. In the current cycle, housing starts have fallen only 47 percent.

“Unless you work off the inventory, you're not going to be building a lot of new,” Case says.

Unfortunately, inventory is likely to increase before it decreases into the second quarter of 2008, says Mark Zandi, chief economist for Moody's Economy.com. The Census counts 2.1 million vacant for-sale houses as of its third-quarter report on Oct. 27, and Zandi says 1.25 million is a sustainable level of vacant for-sale homes, counting both new and existing.

Ongoing construction of new homes as well as mounting foreclosures will continue to increase housing supply. Zandi is hopeful foreclosures will be stemmed somewhat by loan modification efforts announced in early December by the federal government. If the policy moves fail, the home building and overall housing markets will be in free fall throughout 2008, Zandi warns.

Builders' control over inventory comes via selling their homes, cutting starts, or mothballing communities until better times return. But reducing construction or sitting on communities may be hard for many builders to stomach, says Jonathan Dienhart, director of published research for Hanley Wood Market Intelligence, a sister division of BUILDER.

“In their eyes, [building and selling homes] is the best way to proceed to reduce their risk,” Dienhart says. “It's a challenging scenario. We need builders to stop building, but builders build. How do you ask a fish to stop swimming?”

But many builders have been cutting back on construction and will likely continue to do so. Starts will bottom somewhere between 800,000 and 1 million units and sometime between the fourth quarter of 2007 and the end of 2008, says our panel of experts.

“The pessimistic view, it goes to 850,000,” Case says. “The optimistic view is it stops before it hits 1 million. My guess is it will probably be between 900,000 and 1 million.”

Zelman says that while she projects a bottom in starts at 900,000 units, “My gut tells me that's still too high.”

While it may not be possible for starts to fall enough to cause supply/demand equilibrium, (sales need to increase as well), builders ought to be curtailing their production further, says Dienhart.

“The supply equation ends up being indicative of how bad it's going to get for builders,” he says. “If they don't control the supply situation, it's just going to make it more painful for them to recover from it. The more they build, the deeper we go into the well, and the longer climb we'll have to get out of it.”

PRICE CUTS: During the last two housing cycles, prices have appreciated about 20 percent, then fallen by at least 12 percent. This cycle saw house prices shoot up 66 percent, but so far price reductions have been modest.

Builders could have help, though, in limiting their production, Zandi says. “Bankers are going to force builders to be more cautious, because they aren't going to extend credit to finance construction,” he says.

Despite efforts by the federal government to freeze adjustable interest rates at low teaser levels to save some borrowers from foreclosure, those measures won't help the most needy, because those homeowners have already fallen behind on their payments and will not qualify for assistance.

In a November speech at the Conference on Competitive Markets and Effective Regulation at the Institute of International Finance in New York, Federal Reserve Board Gov. Randall Kroszner said that 1.8 million sub-prime mortgages will undergo their first rate resets in 2008, which will cause a typical monthly payment to rise about 25 percent.

Zandi estimates that the rate freeze could save about 250,000 mortgages from default, the precursor to foreclosure, but not much more.

Finding a silver lining in what will be, government assistance or no, a deluge of additional properties for sale, Zelman sees foreclosures speeding up the price reduction process.

“It sounds funny to call foreclosures a positive, but the seller is so stuck right now, he doesn't want to sell, and he's going to wait,” the former Credit Suisse managing director says.

But if a homeowner has to sell and sees foreclosure signs going up in his neighborhood, offering houses at significant discounts (the Fed estimates a foreclosed home sells for 23 percent less than if it were not a forced sale), he'll likely decide to cut his price, ultimately aiding affordability, says Zelman.

Affordability, defined as monthly payments on homes as a percentage of gross income, is out of balance in most areas of the country, Zelman says.

“You have to have on average a 20 percent correction in new-home prices in order to get a monthly payment that's back to traditional affordability,” she says.

According to research by ISI Group, an international research firm, from 1971 to 2001, median housing value was between 2.6 and 3.0 times the median household income. As the housing boom took off , that ratio jumped to 4.0, and has since fallen back to 3.8 times median household income. But these are national averages and don't give a clear picture of the extremes that exist in various regions.

In some formerly hot areas, such as California's Inland Empire and Florida's Miami and Sarasota markets, prices need to correct more than 50 percent to get back to traditional measures of affordability, where homeowners spend roughly 30 percent of their monthly income on housing, according to Zelman's research.

Zelman estimates prices will fall until 2010 or 2011, while Burns believes prices will start increasing on average in 2010. Burns says the Inland Empire, where many builders flocked during the boom years, could be the worst market in the country in 2008.

OVERSUPPLIED: Months' supply of new-and existing-home inventory has increased greatly from low levels during the housing boom. With cancellations and foreclosures not tracked in official tabulations, the true level of for-sale inventory is higher still.

“What Fort Myers, [Fla.], was to 2007, Riverside, [Calif.], will be to 2008,” Burns says. “It's going to be everybody's biggest write-offs and worst horror stories.”

If people are fearful about the state of the economy, their investments, their job security, the idea that they may not get a raise or bonus this year, or are simply scared of buying a home that will decrease in value, then affordability can improve all it wants but until consumer confidence improves, price reductions will not lead to sales.

“Sooner or later you are going to need some sort of effective demand to come in. If the consumer thinks prices are going to fall, even if they have the money and they're a qualified buyer, they're not going to buy unless they have to,” says UCLA's Shulman. “The consumer is going to have to have some sense that prices are in a bottoming process, and I don't think they're there yet.”

Early December indicators show signs of what economists even as recently as November said would be impossible: consumers cutting back on spending. Riverwoods, Ill.–based Discover Financial Services saw a decrease from 96.5 to 93.4 for November in its Discover U.S. Spending Monitor, an index that measures consumer spending.

“Consumers are doing their best to adapt to the economic environment, spending more on the things they need while cutting back on discretionary purchases and savings,” said Margo Georgiadis, executive vice president and chief marketing officer of Discover Financial Services, in a statement announcing the data.

Consumer spending accounts for two-thirds of total economic activity; and if it declines even a little, the economy will fall into recession. While home building is already in its own recession, an economy-wide recession could mean a several-year delay beyond 2010 for a recovery for home building.

CONFIDENCE BOOST NEEDED: Builder confidence in the market is at historical lows, and while consumers see low prices as an indicator of this being a good time to buy, tighter credit and falling prices have them waiting on the sidelines.

And the subprime mortgage fallout has far from run its course. A mid-December story in the Wall Street Journal highlights just how much of a drag the mortgage crisis could have on the overall economy, projecting losses of $150 to $400 billion, accounting for 1 percent to 3 percent of GDP. By comparison, the savings and loan crisis of the 1980s saw losses of $189 billion, which was 3.2 percent of GDP.

Robert Shiller, professor of economics at the Cowles Foundation for Research in Economics at Yale University and with Case a creator of the S&P/Case-Shiller Home Price Index, says builders should be watching the overall economy and consumer spending in other industries for signs of what's to come for housing.

“It doesn't take a big movement in consumption to throw us into recession,” he says. “It can be amplified through the markets, and it would be felt by home builders. Home builders feel these recessions more than most people.”