Some analysts and homebuilders alike are calling price reductions “backfired tactics”. In response Homebuilders Are Rethinking Price Reductions.

When freebies like granite countertops and no-cost closings didn’t woo back buyers, homebuilders began trying to outdo one another with bigger and better price cuts.

But now, the tactic may have backfired.

The reductions, builders complain, have sliced into already thin margins. And buyers, fearful their house will depreciate faster than a new car, won’t make purchases until prices stabilize.

“If people stop cutting prices, that’s actually good,” said David Goldberg, an analyst with UBS Investment Bank. “If everybody does it, it works. If one builder does it, it doesn’t.”

My comment: David Goldberg needs a lesson in simple economics. That lesson is called supply and demand.

Nonetheless Lennar is determined to not only hold out until prices get better, but to keep building homes in the meantime. Unfortunately for Lennar the Mothball Housing Strategy Doomed To Fail. If Lennar keeps building in the wake of falling demand, they are likely headed for bankruptcy.

The cost of credit default insurance on Lennar is soaring, possibly in reaction to Lennar’s failure to listen to what the market is saying. See Homebuilder Credit Default Swaps November Update for how other homebuilders are faring.

“The reason some companies say ‘enough is enough’ on the price cuts is because price cuts often generate expectations of further reductions,” said Dave Seiders, the Washington group’s chief economist. “The question is: How far can you go?”

My comment: Obviously Dave Seiders is another economist that needs a basic lesson in supply and demand. The question is not how low you can go, but how much inventory you can hold before carrying costs bankrupt you.

In California, Meritage Homes Corp. has made cuts of up to 40 percent, including price reductions and incentives. The Scottsdale, Ariz.-based company has seen sales prices slip to levels not seen since before 2004, and prices are at or below acceptable margins.

Going lower, the company says, won’t necessarily generate more sales.

Meritage has noticed that potential buyers are coming in “nine or 10” times and “if they hear the deal today is better than the deal was two weeks ago or a month ago, they’re not going to buy,” said Steven J. Hilton, the builder’s chief executive, at the recent UBS Building and Building Products conference in New York.

After seeing its average order price fall 16 percent in the latest quarter, Pulte Homes Inc., the nation’s third-largest builder, said it is holding off on reductions and incentives, except in “limited cases.”

“Pulte’s eventually going to have to back off that strategy,” said Michael Rehaut, a JPMorgan Chase and Co. analyst.

My comment: Ding ding ding. We have a winner. The sooner the homebuilders get this silly strategy of holding prices out of their heads, the more likely they will survive.

Empty homes carry costs, including insurance and maintenance. And after a year or so, there can be significant additional costs, such as repainting and redoing landscaping.

“It doesn’t get better with age,” said Jim Dietz, chief financial officer of WCI Communities Inc., a Florida-based condominium and traditional-homebuilder that has sold some completed units for minimal profit.

Reduction-aversion, he said, is a risky play.

My comment: WCI can speak from experience about a bird in hand. They were offered over $20 a share for their stock but turned it down because it was not enough. WCI is currently trading under $5.

“Their risk is that, OK, sales drop 80 percent and now you don’t have enough cash come in to pay the bills and your debt sours. How long can you do that?” he said. “I agree that discounting is bad, but I also believe that the market needs to reset. The inventory needs to be cleared through before we can get to a more normal selling environment.”

My comment: Perhaps this is a normal selling environment. Those who think the mania years of 2003-2005 are normal have another thing coming. Two years from now homebuilders might be wishing for the good old days of 2007 relatively speaking.

Things swing to extremes and inventory buildups suggest a lot more pain is coming. When extremes in sentiment are reached, the pullback is not back to normal. Things will overshoot to the downside as well. Another point is that homebuilders overpaid for land. Those land prices are not coming back and homebuilders will have to eat the difference.

Supply And Demand Considerations

Here are the facts that apparently have not occurred to Seiders, Goldberg, Toll Brothers (TOLL), Lennar (LEN) , Meritage (MTH) and Pulte (PHM) and anyone else that thinks everything will be fine if homebuilders hold hands and sing kumbayah.

  • There was an unmitigated 20 year boom in housing with housing prices several standard deviations from the norm in comparison to both rental prices and wages.
  • Consumers are clearly tapped out.
  • Stores like Walmart and J.C Penny are cutting back on hiring plans.
  • People without a job are not likely to be buying homes.
  • Lending standards are tightening. Evan as prices drop, few can afford to buy.
  • If cancellations are factored in, inventory is near 12 months and rising.
  • Everyone who wants a house and can afford one already has one.
  • Empty homes have huge carrying costs.
  • Empty homes are subject to vandalism and theft.
  • Too many people have houses they cannot afford. Rising bankruptcies and foreclosures should be proof enough. That is adding to supply and will continue to add to supply for years to come.
  • The economy is headed into a recession. All the signs are now in place.

Builders Going Bust

Given that several homebuilders have already gone bust, the following AP headline is quite an understatement: Some Homebuilders Could End Up Bankrupt.

Homebuilders such as Centex Corp. and Pulte Homes Inc. aim to survive an industrywide unraveling by selling houses at bargain prices, slashing jobs and scrapping growth plans.

My comment: OK Pulte which is it? Are you holding the line in price reductions or not?

Builders constructed more than 2 million housing units nationwide in 2005, the year the boom peaked. So far this year, housing starts have fallen to an annual rate of 1.2 million units through September, and economists expect the number to drop to an annual rate of 1 million by mid-2008.

My comment: Housing starts are under the long term trendline but they are reasonably close which would make this a pretty normal year actually. Given the likelihood things will swing hard to the downside on account of the upcoming recession and lack of pent up demand, I expect housing starts to drop to the 600,000 – 800,000 area. That is quite a drop from here. For more on this please see When Will Housing Bottom?

To move unsold inventory quickly, builders are staging flashy sales promotions of the kind common at used car dealerships. In particularly hard-hit housing markets, such as California and Florida, and even in less-devastated regions, such as the suburbs around Washington, D.C., developers are resorting to auctions to sell new houses, townhouses and condominiums.

Earlier this month, credit rating agency Standard & Poor’s downgraded three of the four largest homebuilders by market value — D.R. Horton Inc., Pulte and Lennar — to noninvestment grade, or “junk” status.

The ratings picture is even worse for struggling WCI Communities Inc., Standard Pacific Corp. and Tousa Inc., which last month retained advisers from Lazard Freres & Co. “to conduct a comprehensive review” of its finances.

Traders are especially negative about Beazer Homes USA Inc., which faces federal investigations of its business practices and is planning to restate financial reports after an internal probe found employees in its mortgage unit violated federal lending rules.

On Friday, Levitt and Sons, a subsidiary of Florida-based Levitt Corp. filed for Chapter 11 bankruptcy protection, citing “unprecedented conditions,” particularly in Florida and the Southeast, where the company operated.

Neumann Homes Inc., a large privately held homebuilder in the Midwest and Colorado, did the same last month. New Jersey’s Kara Homes did so in 2006 and, after finding new investors, reorganized this fall under a new name, Maplewood Homebuilders.

More pain will come when the recession hits full force. And homebuilders who attempt to hold prices in the face of falling demand will be swept away with the outgoing tide. It’s a simple case of supply and demand. I guess it’s so simple that some economists can’t see it.

Mike Shedlock / Mish
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