From Standard & Poor, Publication date: 05-Oct-06

Commentary/Key Trends

While the housing market's anticipated soft landing has turned out to be much bumpier than expected, most U.S. homebuilder credit ratings remain on solid ground. Many production homebuilders have well-diversified operating platforms and conservatively leveraged balance sheets, so the primary challenge for these companies will be to swiftly rationalize real estate investment and reduce overhead to offset sharply lower orders and higher cancellations. However, several weaker niche players are likely to see downgrades over the next one to two years, particularly if mortgage default rates rise materially and exacerbate this supply-driven correction.

Speculative-grade homebuilders with heavy concentrations in formerly hot markets that are now inundated with competitive inventory are the most likely to feel credit pressure going forward. Companies with large land inventories and limited balance sheet flexibility, or those that aggressively repurchase their discounted shares without regard for leverage levels, are particularly vulnerable. An extended downturn would also test those companies that have pursued aggressive growth through multiple acquisitions in newer markets.

Conversely, the credit quality of several of the better-positioned homebuilders stands to benefit should weaker private and public competitors stumble in the downturn. By and large, the investment-grade homebuilders have maintained historically low debt levels and remain disciplined in their approaches to real estate investment and share repurchases. They have also accumulated larger cash balances and retain ample capacity under unsecured credit facilities. Relative to lower-rated peers, these companies maintain significant capacity to make opportunistic investments in distressed real estate and may emerge from this downturn with improved market share and more competitive business profiles.

Long-Term Underpinnings Remain Favorable

Supporting our generally stable outlook for rated homebuilders are very favorable longer-term demographic trends for housing demand. These trends include steady immigration that will continue to drive demand for entry-level housing, along with the relative wealth and maturation of the baby boom generation, which will drive demand for second homes and active adult communities. These trends are currently buttressed by good job creation and mortgage rates that remain below historical averages.

Still, key housing markets continue to weaken, as evidenced by dramatically lower sales and higher cancellation rates. Unchecked and underestimated speculation during the housing bull market has resulted in record-high inventories of new and existing homes. Loosened underwriting and aggressive appraisals exacerbated the supply bubble, which may portend a longer than anticipated correction. Therefore, our rating bias will favor those companies with more seasoned management teams and track records of operating successfully through business cycles. Furthermore, the stability of homebuilder ratings in the near term is contingent upon prudent investment policies and maintenance of adequate liquidity.

The Outlook Is Stable For Most Homebuilders

Standard & Poor's Ratings Services rates 17 public conventional homebuilders, six private conventional homebuilders, and three manufactured homebuilders. These companies currently have approximately $30 billion in publicly rated debt outstanding. The ratings are about evenly distributed between the 'BBB' (nine), 'BB' (eight), and 'B' (nine) rating categories. Approximately 81% (21) of these companies maintain stable outlooks. Our outlooks on Hovnanian Enterprises and Meritage Homes Corp. are positive, while our outlooks on Comstock Homebuilding Cos., Technical Olympic USA Inc., and WCI Communities Inc. are negative.

Cooling Sales And Higher Inventories Are Among The Issues Affecting Credit Quality

New home sales are falling

July's new home sales fell 4% sequentially and 22% year-over-year, to just under 1.1 million. However, this figure likely understates the severity of the correction. The U.S. Census Bureau counts a sale when a contract is signed, not when the sale is closed, and the number is not adjusted for subsequent cancellations. This distinction is important because the median cancellation rate for homebuilders rated by Standard & Poor's jumped to 31% during the most recent fiscal quarter.

Inventories are building

The number of new homes for sale reached 568,000, or a 6.5-month supply, in July, a record-high number that still pales in comparison with the nearly 3.9 million existing homes for sale—a 7.3-month supply based on current sales rates. It will likely take longer than that to absorb this inventory, as sales continue to slow and cancellations are climbing. The wild card that could determine the duration of the downturn is the severity of repossessions that will result from loosened underwriting.

Tech-savvy consumers are holding out for the best offers

The current downturn is unprecedented, not only because the economy is sound and mortgage rates are low, but because of the way the Internet has empowered the customer. Consumers now have the ability to shop dozens of communities right from their laptops, and the bombardment of "house of the week" and other offers is likely encouraging the wait-and-see mentality.

The rent-versus-buy decision 

It is not a coincidence that homebuilder share prices fell about 32% over the first eight months of the year, while the NAREIT index of multifamily REITs offered investors a total return of 32% over the same period. Apartment owners, who struggled mightily during the housing bull market, are now benefiting from homebuyer reticence. Occupancies are higher and rents are rising.

Some renters may be waiting to buy until they perceive the housing market has bottomed, which could bode well for a quicker recovery. Also, anecdotal evidence suggests that condominium projects are starting to revert back to the rental pool because of the favorable yields provided by newly developed apartments. If this trend continues, it could hasten the absorption of speculative condominium inventory.

These work boots were made for walking

We think it's credit-friendly that most homebuilders are aggressively revisiting their lot option contracts, and having some success extending or revising the terms. Where they are unable to renegotiate contracts, builders increasingly are forfeiting deposits and walking away from the option agreements altogether. Standard & Poor's estimates that its rated homebuilders turned their backs on approximately $3 billion of land last quarter alone.