Wrapping the housing market in mothballs when prices tank

With home sales plummeting nationwide, many new home developers have been frantically slashing prices and adding incentives to draw buyers.

But not all home builders are joining the race to the pricing bottom. Last month, Miami-based Lennar Corp. applied the brakes.

The company announced that it will build just 259 of the 1,100 homes planned for its Central Park West development in Irvine, and will not sell any until the market improves, an industry practice known as “mothballing.” To better understand Lennar’s decision and the implications for the home building industry, we spoke to Stan Ross, chairman of the board of USC’s Lusk Center for Real Estate. Here is an edited transcript:

Question: Why would Lennar choose to mothball its development?

Answer: Companies are taking a hard look at the market and what’s happening with regard to discounting in order to move their homes. A number of builders are stepping back and saying, “If it’s taking such a deep discount for us to move our houses, are we better off just stopping and waiting for the market to recover?”

Mothballing means shutting down new construction and putting future development activity on hold until the market changes, then resuming once things have improved. Lennar’s developments are large-scale and in highly competitive markets, and the company is big enough to treat them as long-term assets. Also, some of its properties are in the early stages of development, when you can make that decision more easily.

Question: How does mothballing affect home builders?

Answer: Mothballing can be extremely beneficial. I’ve been through six down cycles in my lifetime. When you go back to the last couple of cycles, those companies that had the financial capacity to just hold on to their inventory wound up with a huge recovery when the markets turned. Those companies that walked away [by selling rather than mothballing] didn’t participate in any recovery -- in fact they had significant losses.

On the other hand, we don’t see significant market recovery coming through the end of 2008. So if that’s correct, then a mothball strategy could take you out as long as a year, during which sales and earnings are down. That can be a big issue for companies’ balance sheets.

Also, firms that loaned money to builders may demand a restructuring of the loans, which will result in higher payments for the developer.

And if I’m mothballing, and all of a sudden the market starts to change, my competitor who didn’t mothball is ready to sell immediately and I’m not. But that’s unlikely.

Question: What about the market as a whole?

Answer: Mothballing reduces the supply of homes available. So if demand increases as the market improves, that could push the prices up more quickly, and developers and the industry will benefit.

Mothballing is beneficial to existing homeowners trying to sell because it stops further reductions in price. Discounting by builders has an impact on home pricing: If I’m your neighbor and you reduce your home’s sales price by $30,000, you’ve pretty much reduced the value of my house by the same $30,000. On the other hand, if you mothball, and you’re not selling it . . . then you haven’t readjusted my price. The market will stabilize, and if homeowners wait it out just like builders are, their values will recover.

On the other hand, neighbors of mothballed areas might say, “I thought I was living in a neighborhood, and now I’m next to vacant land.” And worse than that is, if a company mothballs an amenity that’s been promised, like a playground or a park, customers are really unhappy. That could expose companies to lawsuits.

Also, municipalities that approve development might react negatively. They are anticipating sales tax revenue, property tax revenue, fees from development; if the developer mothballs, they won’t get some of that.

Question: Do you think more builders will jump on the mothballing bandwagon?

Answer: I think mothballing is clearly one of the strategic options that companies are looking at. I attend many strategic meetings with these companies, and we look at all options. Mothballing is clearly an acceptable strategy, especially in markets where there’s a huge supply -- places like the Inland Empire.

I think with Lennar taking the lead here, you’ll probably start to see some more happening.