For home builders, the worst is to come

By Jon Markman

Citigroup sparked a sharp rally in the home-building industry this week by upgrading the group in a 54-page report titled "The Dark Before the Dawn." A few of the most beaten-down companies in the sector saw shares advance as much as 8% in a couple of days, while most rose at least 3%.

Not bad, yet you just have to wonder what Citigroup analysts and the avid buyers were smoking. Because a more sober title for a report on the prospects for residential real estate would have been "It's Always Darkest Before It Goes Pitch Black." Or perhaps "Dawn of the Dead."

The home-building industry, after all, is all about building homes. And that is a big, big problem in a country that has way too many of them. The stats vary by region, but the national inventory of homes is at an all-time high, with an eight-month supply. One in 7 1/2 houses is actually vacant. Prices are tumbling. And there is little relief on the horizon, even from the Federal Reserve.

The early bird gets to worry

I know this isn't really news to anyone who's been paying attention. But it seems that some analysts and investors want to be heroes by calling the turn a few months before they believe it will occur. My suggestion: Let's skip the whole bit about how it pays to be early as a value investor. I seem to remember that phrase about networking stocks in 2001, and many of those companies still haven't recovered six years later.

• Talk back: What effects do you see from home builders' woes?

Although it has scraped itself up off the floor lately, Cisco Systems (CSCO, news, msgs), for example, is still 60% off its 2000 high. That's better than the 90% discount seen a few years back, but anyone who bought into the optimism early is still waiting for a payday.

The main point for home-building bulls is that valuations have already plunged to levels last seen at the bottom of the real-estate recession in the early 1990s. Builders' shares stopped collapsing back then when their price-to-book values hit an average 0.54. Right now, many homeys -- as traders call the stocks -- are in that realm and worse. Some of the industry's most prominent companies, such as Beazer Homes USA (BZH, news, msgs), Standard Pacific (SPF, news, msgs) and WCI Communities (WCI, news, msgs) have the lowest valuations, trading at 0.22 times, 0.26 times and 0.27 times book value, respectively, after seeing their stocks decline by as much as 85%.

While that sounds undeniably juicy, chief executives in the industry still report no signs that buyers are demanding more houses even after the half-point cut in interest rates by the Fed. Quite the opposite: In conference calls they've said they expect conditions to worsen over the next 12 months, further contracting book value as the value of their vacant land collapses and cash flow thins.

These anecdotes, plus the data, suggest the builders have at least one more serious leg down to go, as earnings estimates are cut further for 2008.

Death of the NINJA

The problem with comparing the current situation and 1990's is that the Fed cut rates by a full percentage point in the three months starting in October 1990, to 7%. That sparked an initial rush of demand. It then slashed rates by another 4 percentage points over the next 21 months to 3%. Thirty-year mortgage rates fell over the span to 6.8% from 10%, a whopping one-third off.

This time, mortgage rates have already started out really cheap by comparison, at around 6.4%, or about where they bottomed in 1990. So even if the Fed cuts by another percentage point, mortgage rates are still only likely to hit 5.5%, a level unlikely to coax out more latent demand. The mortgage industry has more creative ways of getting the middle class into houses now than in 1990, but banks have tightened way up on lending standards.

Continued: The NINJA era is dead

 1 | 2 | next >