Home Myths Meet Reality
As Downturn Continues

Recently, the nation's largest home builder, D.R. Horton Inc., reported the first quarterly loss in its 15-year history as a public company.

Yet, only two years ago, Donald Tomnitz, Horton's chief executive, declared confidently: "We can earn our way through any economic cycle, except one like the Great Depression." The Great Depression hasn't hit -- but Horton's earnings have declined more severely than most anyone imagined.

Another big home builder, Beazer Homes USA Inc., was beset by rumors the past week that it might be filing for bankruptcy-law protection. Beazer firmly denies the rumors. Still, housing analysts are fretting that banks will clamp down on lending to some builders -- squeezing them of cash just when they might need it.

It wasn't supposed to happen like this. Today's home builders were thought to be better-capitalized, savvier and more geographically diverse than many of their predecessors in the last downturn, in the early 1990s. While many are expected to weather the slump, concern is mounting about the balance sheets of a growing number of companies.

Amid a broad retreat in housing stocks on Friday, Horton shares fell 4%, Beazer plunged 13% and Hovnanian Enterprises Inc. sagged 9.4% in 4 p.m. New York Stock Exchange composite trading.

What's going wrong? An array of business assumptions that both builders and housing analysts propagated have turned out to be misguided.

The 'Cash Machine' Fallacy

One big assumption had to do with their cash flow: The common wisdom among some analysts was that builders would turn into "cash machines" in the event of a housing downturn, because they would pare construction and land buying.

In reality, most builders haven't been able to stockpile as much cash as expected. That is partly because they have had to keep building large housing developments, even though demand dropped off sharply.

"Once you start putting in the plumbing hookups and the roads, you can't abandon these projects halfway," says Nishu Sood, a housing analyst at Deutsche Bank, because a half-built development risks angering homeowners and local officials.

Also eating into that cash flow: the sharp drop in sales and home prices. After several years of double-digit annual increases, some builders say their average prices are down 7% to 12%.

The incentives that companies are using to sell homes are so large that they are crippling profits. Take Miami-based Lennar Corp., which said its average incentives were $43,700 on houses worth an average of $342,000. That is up from a year ago, when incentives averaged $24,700. And Lennar has one of the best cash flows in the industry.

Others are in a different boat. As of April 30, the Red Bank, N.J., builder Hovnanian had negative cash flow from operations for the trailing 12 months, according to Moody's Investors Service.

"We are confident that we will be cash-flow positive in the fourth quarter," said Hovnanian's chief financial officer, Larry Sorsby. "We have been a little slower to generate cash than some of our peers because we were one of the fastest-growing home builders. It takes a little longer for us to slow down the train."

Analysts say luxury-condo developer WCI Communities Inc. could also face cash-flow problems, because they expect a growing number of buyers to cancel contracts to buy condos.

WCI declined to comment, saying that it hasn't released its second-quarter earnings.

Of course, not everyone is in this pickle. Some builders, including KB Home, have good cash flow, partly fueled by the sale of it stake in a French home builder. Centex Corp. also adjusted early to the downturn.

Too Much Land

One thing that tripped up builders during the previous slump was that they owned too much land. This time, builders protected themselves by using options to secure land, rather than paying for it outright. In many option agreements, a builder puts down a deposit on a parcel with the option to buy the land in the future at a set price.

In theory, this should have let builders buy land only when they needed it, while giving them the right to walk away if they didn't need it. The builders would also be helped by the overall scarcity of developable lots in many markets, Citigroup analyst Stephen Kim wrote in a bullish March 2006 research report.

"The linchpin to our bullish thesis has been the emergence of land constraints," Mr. Kim wrote at the time. "This will allow the builders to outperform expectations in any given demand scenario."

But as it turns out, some builders still ended up owning too much land. Horton says it has a 5.4-year supply of land. That's up from a 3.5-to-four-year supply of land when the downturn hit.

Mr. Kim still believes land constraints will help the builders in the long run. "But when housing demand drops as much as it has, the supply constraint cannot save you from near-term pain," Mr. Kim said in an interview.

Many companies were also acquiring land based on growth rates of as much as 15% and 20%. The options helped reduce some risk, but many builders still bought lots of land outright because they could get higher returns.

"Their discipline broke down," says Mr. Kim. When growth slowed and home sales fell, they were stuck with a glut of land.

Wanted: More Diversity

Builders believed they could protect profits by building in numerous markets across the country. With geographic diversity, they figured that if some markets slowed, others would likely remain stable.

But while the biggest builders did achieve geographic diversity, many didn't achieve profit diversity. In other words, much of the builders' profits came from the markets hardest-hit by the recession.

According to a Credit Suisse analysis, 32% of the builders' profits at the peak of the boom in 2005 came from one state: California. Florida, also an extremely strong market during the boom, was responsible for 14% of profits, and Nevada was responsible for 10% of profits.

Markets that were doing relatively well, such as Texas, bring only moderate profits, in part because home prices are low and those markets are open to enormous competition from thousands of small builders.

Bad-News Bankers

Until recently, many analysts believed banks would be forgiving of the builders. But it now looks as if some companies could run into trouble with their banks.

That is because some builders' net worth is eroding so quickly -- as they write down the value of land -- that some may be getting close to tripping contractual agreements that limit their level of debt in relation to tangible net worth, which is typically their assets minus liabilities, goodwill and intangibles such as trademarks.

As of March 31, WCI had the smallest net-worth "cushion" before it tripped its debt limit, according to Moody's, which recently downgraded its credit rating of the builder.

The banks recently cut Beazer's credit line in half. Beazer said in a conference call with analysts that it didn't need as large a credit line as its previous one. And while most builders' credit is unsecured, the banks gave Tousa Inc., a Florida builder, a secured line late last year. The company declined to comment.

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