To effectively run a home-building company today, executives need to be well versed in complicated economic and financial issues because these issues impact the decisions you need to make today.
Subprime is a Leading Indicator for Prime – Do not downplay the risk to your business of the front-page news in the subprime market. The real reason for the stress in subprime has to do with flat home prices and rising adjustable interest rates, which are impacting all home buyers who have bought in the last 24 months. The stress is currently most obvious in subprime because those loans tend to reset after two years, versus three-plus years for other loans, and those borrowers are more likely to default. The primary housing market will have significantly more stress 12 months from now than it has today unless mortgage rates fall dramatically or home-price appreciation returns. Why? Because an adjustable-rate loan made in early 2005 will result in a 30 percent-plus increase in the borrower’s mortgage payment, and the value of their home may have declined since they bought the home.
Subprime 101 – This week’s collapse in the subprime lending market is indicative of the credit crunch that has been occurring over the last several months, which is making it considerably more difficult for home builders to sell homes to buyers with marginal credit histories. We believe the builders who are getting hurt the most today are the ones who were primarily selling entry-level homes on the outskirts of metropolitan areas. Even if this represents a small percentage of your sales, please keep in mind that the submarket you are in is likely to be full of these types of borrowers. The investor issues over the last several years are an excellent analogy. You may have been doing a better job keeping investors out than others, but have you been impacted by the departure of investors?
The ABX.HE index, as shown in the graph below, illustrates the risk of insuring bonds backed by subprime loans — in this example, the lowest-rated BBB-. The rapid decline in the index in recent months illustrates investors’ expectations that the value of subprime mortgage bonds will fall, which is indicative of the increased risk associated with these loans. Increased risk means that subprime interest rates will rise significantly. An informal survey we conducted two weeks ago at an event that primarily involved small builders on the outskirts of Southern California led us to conclude that borrowers with very poor credit can no longer get a loan, and those with marginal credit are finding interest rates have risen 50 basis points since last Fall.
Our grading system of the economy and the housing market is a “bell curve” model, with statistics at an all-time high receiving an “A,” statistics near the long-term average receiving a “C,” and the worst times ever receiving an “F.” In this grading system, it is OK to be a “C” student.
Here is our current report card:
Economic Growth: C
The U.S. economy continues to expand at a moderate pace. Fourth-quarter real GDP was revised downward to 2.2 percent versus the advance estimate of 3.5 percent, and many believe current growth is even lower. Former Fed Chairman Alan Greenspan indicated that a recession could be less than 12 months away. Year-over-year retail sales and personal income growth declined during the month, while core CPI inflation increased slightly to 2.7 percent in January from 2.6 percent in December. Core inflation is currently above the Fed’s expectations.
Leading Indicators: C-
Interest rates decreased slightly this month, and the yield curve remains inverted for the eighth consecutive month, which is usually a sure sign of a looming recession. At month-end, the 10-year Treasury rate was 13 basis points lower than the 2-year rate. A large selloff in China sparked the biggest single-day decline in U.S. stock market indices in more than five years. After six consecutive months of improvement, the S&P Super Homebuilding Index reversed course this month, dropping to 24 percent below its year-ago value. Oil prices have begun to creep up, closing at $59.26 at the end of February.
Mortgage Rates: B
The 30-year fixed mortgage rate remained at 6.22 percent in February, while one-year adjustable rates increased marginally to 5.49 percent. Adjustable-rate loans continue to decrease as a percentage of total loans. In the last week of February, ARMs fell to 21.1 percent of total loan activity. We have added the ABX index, which tracks the performance of subprime mortgage bonds, as one of the metrics we are tracking. Rising delinquencies in the subprime mortgage market have caused the index to drop precipitously, which is resulting in a lack of capital available for low-credit home buyers. This will have a significant impact on those communities relying on subprime capital, which are generally the entry-level homes on the outskirts of metro areas that have seen substantial price appreciation, such as Phoenix, Ariz; Tampa, Fla.; and Riverside-San Bernardino, Calif.
Consumer Behavior: B-
Consumer confidence improved in February and now stands at its highest level since August 2001. Recent increases in gasoline prices, the precipitous stock market decline on Feb. 27 and the subprime dilemma may mitigate further improvement next month.
Existing-Home Market: C+
Home sales increased to 6.46 million annualized units in January, and inventory appears to have stabilized for the time being, with supply remaining unchanged at 6.6 months in January. Prices continue to depreciate, with the median single-family home price currently 3.5 percent lower, year-over-year.
New-Home Market: C-
New-home sales in January declined 17 percent sequentially and 20 percent year-over-year to an annual rate of 937,000, the steepest one-month drop since January 1994. This figure overstates true sales because it includes sales that were later cancelled. Supply of new homes remains high, rising from 5.7 months in December to 6.8 in January. Median new-home prices were down 2.1 percent year-over-year in January. Pricing data does not reflect the rampant incentive discounting that is now very common.
Housing Supply: D+
Builders are cutting back, gradually reducing the glut of inventory currently on the market. During the month of January, home builders began construction on the fewest homes since January 1997. Housing starts dropped 14.3 percent sequentially and 38 percent year-over-year, to a seasonally adjusted annual rate of 1.41 million. Building permits, which are a leading indicator for housing, declined 2.8 percent sequentially, 28.6 percent year-over-year, to a seasonally adjusted annual rate of 1.57 million in January.
John Burns is the founder of Real Estate Consulting in Irvine, Calif., which monitors changes in real estate market conditions and provides consulting services, including strategic planning, market research and financial analysis. He can be reached at jbrec@realestateconsulting.com.
