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Construction sites like the one above in Cave Creek have become near-constant sights in the North Valley. But with the weakening U.S.economy causing a decline in new home construction and building.
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More trouble ahead for homebuilders?
by Rachel Beck
Associate Press

As if investors in homebuilding stocks need more to worry about. They’ve already watched their shares get hit by the slump in home sales and the weakening of the economy.

Now add this concern to the list: companies writing down their land values because they aren’t worth what they paid for them. It’s not a matter of if that could happen, but how serious and widespread those write‑downs turn out to be and what they do to earnings.

How this turns out could greatly influence where these troubled stocks go next.

The bursting of the five‑year housing bubble is hard to miss. As mortgage rates have climbed over the last two years while the Federal Reserve boosted short‑term interest rates 17 times, new home construction and building permits have sharply declined, and the demand for home loans has dropped. The National Association of Home Builders said its index of housing‑market activity in July slipped to its lowest level since 1991.

That has sent homebuilding stocks tumbling. Since peaking last July, the Standard & Poor’s 500 Homebuilders index is down more than 47 percent, making the sector its worst performer.

The concern on Wall Street is that more bad news could be ahead should there be a massive rise in land‑value write‑downs. Not only would that reduce already weak earnings, but it could lead to further erosion in the “book value” of many homebuilders–which is generally defined as the value of a company’s business should it have to be liquidated. D.R. Horton Inc., for instance, announced last week that its profits slid 21 percent to $292.8 million, or 93 cents a share in its fiscal third quarter that ended June 30. The results in the latest quarter at the nation’s largest homebuilder include a charge of $57.2 million, or 11 cents a share, related to a land‑option write‑down.

It was a similar situation at MDC Holdings Inc., which reported second‑quarter profit slumped 25 percent to $76.5 million, or $1.66 a share. The company took a $7.9 million writeoff for project costs, including option deposits and other costs related to lots it has decided not to acquire.

Citigroup analyst Stephen Kim wants investors to realize that not all write‑downs are created equal, and encourages them to differentiate between what’s bad and what’s worse.

As he sees it, it is not as serious when companies take write‑offs on option deposits that they had put down for a piece of land but then decide to not go through with the project. That, in fact, generates free cash flow.

He contrasts that with a write‑down on an asset impairment, which means a builder sees the expected returns from a project are insufficient to cover the builder’s fixed costs.

“A builder that walks away from an option is driving shareholder value proactively,” Kim said in a recent note to clients. “A builder recording an asset impairment is belatedly acknow‑ ledging that shareholder value has been destroyed.”

Kim suggests that investors try to gauge the age of the land that the homebuilders own. Those with newer investments–especially those negotiated at the peak of the housing market in 2005–might be at greater risk for asset impairments. D.R. Horton and MDC. are among those with the most exposure to recently priced land, while Toll Brothers Inc., Pulte Homes Inc. and Centex Corp. have older investments.

Such write‑downs are reducing companies’ price‑to‑book ratios, which investors often use to gauge whether a stock is undervalued.

In recent weeks, the decline has spurred some talk on Wall Street over whether it is time to start buying homebuilding shares, as the ratio closes on a level where it historically has bottomed. D.R. Horton, for instance, has a price‑to‑book ratio of 1.05.

Not everyone, however, is convinced the retreat for the homebuilding stocks is over.

Analyst Rick Murray of Raymond James & Associates notes that during past housing‑cycle slumps several builders took impairment charges totaling as much as five to 10 percent of their book value on an annual basis for several years. That pushed down stocks below book value, including after the 1980s housing collapse when the price‑to‑book fell as low as 0.594.

With all this to weigh, a move into homebuilding shares right now might not be something most investors can stomach, especially when considering how the current risks seem to outweigh the potential rewards.

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