Fitch: Year 3 of Housing Downturn Remains Dismal for U.S. Homebuilding
By Business Wire
Last Updated: 12/13 12:32PM
NEW YORK–The housing contraction unexpectedly gained momentum in 2007 and looks to extend, with some ferocity, at least well into 2008, according to Fitch Ratings.
Affordability and wavering buyer confidence were the key issues in 2006, while significantly tighter mortgage standards (for subprime and Alt-A) and disrupted mortgage markets were the ‘other shoes to drop’ in 2007. A continuation of these pressures and possible tightening of the conforming loan market segment, as well as still considerable inventories of new and existing homes for sale (boosted by foreclosures), suggest another dismal year for housing in 2008. If mortgage rates should rise or credit terms further tighten, then Fitch’s housing forecast could turn even more pessimistic. And, of course, if the economy slides into recession then the downturn would not only deepen, but possibly extend further into 2009.
Operational and financial pressures will persist and, perhaps, intensify for the public homebuilders. Yet homebuilders have to successfully operate within this challenging environment or wither away. ‘Companies have to continue to downsize to the point where they can remain profitable, excluding non-recurring real estate charges, which means further cuts in staffing and other overhead, as well as other cost reductions,’ said Managing Director and lead Homebuilding analyst Bob Curran. ‘The public homebuilders cannot significantly influence profitability, but they can manage their balance sheets and their liquidity.’
Fitch believes that, overall, the U.S. homebuilding sector has good liquidity, although some weaker companies face greater risk. Many companies in this sector have generated meaningful free cash flows over the past twelve months, while terming out borrowings and maintaining access to committed bank facilities which together provide ample room to handle maturities and fund working capital needs. As compared to the last major housing downturn in the latter 1980’s into the early 1990’s, leverage was lower during the later part of this upcycle, at the peak and currently. For the majority of public homebuilders, debt composition 15-to-20 years ago was mostly, or all, short-term construction loans and possibly a secured credit line, while today the debt is often weighted most heavily to well laddered public debt (a more appropriate balance with longer-lived real estate assets), and, to a lesser degree, to an unsecured revolving credit facility. (All of the public homebuilders in Fitch’s coverage have unsecured revolving credit facilities except for Beazer Homes USA and TOUSA, Inc., which have secured revolving credit facilities.)
Fitch will continue to assess each homebuilder’s approach and performance relating to land and development spending, balance sheet (inventory) contraction, free cash flow generation and debt reduction in consideration of its ratings, as well as builders’ credit metrics, liquidity, size, geographic and product diversification, margins, frequency and size of real estate write-downs and option write-offs, etc.
The Rating Outlook for the Homebuilding sector is Negative.
Fourth-quarter 2007 (4Q’07) and calendar 2008:
The Outlook for U.S. GDP growth depends critically on the path for consumption. Probably the single most important driver will be the state of the labor market. The Dec. 7 payroll release showed a 94,000 increase in non-farm jobs in November, but the trend has been erratic in recent months, especially since June. Job growth has fallen to a level which is consistent with below trend GDP growth and probably rising unemployment.
Increasing uncertainty about income prospects and job security – as reflected in the weakening of consumer confidence indicators – is likely to take a toll on consumer spending. Employment growth has been a key support to the consumer outlook in the face of pressures from the housing market and debt servicing and current and expected volatility and deterioration comes just as these other pressures are intensifying. Various national house price measures are now showing sizeable annual declines in nominal terms which will reduce net wealth and further reduce possibilities for home equity extraction.
And despite Fed rate cuts (including 25 basis points on Dec. 11) and stable to lower prime mortgage rates, debt servicing pressures are set to rise as borrowers (subprime and others) who took out mortgages in 2005 and 2006 with lower rates for the initial two years face upward resets – a shock which the IMF estimates will be equivalent to a 0.4% decline in disposable income. Moreover, financial market turmoil over the summer resulted in a decline in the supply of new consumer and housing credit. The October Fed survey of loan officers shows that commercial banks have substantially tightened lending standards in all major components of the home mortgage market. Consumption is expected to slow in the 4Q’07 and into 2008 and to grow by just 1% in 2008 as a whole. This would be the lowest growth rate since the 0.2% recorded in 1991.
Even allowing for some pick up in government expenditure, domestic demand is forecast to grow by just over 1% in 2008, similar to the rate seen in 2001. The gap between domestic demand and GDP growth points to the role of net trade as a key support for growth. While recent trade data have been erratic, the pattern of strong export performance – running at about 10% per annum in terms of volume indices for goods – and a sharp slowdown in imports is well established. Export growth may moderate a little in the face of weaker growth elsewhere but with the dollar down sharply in real effective terms so far this year and the high import propensity of U.S. demand, net trade should make a sizeable positive contribution to growth in 2008.
Public policy responses will also likely support growth. The aggressive Fed easing so far and anticipated should help to head off a more pronounced retrenchment by the household sector and underpin corporate spending, while some measures have been announced to ease the household sector’s financial burden. Following recent improvements in the fiscal deficit there may also be scope for higher public spending and tax cuts. However the impact of policy adjustments may not be felt until the second half of 2008. Quarterly GDP growth is expected to fall to 0.2% in fourth quarter-2007 – with domestic demand virtually flat – before recovering towards the middle of 2008. This translates to GDP growth of 1.7% in 2008 as a whole.
The Fed implemented quarter point cuts in both the federal funds rate and the discount rate at the end of October, following half point cuts enacted at the September FOMC (Federal Open Market Committee) meeting. On Dec. 11, the Fed cut the federal funds rate by a quarter point to 4.25% and lowered the discount rate, the rate it charges to lend directly to banks, by 25 basis points (bps) to 4.75%. Fed officials signaled that further cuts are possible if the severe downturn in housing and the crisis in mortgage lending worsen. The FOMC noted that some inflation risks remain and it will continue to monitor inflation developments carefully. 30-year fixed mortgage rates, which averaged 6.4% in 2006, up 50 bps compared to 2005, should be down slightly in 2007 and moderately decrease in 2008.
With distinct weakness in many business sectors in 2001, 2002 and 2003, construction and housing in particular stood out as bulwarks of the economy. The combination of consumption and private investment spending on housing represented about 15% of GDP in 2001 and close to that percentage in 2002 and 2003. In a more broadly growing economy, housing was still a significant, positive stimulant in 2004 and in 2005. That was not the case in 2006, and certainly not in 2007.
For 2007 as a whole, real GDP should advance 2.3% with consumption (plus 3.1%) and exports (plus 6.7%) providing the impetus. Inflation (as represented by CPI) is expected to moderate from 3.2% in 2006 to 2.5% in 2007. 10-year bond yields should average about 10 basis points lower than last year.
Fitch’s forecast for the housing sector became more bearish as 2007 evolved. This is principally due to the impact from even tighter credit standards for homebuyers and the effect of disruptions in the secondary markets for subprime, Alt-A and Jumbo mortgages. Looking ahead, should mortgage rates rise, new mortgage underwriting standards will mean a more expensive mortgage or the inability to qualify for a mortgage, depending on one’s financial position and credit history.
Of course, most potential homebuyers, absent any real urgency to buy, are deferring the purchase decision, concerned that selling their existing home at a fair price may be challenging, and fearing that real home prices might further decline as builders increase the level of incentives being offered to the advantage of those who wait to buy.
Total housing starts are forecast to be 1.37 million in 2007, 23.9% lower than in 2006. Single family starts are expected to be 1.06 million, down 27.4% as compared to a year ago. Multi-family starts should decrease 8.8% to 310,000. New single family home sales should fall 23.9% to 800,000, while existing home sales ease 12.7% to 5.66 million.
For the full year of 2007, production, as represented by housing starts (especially single family), is expected to fall slightly faster than sales (new orders), but unfortunately the supply of homes is expected to still be excessive entering 2008.
The average single family new home price is expected to drop 2% in 2007, while the median new home price slips 1%. The ‘real’ price reductions surely are larger than shown by the government’s published transaction prices (and Fitch forecasts) as, for example, sales incentives are not included. However, in 2007 a greater portion of the ‘real’ price reduction was due to overt sales price decreases than was the case in 2006. Unfortunately, home prices have not yet reached market-clearing levels in most places. Home prices (especially existing home prices) definitely had been ‘sticky’ on the downside, at least until recently. This is a similar pattern to price behavior exhibited in earlier major housing corrections.
Fitch is forecasting a growing economy in 2008, although still below historic trend line. Real GDP is forecast to only grow 1.7%, paced by healthy exports (plus 6.6%), a slight rebound in investment (plus 1%) and modest consumption (plus 1%). Inflation is expected to slow to 2% from 2.5% in 2007. Interest rates are expected to slightly recede.
The modestly expanding economy will aid the housing sector in 2008, but will not be robust enough to counter continuing negative buyer psychology, and tight credit qualification standards. Fitch is now depicting two housing scenarios for 2008. Although the economy isn’t likely to fluctuate much off the base case (scenario 1), housing metrics are potentially much more variable. Fitch has estimated the probability of scenario 1 as 60% with scenario 2 (the weaker case) as 40%.
In Fitch’s base case, total housing starts are projected to fall 13.9% to 1.18 million with single family volume declining 15.1% to 900,000. New home sales are forecast to decrease 5% to 760,000, while existing home sales slip 8% to 5.2 million.
Average and median single family new home prices are projected to fall 3% and 2%, respectively, in 2008. However, the combination of overt price decreases and sales incentives should represent a less significant percentage of the base home price next year than was the case in 2007.
Implications for the Companies and the Ratings:
Through the three quarters of calendar 2007 builder revenues are down about 25%, home deliveries are off 27%, and EBTIDA margins (before non-recurring, non-cash real estate charges) are 660 basis points lower than year earlier levels. Net new unit orders are down 21%, on average, and unit backlog at the conclusion of the third quarter, on average, is 37% beneath year earlier levels.
These companies have been contracting staffing as demand has evaporated with personnel typically down 30-35% as compared to year end 2005. Just as important, builders have been reducing inventories in 2007, down 23% on average as of the end of the 3Q’07 (or equivalent) as compared to the peak quarter end in 2006. (Admittedly, this is partially as a consequence of write downs). The companies have lowered debt – on average 21% since the peak last year. Free cash flow comparisons have generally improved.
Credit metrics (LTM EBITDA/interest incurred, debt to LTM EBITDA, and FFO interest coverage) are considerably lesser than at this time last year. Even debt/capitalization ratios have modestly deteriorated for the majority of builders when compared to September 2006, largely as a result of erosion in shareholders’ equity from sizeable real estate charges.
Given Fitch’s adjusted macro forecasts for the balance of 2007 and 2008, it appears likely that builders’ financial pressures will continue unabated. For the full year of 2007 homebuilders’ revenues could drop 30%, on average, while pretax profits, before real estate charges, could plummet 75-80%.
Price competition will likely persist at current levels well into 2008. Consequently, margins will remain under pressure and more land value write downs are a distinct possibility. However, fewer option write-offs are likely.
Deterioration in credit metrics will continue during the fourth quarter of 2007 and next year, particularly for profit related metrics (EBITDA, interest coverage; debt to EBITDA). Tangible net worth covenants will be challenged.
Most of the public builders that Fitch tracks have negotiated new revolving credit agreements or amendments to existing agreements that should prevent the companies from violating interest coverage covenants in the fourth quarter of 2007 and into 2008. Some have also secured adjustments in covenants applicable to speculative inventories and tangible net worth. The few remaining builders that haven’t changed their covenants may yet have to do so in 2008. Some builders may have to revisit their bank syndicates and request further covenant adjustments in 2008.
If Fitch’s year-end forecast for 2007 is correct, then 2008 will start off with still considerable inventory over-hang. Should the Fitch base case (scenario one) prove out, then new home sales comparisons (year-over-year) would likely bottom late in 2008 with housing starts bottoming three-to-six months later. If scenario two prevails, then new home sales and starts would be under greater pressure in 2008 and not bottom until mid-2009.
There is a high probability that public builders’ revenues and profits will fall further in 2008 and drop rather sharply from already depressed levels.
Credit pressures will continue. It will be imperative that builders continue to contract their balance sheets, further (sharply) reducing land and development spending. Even more aggressive pricing may be necessary to lower inventories, especially specs. Positive free cash flow comparisons should result as well as improved liquidity.
Fitch expects homebuilders to reduce debt where possible and to exercise restraint as to share repurchase, dividends and acquisitions in these uncertain times.
Although some builders have been more proactive than others in reducing inventories and lowering debt levels, most, in retrospect, started relatively late during this cyclical downturn.
Fitch rates the builders within the context of a typical cycle. In the midst of an untypical upcycle, as took place in the 1992-2005 period, a number of builders realized higher credit ratings. Conversely, in this sharper than expected contraction, which now appears will last longer, and as builders’ credit metrics (despite their new ‘operating models’) are likely to be even more stressed, ratings have been downgraded. There is potential for further downgrades due to ‘macro economic and/or housing events’ as well as company specific situations.
The following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. homebuilding sector:
–Beazer Homes U.S.A., (‘BB-‘; Rating Watch Negative);
–Centex Corp. (‘BBB’; Outlook Negative);
–D.R. Horton, Inc. (‘BBB-‘; Outlook Negative);
–Hovnanian Enterprises, Inc. (‘BB-‘; Outlook Negative);
–KB Home (‘BB+’; Outlook Negative);
–Lennar Corporation (‘BBB’; Outlook Negative);
–M.D.C. Holdings, Inc. (‘BBB’; Outlook Negative);
–M/I Homes, Inc. (‘BB-‘, Outlook Negative);
–Meritage Homes Corp (‘BB-‘; Outlook Negative);
–NVR, Inc. (‘BBB’; Outlook Stable);
–Pulte Homes, Inc. (‘BBB’; Outlook Negative);
–Ryland Group, Inc. (‘BBB-‘; Outlook Negative);
–Standard Pacific Corp. (‘BB-‘; Outlook Negative);
.
