Storm Front Approaching the Home Builders

There is only one problem with the home builders – expectations are way too high. The builders are not only priced for perfection by the market, the builders themselves have business strategies that are modeled for perfection. I believe the bar is set at an unattainable level.

Here is why.

In the beginning there is raw land. It takes years, if not decades, to develop this raw land into finished lots, lots that are ready for permitting and construction. When the final product is sold, the process of monetizing land is completed. Depending on their strategies, home builders buy land during various stages of this long development process. NVR, for example, is at one extreme. They only buy finished lots based on what they need at the moment. Even with NVR, it will still take them a few months to complete the finished design and put up a couple of models before they can officially market the communities. Most other builders take much longer from land purchases to final sales. They are exposed to market fluctuations during this holding period.

 


 

NVR, Inc.: buying only finished lots




With the time lag, there are three possible outcomes. First, when the houses are finally sold and closed, the sales price and costs are exactly what the builders projected when the land was purchased. Second, market conditions improve beyond their original estimates and margins come in much better than expectations. Finally, the third possibility is market conditions turn out to be far below expectations and all profits gone.

The lesson here is that it is not enough for the real estate market to be improving for the builders to be profitable, they need to have a low enough cost basis in order to have a decent margin. To really do well, they will also need volume.

 

Looking back a decade, starting with the bursting of the tech bubble, the builders were preparing for lean years and did not overpay for land. They did not know that Greenspan had different ideas. Consequently, with the Greenspan versions of quantitative easing, their margins increased way beyond their expectations. With the surprise windfall, builders went wild and paid higher prices to replenish their land inventory. This did not affect their profit margins. The subprime bubble was beyond their wildest dreams and offset all the higher costs, generating even more profits. At the peak of the bubble, the builders were totally fearless and kept buying land at even higher prices until one day it all came tumbling down.

Where are we today and why do I believe a storm front is fast approaching?

Easy Money, and Cheap too. With the help of the Bernanke QEs, every builder has since issued equity, convertibles, new debt and/or refinanced existing debt. The cost of these funds is unbelievably reasonable. This is however a double-edged sword. The cheap money lures the builders into buying more land and/or develop what they already have on hand. The cost basis is no longer cheap.

Land Cost. If we take a snap shot of the builders' land portfolios today, most builders have plenty of land but the finished lot inventory has been absorbed by the favorable conditions so far this year. To survive, they have been purchasing finished lots to meet demand. During the recent earnings conference calls, most builders still claimed that they have underwriting standards that do not rely on future home price appreciation. Anyone who has looked at any recent land deals knows that is not true. They can also spend money developing the raw land in their own inventory but that would add to costs and hurt earnings for the current and upcoming quarters.

No Competition, for now. The builders could not have planned for a more perfect set of circumstances. Whether it is intentional or unintentional, public policies have been the greatest friend the builders can dream of. They were given free money in the form of tax loss carry-back. There were tax credits. The greatest gift, of course, are low mortgage rates along with cumbersome underwriting documentation. Builders are uniquely positioned to coach buyers through the process, far better than their existing homes counterparts. Distressed properties are artificially held off the market. For the better deals that do reach the market, investors are gobbling them up, forcing the owner users to overpay for new homes.

Confused. The market is confusing a listing shortage with a housing shortage. The US population grew by only 2.3 million between 2010 to 2011. Housing starts for this year are around 900,000. Baby boomers are rapidly reaching retirement age, changing housing demand. Employment remains stagnant with no signs of wage appreciation. We are at best at equilibrium, while the market is still trying to absorb the excesses of the past decade.

In summary, the building model is flawed. They cannot avoid boom bust cycles. Right now, builders have to keep buying even if they believe that the market may slow. When every "A" location property is receiving multiple bids from builders, the price is not likely going to be cheap. Can the builders afford to buy, at prices that rely on future appreciation? Can the builders afford not to buy? How are they going to generate revenue if they are not buying land and therefore not building?  Shareholders would destroy them. They have no choice but to keep building, hoping favorable market conditions will continue indefinitely. Having used up most of the cheap land already, builders are now facing a "must appreciate" predicament. If the market slows, look out below.

 


 

The Home builder ETF, XHB – still in the market's good graces for now, but for how long?

 


 

 

Charts by: StockCharts.com


 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • America Goes Full Imbecile
      Credit has a wicked way of magnifying a person’s defects.  Even the most cautious man, with unlimited credit, can make mistakes that in retrospect seem absurd.  But an average man, with unlimited credit, is preeminently disposed to going full imbecile.   Let us not forget about this important skill...  [PT]   Several weeks ago we came across a woeful tale of Mike Meru.  Somehow, this special fellow, while of apparent sound mine and worthy intent, racked up...
  • Retail Capitulation – Precious Metals Supply and Demand
      Small Crowds, Shrinking Premiums The prices of gold and silver rose five bucks and 37 cents respectively last week. Is this the blast off to da moon for the silver rocket of halcyon days, in other words 2010-2011?   Various gold bars. Coin and bar premiums have been shrinking steadily (as have coin sales of the US Mint by the way), a sign that retail investors have lost interest in gold. There are even more signs of this actually, and this loss of interest stands in stark...
  • Credit Spreads: Polly is Twitching Again - in Europe
      Junk Bond Spread Breakout The famous dead parrot is coming back to life... in an unexpected place. With its QE operations, which included inter alia corporate bonds, the ECB has managed to suppress credit spreads in Europe to truly ludicrous levels. From there, the effect propagated through arbitrage to other developed markets. And yes, this does “support the economy” - mainly by triggering an avalanche of capital malinvestment and creating the associated boom conditions, while...
  • Gold Divergences Emerge
      Bad Hair Day Produces Positive Divergences On Friday the ongoing trade dispute between the US and China was apparently escalated by a notch to the next level, at least verbally. The Trump administration announced a list of tariffs that are supposed to come into force in three week's time and China clicked back by announcing retaliatory action. In effect, the US government said: take that China, we will now really hurt our own consumers!  - and China's mandarins replied: just you wait, we...
  • Industrial Commodities vs. Gold - Precious Metals Supply and Demand
      Oil is Different Last week, we showed a graph of rising open interest in crude oil futures. From this, we inferred — incorrectly as it turns out — that the basis must be rising. Why else, we asked, would market makers carry more and more oil?   Crude oil acts differently from gold – and so do all other industrial commodities. What makes them different is that the supply of industrial commodities held in storage as a rule suffices to satisfy industrial demand only for a...
  • Chasing the Wind
      Futility with Purpose Plebeians generally ignore the tact of their economic central planners.  They care more that their meatloaf is hot and their suds are cold, than about any plans being hatched in the capital city.  Nonetheless, the central planners know an angry mob, with torches and pitchforks, are only a few empty bellies away.  Hence, they must always stay on point.   Watch for those pitchfork bearers – they can get real nasty and then heads often roll quite literally....
  • Lift-Off Not (Yet) - Precious Metals Supply and Demand
      Wrong-Way Event Last week we said something that turned out to be prescient:   This is not an environment for a Lift Off Event.   An unfortunate technical mishap interrupted the latest moon-flight of the gold rocket. Fear not true believers, a few positive tracks were left behind. [PT]   The price of gold didn’t move much Mon-Thu last week, though the price of silver did seem to be blasting off. Then on Friday, it reversed hard. We will provide a forensic...
  • Merger Mania and the Kings of Debt
      Another Early Warning Siren Goes Off Our friend Jonathan Tepper of research house Variant Perception (check out their blog to see some of their excellent work) recently pointed out to us that the volume of mergers and acquisitions has increased rather noticeably lately. Some color on this was provided in an article published by Reuters in late May, “Global M&A hits record $2 trillion in the year to date”, which inter alia contained the following chart illustrating the...
  • Cryptocurrency Technicals – Navigating the Bear Market
      A Purely Technical Market Long time readers may recall that we regard Bitcoin and other liquid big cap cryptocurrencies as secondary media of exchange from a monetary theory perspective for the time being. The wave of speculative demand that has propelled them to astonishing heights was triggered by market participants realizing that they have the potential to become money. The process of achieving more widespread adoption of these currencies as a means of payment and establishing...
  • The Fed's “Inflation Target” is Impoverishing American Workers
      Redefined Terms and Absurd Targets At one time, the Federal Reserve's sole mandate was to maintain stable prices and to “fight inflation.”  To the Fed, the financial press, and most everyone else “inflation” means rising prices instead of its original and true definition as an increase in the money supply.  Rising prices are a consequence – a very painful consequence – of money printing.   Fed Chair Jerome Powell apparently does not see the pernicious effects...
  • A Walk on the Wild Side
      A Walk on the Wild Side   “Never play cards with a man called Doc.  Never eat at a place called Mom’s.  Never sleep with a woman whose troubles are worse than your own.” – Nelson Algren, A Walk on the Wild Side   Fresh Fruit or Rotting Vegetables? A subtle gas seems to always be vented into the atmosphere at the sunset of an extended bull market.  As the light fades, an odor that’s indiscernible from that of fresh fruit or rotting vegetables wafts down...

Support Acting Man

Item Guides

j9TJzzN

The Review Insider

Dog Blow

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com