Takeaway: Disappointing new home sales is leading builders to diversify.
In the past week, government data on housing starts and permits were not anything to get excited about. Moreover, there were little signs the housing market is any closer to a recovery. At best, we see housing starts flat to up low single-digits in 2011 versus 2010, which totaled 580,000 for single and multi-family units that year. Also, the widely followed spring selling season for realtors and new homebuilders was very disappointing, and there is little visibility for major improvement in the second half of 2011.
So what’s a homebuilder to do?
In the 1967 romantic comedy film, The Graduate, starring Dustin Hoffman, the opportunities for a young man graduating college was in plastics. For U.S. publicly-traded homebuilders, which wrote off more than $34 billion during the housing bust of 2007 through 2010, some have the found their opportunity now being diversification.
In our view, though, the “D” word does not always sit well with investors. For instance, the action to diversify into new businesses can be taken as a sign that things are not really good in the core business, and this appears to be case for homebuilders. Also, near term, demand or traffic to new home communities is weak, and cancellation rates remain high, which erodes gross new contracts that eventually net out to home deliveries. Longer term, the dozen or so publicly-traded homebuilders will gain market share from private builders that can only get financing from local banks, but the bigger question beyond market share gain is: will the homebuilding market will get back to pre-recession or normalized size?
The good news is that most homebuilders have strong balance sheets and ample liquidity for new land acquisitions and investing in new businesses. So, the question remains, where can these companies get a higher return on investment for their capital? Most of the homebuilders are sitting on cash, which, in some cases, exceeds $1 billion, but a few are looking to make money in diversified businesses.
For instance, Lennar (LEN 17 ****) has experience in investing in distressed government mortgage securities. Rialto Investments was founded by Lennar in 2007 to take advantage of turmoil in the real estate market. The group closed on $4.6 billion in 2010 in securities in partnership with U.S. Treasury to invest in and manage commercial and residential mortgage back securities. Lennar also purchased equity interests in two partnerships containing $3.1 billion in 2010 of distressed loans alongside the FDIC – part of the government program of clearing distressed assets from failed financial institutions.
Beazer Homes (BZH 3 ***), another of the top-10 homebuilders, introduced the formation of its Pre-Owned Homes Division in April 2011. Starting with the Phoenix market, the new division will be acquiring, improving, and renting recently built previously-owned homes within select communities in which the company currently operates. In our view, Beazer is trying to maintain the overall quality of their home communities by fixing up distressed or foreclosed homes.
Beazer intends to acquire these homes at a discount to their replacement cost and then rent them. The Phoenix rental market, like the rest of the country, is very strong, as households have opted to rent instead of pursuing home ownership. Beazer may expand its Pre-Owned Homes properties to Nevada and California, areas that are ripe with distressed and foreclosed homes.
Another example of diversification is Toll Brothers (TOL 20 ****), the market leader in the luxury home segment. Through its wholly-owned subsidiary, Gibraltar Capital and Asset Management LLC, and Deutsche Bank, Toll Brothers in March 2011 announced the closing of a transaction to buy 83 non-performing loans with outstanding balances of about $200 million. The assets are located in nine states and Washington DC and comprise construction loans secured by properties at various stages of completion. Toll’s Gibraltar subsidiary has nearly $2 billion in its real estate portfolio.
Conclusion: If the housing market takes longer to recover, I think other homebuilders will look to diversify investments away from building new homes. Absent signs of a housing market recovery, I also see builders being reluctant to spend too much on raw or improved land acquisitions, so long as demand is not there. Given history, I think most homebuilders will increase land spending once they are confident that a housing recovery is firmly in place. However, the market is not there yet.