Strategic Exchange - March 2008

By Jay Smith

After eight years in the fast lane, new home construction has finally hit the brakes. Hard. Builders, flooring suppliers and flooring contractors are feeling the pinch. The big question on everyone’s mind is, when will this mess end and the recovery process begin?

We will get to that in a moment, but, first, let’s take a constructive look back at how the segment got to where it is now.

Yesterday—Anatomy of a Bubble
By 2005, the home building market had been going strong for several years. That year we saw over 1.7 million new home starts, the single largest year on record. National builders had been growing at explosive rates. The top ten mega builders were building 25% of all new homes in the country. Flooring contractors were booming, too. Consolidation was happening at all levels of the segment. Life was good. However, even as the segment was setting records, clouds were forming on the horizon. It was in 2005 that we first heard the whispers of that dirty little word… bubble.

Some were comparing the housing market to the dotcom bubble that had burst a few years back. But most industry participants and watchers in 2005 did not foresee the dramatic bursting of a national bubble. In fact, many did not even see a bubble. They believed that the markets for housing and homebuilding are just too individual in nature. Sure, some of the super-heated housing markets like Phoenix, southern California, Las Vegas, and Florida would have to come back to earth a bit, but that wouldn’t equal a bursting national bubble.

But, simply put, the majority got it wrong. Due to cheap, easy money, ever increasing home prices, and a healthy dose of irrational exuberance, we had ourselves a nice, big housing bubble. A bubble that was set to pop… and pop it did. In 2007, starts of new single family homes were off over 40% from the highs in 2005. Builders and their suppliers around the country are feeling the pinch, none more so than the large public builders. The combined market value of eight big homebuilders (Lennar, D.R. Horton, Toll Brothers, Centex, NVR, Pulte, KB Home and MDC), which reached a peak of $80 billion in 2005, was reduced to less than $20 billion during January of this year. Now don’t feel too bad if you were a subscriber to this line of thinking. Alan Greenspan, former Federal Reserve chairman, has said that even he “didn’t really get it until very late in 2005 and 2006.”

TODAY—Action and Reaction
Credit
Housing was supercharged with historically low interest rates and overly aggressive mortgage lending practices. The fact that the subprime market fell apart should not have been a shock to anyone. After all, the subprime loan was invented to loan funds to those who have proven to be poor credit risks.

The subprime problem has received most of the attention, but other mortgage practices share the blame. We had adjustable rate mortgages purchased by buyers who did not understand that the ‘adjustable’ part meant that their payments could, and would, skyrocket. We had loans in excess of a home’s appraised value, reverse-amortization loans, low-document loans and, my personal favorite, the interest-only loan. The credit market became an enabler and Americans took the easy money. Every other person you met at a cocktail party was an expert real estate investor/speculator. Flip that house!

Today, the credit guys have their hands firmly on their wallets again and are very risk averse. The days of closing a loan without having to produce a W-2 are behind us.

However, there are some positive developments. Money is still cheap and that is very important for housing. The stimulus package from Washington, though small, is on the way. Lenders are finally seriously looking for ways to keep their borrowers in their homes and out of foreclosure, including restructuring rates and payments for qualifying home owners.

Affordability
The frothy environment created inflation in home prices. The fundamental problem with affordability was that home prices outpaced income growth, a condition that is not sustainable. From 1990 to 2006 the median home price in the U.S. doubled. At the same time income rose 60%, which matched inflation. A couple of specific market examples: in Miami, income just matched inflation while home values quadrupled. In parts of Las Vegas, income doubled, but home values went up fivefold.

The net result in many markets was that regular folks could no longer afford to buy a home where they worked. At the height of the market in the Long Beach/Glendale area, just 3% of the homes were affordable on the median household income in the area.

This issue is currently correcting itself, and 2007 saw the largest drop in home prices in years. This return to affordability is a very healthy thing for the market recovery.

In December, the national median price of a new home was down more than 10% over 2006. It’s off even more in some spots. In Las Vegas for example, it was reported that the median price of a single-family home dropped 17.3% from a year ago.

Inventory
Housing supply exceeded demand. We simply built more homes than we needed. As a result, homes went unsold and inventory went up—way up. We now have more than ten months of inventory. Three months of inventory represents a healthy, balanced market. We will have to churn through this inventory on our return to health. The downturn in new construction is actually a positive as it relates to inventory and long term recovery. The construction slow down allows time for supply to balance with demand as existing inventory is sold. This is a painful, but necessary, step in the recovery process.

As construction slows, builders, flooring suppliers and contractors are put under tremendous pressure. Flooring contractors, in particular, are facing a squeeze. They are stuck between a very demanding builder customer who is looking for cost reductions and flooring manufacturers who are raising prices. These increases are difficult, if not impossible, for the contractor to pass along in this environment. This pressure on costs has caused product shifts in some markets. For example, in some cases we have seen resilient sheet being used where ceramic tile had been the long-running standard.

Builders are now offering very aggressive incentives to turn their existing inventory of homes and land into cash. In January, Ryland Homes conducted a major sales promotion at their neighborhoods across the country. John Wieland Homes in Atlanta also held a successful sale, moving 89 homes in just ten days this January. This is a very positive sign that when the circumstances are right the buyers will return. DR Horton is offering homes in California at discounts of up to 50%.

Tomorrow—Ready to Recover
We’ve yet to hit bottom, but at least we can see it from here. This year will be another challenging year for builders and the flooring players who service the segment. However, I am strongly bullish on residential construction. Similar to the early 1990’s, we are in a momentary rough spot that will be followed by another extended period of robust activity. We should see the beginning of a recovery in 2009. Most important for those with a long view, demand for new housing will be strong for the next 20 years.

Experts say the household creation from 2005 to 2015 will be between 11 million and 15 million. Another 11 million are forecasted to be created through 2025. Get ready to house well over 20 million new households by 2025.

Home ownership continues to be the “American Dream” and that’s not going to change anytime soon. The homes we build tomorrow, however, will surely look different. We can expect less suburban, tract style projects. We will see more urban infill, cluster homes, attached product, mid- and high-rise projects, and extensive remodeling of our existing, aging housing stock.

The home buyer, too, will be changing. Immigration is a significant factor, accounting for more than one third of net household growth between 1995 and 2005. It is interesting to note that one out of every five American households speaks a language other than English at home.

Dotcom of the early 2000s had its irrational exuberance. The housing market of mid-2000s had its frothiness. Both were bubbles, both busted and both will recover and grow. The technology sector, in fact, is well on its way to a brighter future. Opportunity knocks for smart and energetic companies in the housing segment.

The best companies will see all the facts regarding housing. They will see that money is still available to qualified home buyers and that it is very cheap. They will see that homes are becoming more affordable for America’s home buyers. They will see that the reduction in new construction means that inventories will be coming down, rebalancing the market. They will see that the long term demographics of our country are very favorable to new home construction. They will even see that U.S, government policies encourage and enable the American dream of home ownership.

The best companies will see these positive facts and they will act. They will return to their entrepreneurial roots. They will act like a new entrant to the market. They will not be prisoner to how they did it two years ago. They will improve their marketing, train their people, increase their service levels, seek out partners who offer support and know-how, and find creative ways to add value for their customers. Ultimately, these companies will not only survive, but prosper.

Dotcom companies like Google, Microsoft, and eBay have shown us there is life after a bubble. Conditions in the new home construction market will pass. Be there and be ready when it happens.