No More Boom-Bust Blues
A sign in the window of a bank on Wilshire Boulevard in Los Angeles advertises home equity loans at “Prime -- 1/2%.” Just in case it is not obvious, “(minus)” is spelled out under that little dash in front of the 1/2.
This 2-by-3-foot sign hints at a serious problem with housing policy in California: Every imaginable initiative is available to increase demand for housing, but every imaginable roadblock is in place to restrict supply. Until that changes, housing prices will continue to rise.
The vagaries of supply and demand in the California housing market have made for a wild ride ever since the first “for sale” sign went up on the state’s initial crop of suburban tract houses more than half a century ago. Prices would rise as demand was stimulated through lower interest rates, down payment assistance or tax breaks. Then, in an effort to meet the demand, builders would overreact and build more homes than were necessary, sparking a rapid drop in prices as developers scrambled to sell off excess inventory.
Recent changes in the way home builders do business have interrupted the “bust” end of the cycle. But the “boom” part, when housing prices rise unchecked, is still a serious problem. So the good news is, we’re probably not in a “bubble” of housing prices, as some economists have predicted. But the bad news is that housing is in short supply -- meaning it’s expensive.
The model used to be simple: Developers bought large tracts of land, built a lot of houses, then tried to sell them. This formula, of course, subjected home builders to many risks, not the least being that prices fell when supply outpaced demand. Indeed, this business model subjected the entire U.S. economy to unnecessary risk, because housing represents such an important share of household balance sheets. The result was a national boom-bust cycle in real estate that coincided with national business cycles.
The extremes of the cycle were exacerbated at the end of the 1980s, when the financial institutions that provided ongoing financing for housing encountered an increasing number of problems, causing Congress to limit construction lending. These limits, as well as market factors, caused total construction lending by commercial banks to decline more than 40% between 1989 and 1992.
At the same time, home builders faced increasing risks that drove many of them out of the California marketplace. In 1990, a state appellate court ruled in the case of Maryland Casualty Co. vs. Reeder that home buyers could sue home builders for latent defects -- such as soil subsidence -- even if negligence wasn’t proved to have caused the problem. California builders soon found themselves paying much higher insurance premiums for less coverage. By 1996, insurance companies were withdrawing from the market, and general liability coverage for projects like condos and apartment buildings -- the most affordable of all housing -- became virtually unavailable.
The biggest builders were forced to dramatically change how they did business. First and foremost, they were forced to find alternative sources of construction capital, because, without general liability insurance, no lenders would come to the table. So they started selling homes before they built them. The result is a national industry that has virtually eliminated risk and uncertainty from cash-flow prediction.
This new business model -- building homes only after they have been sold -- has dramatically changed the financial performance of large development firms by dramatically lowering the risk of carrying an inventory of completed homes and by stabilizing earnings predictability.
Consider, for example, Pulte Homes, one of the largest builders of single-family detached homes in the United States. In 1991, Pulte had an operating profit margin of 4.5% and a return on assets of 1.07%. By 2002, Pulte had more than doubled its operating margin to 9.59% and raised the return on assets to 7.2%. Pulte’s debt-to-assets ratio dropped from 83.6 to 35.9 during the same years.
The “build-to-order” model has changed the financial patterns for the home construction industry in ways that now set it apart “from many other types of industries,” says says F. Patterson Schiewitz, head of national homebuilding at Bank One in Chicago
Unfortunately, few people outside the industry have recognized this transformation, and that has resulted in underpriced securities, underrated credits, continued difficulties in home builders’ getting financing and even speculation about a national “bubble” in housing. In the case of Pulte, Moody’s rated its senior notes the same in April 1991 and April 2002 -- Baa3 -- because they “lack outstanding investment characteristics.” Moody’s rating reflects its belief that Pulte has “speculative characteristics as well,” despite the fact that Pulte has 52 years of unbroken profitability, an extraordinary accomplishment in a cyclical industry.
Pundits and analysts have lined up all month on television and in print trying to explain the seemingly unstoppable juggernaut of rising home prices. They apparently lack the ability to consider two pieces of information in unison. The first piece tries to explain everything from the demand side. The second -- and often missing -- piece presents the fuller picture by showing the supply side.
When new-home sales fell 15% in January, there were renewed predictions of a bursting housing bubble. Most people overlooked a second piece of information that explained a primary reason behind the decline. KB Home, one of this country’s largest home builders, said it was purposely slowing sales as it reached full production capacity. In other words, it wasn’t selling any more homes because it couldn’t build them any faster. Hardly a bursting bubble.
We are beginning to see the effect of these changes. We just experienced the first recession under the new model of home building. In a new report, “The Housing Boom: Another 20 Years of Growth,” Al Ehrbar, a partner at consulting firm Stern Stewart & Co., calls the phenomenal strength of housing through the recession a “true anomaly.... The result was a radical new role for housing. Instead of adding to the severity of the recession, it helped sustain employment and consumption, and softened the economic landing. Housing went from being a safety valve at the inflationary peak of the cycle to acting as a safety net on the downside.”
So why is all this important? It could mean we’ve seen the end of the boom-bust cycle in real estate. The smooth, steady rise in the value of homes -- and therefore the value of home builders -- should mean we’ll see increased access to the capital and financing that could be used to reduce the shortage of housing in the United States.
Smith Barney Citigroup recently raised its target share prices on all the publicly traded home builders. More important, the behavior of this industry has the potential to reduce or even eliminate its own cyclical fluctuations. If housing holds up, as I expect it will, this could signal a fundamental change in the way we analyze the U.S. economy, with housing becoming the sector to watch all the time.
Despite these improvements, severe restrictions on home building remain -- from a prevailing not- in-my-backyard mentality to liability insurance premiums for home builders that have tripled in a decade. Until we solve these problems and focus more on increasing supply in California, don’t expect prices to stabilize any time soon.
