Morningstar Advisor - Winter 2008 - 74

Sector Rap Strongest Homebuilders Will Withstand the Wrecking Ball By Sonya Morris The sector’s lack of curb appeal presents an opportunity for long-term investors. Now that some of the dust has settled from the subprime mortgage crisis, Morningstar homebuilder analysts Eric Landry and Parrish Glover have taken a long, hard look at the companies on their lists. I sat down with Eric to get his view on these and the challenges they face. Sonya Morris: It’s hard to pick up a newspaper ditional million or so units coming back over the next couple of years. All in all, it’s not that hard to arrive at the oversupply of 2 million units currently plaguing the market. SM: How long do you think it will take home- homebuilders will do well to get 65% to 70% of total starts, with the rest of the market going to rental units and manufactured housing. One wild card is that echo boomers (the children of baby boomers) are approaching prime household formation age. That could cause an uptick in demand, but we haven’t seen signs of that yet. Affordability could be a problem for them in certain geographical markets. So right now, we’re assuming they won’t have an appreciable influence on demand. SM: How are homebuilders holding up under these difficult conditions? EL: Some are doing better than others. Toll builders to burn through that overhang? without reading a headline about the housing slump. Clearly, demand for homes has weakened considerably, and a lot of unsold homes are sitting on the market. What’s your assessment of excess supply and the inventory overhang that homebuilders face? Eric Landry: There are several ways to examine EL: Homebuilders have significantly cut production this year. Our forecasts assume continued reductions in 2008, followed by a flat 2009 and then low-single-digit production growth thereafter. Equally plausible, though, is a severe reduction in housing starts, perpetuated by the current mortgage meltdown. The latter scenario may, in fact, be more healthy. SM: What about the demand side? EL: Demand for overall housing should average the problem, one of which is by looking at the vacancy survey published quarterly by the U.S. Census Bureau. Based on the most recent survey, there are more than 2 million vacant owned homes for sale right now, which is 2.6% of the total supply. The norm is closer to 1.65%. If we view the latter as an equilibrium rate, one could infer a baseline of approximately 800,000 extra homes on the market now. But that understates the problem. Adjustablerate mortgages that were written during the boom years are resetting to higher rates as we speak. The reset volume is peaking and will continue at high levels through all of 2008. Even under modestly conservative estimates for default rates, it’s easy to come up with an ad- somewhere between 1.5 million to 2 million units annually for the next several years. The question for homebuilders is: What will the mix of owned/rented housing look like? Currently, homeownership rates are close to all-time highs—a condition we see as unsustainable. The metric held steady in the 65% range until about a decade ago and then rose swiftly to near 70% as all the innovation in the mortgage market flourished. During these boom years, homebuilders captured 75% to 80% of the total market. But going forward, we think Brothers TOL, for example, has a modest debt load and decent amounts of cash, and it is still profitable. At the other end of the spectrum is Technical Olympic USA TOUS; its reckless use of joint-venture financing and aggressive acquisition of land has put the company in dire financial straits. Most firms have significantly written down the value of the land that was purchased during the boom years, but we expect more write-offs to come. The next few quarters are likely to be ugly for all homebuilding companies, due in no small part to the recent dislocations in the mortgage market. Most were close to breaching loan covenants before the subprime mess 74 Morningstar Advisor Winter 2008

Morningstar Advisor - Winter 2008

Table of Contents for the Digital Edition of Morningstar Advisor - Winter 2008