Thoughts on the US Publicly Traded Homebuilders

I noticed that many pundits are focusing on single family residential market, most likely because it is in the news so often. It is bad, very bad. I am an ex-residential real estate investor who sold off in 2005 due to fundamentals that were totally out of whack. It appears that many do not see how precarious the commercial sector has become, with many deals being done at 2-5% cap rates (net profit yields) in Manhattan and many major metro areas, which is absolutely ridiculous considering the risk and illiquidity of these deals. The compensation for these deals are coming no where near justifying the risk. I am sure the excessive liquidity coupled with significant demand caused the cap rate compression, but the buyers fell for it assuming liquidity and demand would continue for some time. Well, corporate liquidity has just dried up, and

many are stuck holding the bag with buildings that are yielding as low as half that of treasuries, yet easily quadrupling the risk. Some are even selling at lower cap rates in successful flips (reference the Blackstone purchase of Sam Zell's portfolio, which was totally overpriced, yet Blackstone managed to flip much of the portfolio over to speculators, some of which actually flipped it over to someone else at a profit - ALL in a period of a few months). This has now become nigh in impossible, but in an attempt to raise the cap rates, commercial rents have skyrocketed to all time highs in the major metro areas, causing significant pressure on corporate profits (I have inside knowledge of this affecting MAJOR public and private firms who are looking to expand and are getting squeezed).

And now, on to small residential (single family and 1-4 family residential)...

For those who really have a life and do not have the time to read building company annual reports, here is a bullet list of tidbits that all will find interesting, particularly in light of today's mortgage environment (pardon if their is info that you are already privy to, this is a comprehensive summary, but I am sure everybody is to find something that is of illuminating):

1. Joint venture debt and depreciating inventory held off balance sheet, so you and I can't see it.

2. A significant amount of the non-conforming market has all but seized up, which will significantly reduce the demand for housing, in an environment where the supply demand ratio was totally out of whack to begin with. I know you think you already know this, but wait...

3. Large public home builders are some of the largest non-conforming mortgage originators, funded by warehouse credit lines that have been the source of unprecedented margin calls throughout the non-bank mortgage industry (which the homebuilders are a member). Banks have internal financing such as deposit accounts to fund mortgages, but non-bank entities must rely on credit lines to fund loans. Significant non-conforming mortgage operations that have already been put out to pasture amount to about 60 mortgage companies - totally out of business, and the secondary market has effectively frozen. Reference LEND, American Home Mortgage, New Castle, most recently LUM to see how quickly this can bankrupt a company. These are entities that do not have to deal with the cash burn and depreciating assets of the homebuilders as well. In just a few months, American went from the 10th largest lender, to bankruptcy. In just one week, LUM went from rosy management pronouncements to postponing earnings and halting trading, stating that their business model has simply been locked up (this is what American did the week it declared bankruptcy). All of these non-bank lenders had margin calls on their credit lines combined with an inability to sell their product. The builders use the EXACT same business model to fund much of their sales, and in some cases the vast majority of their sales. Some builders (such as Centex) named the mortgage subsidiary as one of the significant contributors to their bottom line, performing much better than home building. Think about it.

4. From the 2006 HOV annual report: 9.5% of our home buyers paid in cash and 62.9% of our non-cash home buyers obtained mortgages from one of our mortgage banking subsidiaries. Mortgages originated by our mortgage banking subsidiaries are sold in the secondary market within a short period of time. (Tell that to LUM, LEND, AHM, New Century, etc.) Even those buyers who do not need mortgages will be hurt if they cannot sell their existing properties (to those who need mortgages) to move up to their newer purchase (this is how most pay cash for the 9.5% referenced earlier). Thus the backlog that is stated in the builder's financial statements will not, and cannot, be fully realized, and thus is overstated.

5. From the LEN 2006 annual report: "We provide a full spectrum of conventional, FHA-insured and VA-guaranteed, first and second lien residential mortgage loan products to our home buyers and others through our financial services subsidiaries, Universal American Mortgage Company, LLC and Eagle Home Mortgage, LLC, located generally in the same states as our homebuilding segments and Homebuilding Other, as well as other states. In 2006, our financial services subsidiaries provided loans to 66% of our home buyers who obtained mortgage financing in areas where we offered services. Because of the availability of mortgage loans from our financial services subsidiaries, as well as independent mortgage lenders, we believe access to financing has not been, and is not, a significant
obstacle for most purchasers of our homes." For the record, second lien loans are not being bought in any volume for the week ending the day of this writing. It is the second lien loan that is used to get cash strapped buyers into homes. This is a problem for LEN, if it accounts for up to 66% of their sales. They say they issue FHA and VA loans, but fail to break out a granular analysis. "

"During 2006, we originated approximately 41,800 mortgage loans totaling $10.5 billion. Substantially all of those loans were sold within a short period in the secondary mortgage market on a servicing released, non-recourse basis; however, we remain liable for certain limited representations and warranties related to loan sales."

Can a company that is losing money at the rate of Lennar afford to buy back or get stuck with unwanted assets that have extremely wide spreads such as the $10.5 billion (41,800 actually mortgages) that they quoted here?

"Increasing interest rates could cause defaults for home buyers who financed homes using non-traditional financing products, which could increase the number of homes available for resale.
During the recent time of high demand in the homebuilding industry, many home buyers financed their
purchases using non-traditional adjustable rate or interest only mortgages or other mortgages, including sub-prime mortgages, that involve significantly lower initial monthly payments. As a result, new homes have been more affordable in recent years. However, as monthly payments for these homes increase either as a result of increasing adjustable interest rates or as a result of principal payments coming due, some of these home buyers could default on their payments and have their homes foreclosed, which would increase the inventory of homes available for resale.

In addition, if lenders perceive deterioration in credit quality among home buyers, lenders may eliminate some of the available non-traditional and sub-prime financing products or increase the qualifications needed for mortgages or adjust their terms to address any increased credit risk. In general, if mortgage rates increase or lenders make it more difficult for prospective buyers to finance home purchases, it could become more difficult or costly for customers to purchase our homes, which would have an adverse affect on our sales volume.

We sell substantially all of the loans we originate within a short period in the secondary mortgage market on a servicing released, non-recourse basis; however, we remain liable for certain limited representations and warranties related to loan sales and certain limited repurchase obligations in the event of early borrower default."

6. Additionally from LEN 2006 report: "Our Financial Services segment could have difficulty financing its activities. Our Financial Services segment has warehouse lines of credit totaling $1.4 billion. It uses those lines to finance its lending activities until it accumulates sufficient mortgage loans to be able to sell them into the capital markets. These warehouse lines of credit mature in September 2007 ($700 million) and in April 2008 ($670 million). If we are unable to renew or extend these debt arrangements when they mature, our Financial Services segment’s mortgage lending activities may be adversely affected."

7. Pulte relies on internal mortgage financing for nearly 100% of their home sales. This is a serious problem in the current environment. From the Pulte Annual Report: "In originating mortgage loans, we initially use our own funds and borrowings made available to us through various credit arrangements. Subsequently, we sell such mortgage loans and mortgage-backed securities to outside investors. Our capture rate for the years ended December 31, 2006, 2005, and 2004 was approximately 91%, 89%, and 88%, respectively. Our capture rate represents loan originations from our homebuilding business as a percent of total loan opportunities, excluding cash settlements, from our homebuilding business. During the years ended December 31, 2006, 2005, and 2004, we originated mortgage loans for approximately 77%, 75%, and 72%, respectively, of the homes we sold. Such originations represented nearly 100%, 98%, and 92%, respectively, of our total originations. During 2006, 21% of total origination dollars were from brokered loans, which are less profitable to us, compared with 26% and 36% in 2005 and 2004, respectively. The decrease in brokered loans can be attributed to a shift in product mix towards funded production."

8. HOV, as I am sure other builders, have not only SEVERAL mortgage subsidiaries, but off balance sheet mortgage joint ventures that have the potential to add untold amounts of additional liability and exposure to what has put so many non-bank lenders out of business.

9. The homebuilders, due to their negative cash flow, have either violated or come close to violating their loan covenants. Some have renegotiated them, but have done so with terms that they are not likely to be able to comply with. DHOM has already defaulted on their loans, just to have them bought out by a hedge fund that is charging them 15% interest, up from 9% that the bank charged them for non-investment grade paper. This is a true junk rate that DHOM just can't afford. Look at their numbers... They are losing money hand over fist, and the market is getting worse, not better.

10. Some of builders use special purpose (financing shell) companies that banks fund and the builder repays the bank via swaps to fund their mortgage arms (ex. Centex). Most banks require investment grade swap partners, which most builders will find hard to be identified as.

11. Rating agencies have downgraded most builders to junk status

12. Credit swap spreads are as high as 450 basis points (cost to insure builder debt)

13. Banks have been lenient thus far, but all you need is one to decide that the risk is too great and it will create a run on the builders. The first creditor to move will most likely be the one to get back the most of its lunch money. No one wants to be left holding the bag.

14. Finally, the real estate market, as we all know by now, is entering into a bust, which is most likely to protract into 2 to 3 year range. Do the homebuilders have the cash to last that long, writing down billions of dollars of asset value per year and half of them operating at negative operating earnings (Sans write downs). Will the banks, who have literally ran from non-conforming (loans that cannot be sold to government sponsored entities such as FNMA, Freddie MAC), ALT A, and sub-prime loans be willing to fund these money losing business that rely on these very loans to unload depreciating inventory for another 2 to three years? It appears that many of the banks have real estate related issues of their own, and cannot prudently afford to baby sit the homebuilder.

Needless to say, I am short the entire housing and soon commercial industry - that is not just homebuilders, but insurers, suppliers, mortgage bankers, etc. The spillover into the broader economy is undeniable - construction, brokerage, ancillary services, finance (American Home and Bear Stearns alone have let go 7,000 employees, and over 60 non-bank lenders have been driven out of business in the last 6 months).

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[quail hill homes]

The compensation for these deals are coming no where near justifying the risk. I am sure the excessive liquidity coupled with significant demand caused the cap rate compression, but the buyers fell for it assuming liquidity and demand would continue for some time.

[turtle ridge homes]

I am an ex-residential real estate investor who sold off in 2005 due to fundamentals that were totally out of whack. It appears that many do not see how precarious the commercial sector has become