Struggling Homebuilders

August 13, 2006

The real estate market has cooled significantly over the past year, and shares of homebuilders have given back two years worth of gains during this time.

As the economy rounded a corner in 2003 showing signs of improvement, real estate stocks began a steady 2 year climb to record heights. However, during the summer of 2005, the homebuilders suddenly came under pressure amid concerns of a real estate bubble and deteriorating market conditions. After peaking at this time, homebuilding stocks have trekked lower showing no signs of turning around. What can investors expect from real estate stocks in the future?

Speculative buying and rapid “flipping” of houses was common during 2003-2005 as strong demand and low interest rates helped the housing market flourish. Existing home sales numbers came in strong every month and orders for new homes were booked so fast many builders built up significant backlogs. The optimism faded during the summer of 2005 as rising interest rates finally caught up with the market.

The Federal Reserve continued to gradually raise interest rates causing mortgage rates to edge back up to normal levels. As more standard real estate conditions emerged, speculators sold out of the market, vacating their posts as the day-traders of real estate. Fears of a bursting housing bubble emerged, but so far only a simple correction has presented itself, aside from steeper declines in certain overpriced geographic markets.

Homebuilders are facing slowing orders, as well as cancellations on existing orders. Toll Brothers (TOL), a luxury homebuilder reported on Wednesday that its home-building revenue fell slightly from a year ago. The company reported a backlog of just 8,044 units, compared with 9,727 last year. Toll Brothers is also facing mounting pressure from cancellations, which came in at 18% this quarter.

Toll Brothers stock has fallen sharply from an all-time high of $51.72 set in August 2005, to less than half at $24.42 one year later. According to July 2006 data from ShortSqueeze.com, about 14.5 million shares have been sold short, or about 4.2 times the average daily volume. This raises the opportunity for extra buying pressure from short sellers if any positive news presents itself. The likelihood of a sharp turnaround in sentiment seems unlikely, and shares will likely struggle in the near term.

Another large homebuilder producing massive earnings is Lennar (LEN). Lennar focuses on single-family attached and detached homes, and also provides financial services. Lennar is currently trading at a P/E ratio of just 4.80 and a market cap of $7 billion. The low ratio alone does not give a surefire reason to buy the stock, since analysts are predicting that earnings will fall off significantly in the future, leading to dropping multiples.

The Ryland Group (RYL), Beazer Homes USA (BZH), Centex (CTX), Standard Pacific (SPF), and D.R. Horton (DHI) are some of the other casualties in the homebuilder sector. All have deceivingly low P/E ratios due to strong past earnings. While this past performance gives companies strong balance sheets to work with in the future, the precipitous decline in their stocks was caused by fears about future sustainability.

The population of the United States currently stands at about 300 million, rising at a gradual pace. As the country grows, an increasing number of qualified first time home-owners will emerge in the future. Homebuilders are stuck in a cyclical industry, which has already passed its peak in this cycle. Stocks of homebuilders will probably struggle in the foreseeable future as rising interest rates catch up with consumers. Although it may seem clever to sell these stocks short and try to profit from further declines, it is important to remember that these companies have all already taken big hits, but existing short-sellers will have to buy back their shares at some point.

At the time of publication, Dhinesh Ganapathiappan did not own or control shares of any companies mentioned in this article.