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

The era of NINJA ("no income, no job or assets" ) subprime loans sold by fast-talking storefront mortgage brokers is dead, after all. By some estimates, up to three quarters of sales made in Southern California, Nevada and Florida in the go-go era of 2004-2006 involved some sort of fraud, particularly in the form of exaggerated income.

Foreclosure rates are soaring, and as those owners are kicked out of their homes for not paying, the structures are sitting empty, with no one waiting in line to buy at any price. Meanwhile, more than $1 trillion in adjustable-rate loans will kick mortgage payments much higher by June 2008 for tens of thousands of homeowners, which will push foreclosure rates even higher as people simply walk away from houses they can't afford. I saw this happen in the last down-cycle in Los Angeles in the late 1980s; it gets ugly and stays that way for years, not months.

According to a report by investment bank Punk Ziegel, there are 17.4 million vacant houses in the country, and only 4.3 million of those are second homes. That means there are more ownerless houses in the United States today as a percentage of total inventory than at any time since records have been kept.

Not only are there not enough qualified households available to take them over, but demographics are heading the opposite direction. A Punk Ziegel analysis shows that the number of people aged 25 to 34 -- the age of most home buyers -- peaked in 1989 and will not get back to that level until 2013.

Waiting for a bankruptcy

As a result of too few buyers facing too many homes, the rate of price depreciation has been accelerating, with a 3.9% year-over-year decline in July nationwide after a 3.4% decline in June and a 2.8% decline in May. There is little doubt that builders will be forced to write down more of their inventory as losses over the next quarter, further eroding book values.

Although there are pockets of strength, such as my hometown of Seattle, home values in areas like Detroit, Los Angeles, Phoenix, Tampa, Miami and Washington, D.C., are plunging, with year-over-year declines as great as 9.7%, according to data released by research group Case-Shiller.

While it's tempting to suggest that the price declines should abate soon, there's evidence to the contrary. A new trading instrument called "home price futures" -- based on the S&P/Case-Shiller Home Price Indices -- debuted on the Chicago Mercantile Exchange last month, and real-money bets are being placed that suggest another 8% decline is in store nationwide by this time next year, and an 11% decline is expected by November 2009.

Views on futures exchanges can change quickly, of course, but they merit attention. The psychology of falling prices reinforces the view among potential buyers that they might as well bide their time for lower prices -- an attitude that naturally exacerbates the phenomenon.

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

So when can we expect a real turn? Ned Davis Research analyst Joseph F. Kalish suggests we look for these signs: There must be a moderation in the rate of decline of home sales to around 0%; mortgage purchase applications must rise; 30-year mortgage rates must decline to less than 6%; affordability needs to improve dramatically; inventories need to fall to a seven-month supply; and the number of building permits and housing starts needs to sink to an extreme. I will add one more of my own: At least one major home builder must go bankrupt.

Kalish warns that even when all hurdles are met the industry will still face a long road to recovery. Ultimately, to be sure, home builders' shares will re-inflate, and new real-estate fortunes will be made. Don't expect it for at least a year, though, except for occasional bouts of wishful thinking, like the one the stocks are currently enjoying. In summary, it's too late to short these stocks because they are indeed very cheap -- but it's too early to buy, too.

Fine Print

To learn more about the Case-Shiller Home Price Indices, visit this page at the Standard & Poor's Web site. Here is the futures page at the Chicago Mercantile Exchange. . . . Keep in mind that the Bush administration will try to prevent a housing meltdown from occurring by throwing taxpayer money at delinquent mortgage holders and jawboning lenders. I explained how this could possibly work last month in this column. . . .

Back on Sept. 14, I urged banks to come cleanon their losses in fixed-income investments and trading. It was nice to see Citigroup (C, news, msgs) and UBS AG (UBS, news, msgs) actually finally admit this week that they've suffered massive losses in mortgage-backed securities, subprime loans and derivatives. Their losses were actually breathtaking -- many times worse than those suffered by Long-Term Capital Management back in 1998. I still think there is more to come, so stay tuned. . . .

It's kind of amazing to see how investors have come to see high-growth stocks as a safe haven. Chipotle Mexican Grill (CMG, news, msgs) is up 117% since I recommended it back in Novemberof last year, while shoemaker Crocs (CROX, news, msgs) is up 55% just since I wrote about it in June.

At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.