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Phone  949 975 1800    Email  cjm@blackswanadvisors.net     Fax  949 975 1818
Cell  949 351 3943

P.O. Box 11179, Newport Beach, Cal. 92658

Proprietary Market Research
Major US Home builders
2010-A Year of Declining Financial Condition
2011-The Year Bond Holders Take Defensive Actions

Introduction-Changes to Report Content and Report Format

Black Swan Advisors (BSA) has been conducting this analysis for the last 5 years, and will continue to do so as home building industry conditions warrant such coverage. As it has done in the past, this report focuses on the financial condition of the new  home building industry as a whole, and expresses no opinion on the condition of individual companies or their securities, either debt or equity. However, I have recently joined Global Hunter Securities (GHS) in the Investment Banking department, with an emphasis on real estate finance, especially the restructuring of real estate equity and debt, both residential and commercial.  In keeping with FINRA regulations, GHS expresses no opinion on the content of this report and no opinion on the securities of any of the new home builders, either equity or debt.

In order to communicate more effectively, this year’s report comes in this executive section plus a more detailed Power Point presentation for those readers interested in more detail. Please see the details at the end of the report on how to access the Power Point presentation.
Our target analytic period has been shortened from 5 years to 3 years (2008-10) to allow us to focus more on the near term. 2006/2007 statistics are simply no longer relevant in helping understand where the industry is headed in 2011 and beyond.

In 2011 BSA  will expand its industry coverage to include the commercial property markets. Look for our first report in mid-summer, which will cover office buildings, multi tenant industrial, single tenant industrial, and retail property types.

We would also like to acknowledge the assistance and insight provided by Bill McBride of Calculated Risk, whose charts and data base have added significantly to our understanding of current and future industry conditions. We reprint his charts with his gracious permission. My daughter Meghan McLaughlin has made a significant improvement in the clarity of our analysis.

Executive Summary
2010 was more of the same when compared to the last 2 years:

• Shrinking volume coupled with declining sales prices
• 
  In spite of government housing programs and builder price reductions, volumes still flat to falling, bad omen for future
• 
  High negative cash flows when tax refunds and inventory shrinkage is factored out. Higher negative cash flows in 2011
• 
  Debt service on $18 billion of debt (mostly bonds) is not and cannot be met from current operations or with 100% increase in unit sales coupled with a 50% increase in average sales prices
  
• Liability to equity ratios have increased to 220% from 138%,
  putting many companies dangerously close to violating bond covenants. Continued shrinkage of equity through losses, with no reduction in debt, will necessitate covenant waivers by year end if a significant rise in unit sales and prices does not occur.
  
• Debt stretch outs from new bond sales are misleading- most buyers are existing bond holders, exchanging  new12% paper for old 6% paper. Companies are worse off as a result. Is this next year’s preference argument in the bankruptcy courts? Give an existing lender higher interest payments and he gets more cash out before the Chapter 11 filings.
  
• Too many subdivisions (3,000), too many staff, too few sales
  (< 2 sales/mo/project). Home builders are forced to stay large by debt levels, not by the profitability of sales
  
• Cash balances are a mirage-created by one time events of tax refunds, inventory shrinkage. Balances are headed down again.

New ideas to change the direction (positive cash flow and profitability) are hard to come by. Following are the key considerations in determining which new ideas will work.

• Increased sales at higher prices are virtually impossible in a low job growth environment
  
• The overhang from foreclosures will continue to weigh on the new home market for at least 3 years, stealing unit sales at lower prices, and depressing pricing on all products for an extended period of time.  There are approximately 2.5 million resale units now in the hands of investors; when prices go up they will be the first sellers, keeping a lid on price increases for at least 3years, likely longer.
  
• Is the US homebuyer model (prices always go up, buy the biggest house you can, mortgage money will always be plentiful at easy qualifying terms, go for a house in the country instead of living in an urban environment (i.e. high rise close to work) )going through a permanent downward adjustment?
  
• Expect significant homebuilder consolidations to cut overhead and decrease the constant flow of new projects in over supplied markets. (See Solutions below)
  
• The national homebuilder model is a dead idea due to the high cost of maintaining multiple markets in a low volume/low margin environment. Expect market withdrawals or exchanges of positions within markets to reduce operating costs
  
• Look for major asset (land) for debt (bonds) exchanges as a part of pre packaged Chapter 11 filings.
  
• New equity raises will be extraordinarily expensive and dilutive
  What will be the impact of changes in the mortgage markets?   Expect a shrinkage of mortgage availability from FNMA and FRMA, to be replaced by private sources. Look for stiffer underwriting, larger down payments, and higher interest rates. Over all, a drag on housing until job growth accelerates.

Operating  Statement Indicators
The Consolidated Operating Statement for 2008-10 is included in Exhibit 1005.

Key observations are as follows:

• Current sales volumes cannot service overhead and bond interest payments. Unit sales must increase by 100 % and unit sales prices must go up a concurrent 45 % before homebuilding operating profits are at breakeven (Exhibit 1009)

• While 2010 was a good year for additional tax refunds due to the extended carry back period, gains from income tax refunds are drying up. See detailed discussion later.
  
• Housing revenue has flattened out (stopped declining) over the last 3 years, but has not turned up convincingly.
  
• Home building gross profit margin has gone positive indicating that inventory write downs are finally sufficient. However, we believe the slowed sales pace will dictate additional land write downs during 2011.
  
• Land sales are almost non-existent (Exhibit 1005). Home builders fear that sales will demonstrate true market value of land holdings and force more write downs.

• Capitalized interest pools are large and growing in spite of WIP shrinkage. 75% of interest is still being capitalized into inventory which makes quarterly operating statements useless
  (Exhibit 1005) With sharply reduced housing under construction WIP, more interest is being capitalized to land. (Exhibit 1003) Elevated capitalized interest pools indicate that more land write offs are forthcoming. (Chart 1003)
• Selling G@A, driven by an unsustainable number of open subdivisions and too many markets, remains at a high 13.5% of sales
  
• Corporate G@ A remains elevated as large staffs are needed for multi market operations, public reporting, and land entitlement processing.  If business is moved to different structures
  (new smaller, single market home builders), cost of doing business will be significantly reduced.

Balance Sheet Indicators

The Consolidated Balance Sheet (Exhibit 1006) and Cash Flow Statements (Exhibit 1007) are much better indicators (as compared to the Operating Statement)  of the health of the industry. Key Balance Sheet Indicators include:

As Balance Sheets shrink in a loss producing industry, assets go down faster than liabilities, thereby increasing leverage, which weakens the industry and its participants. Liability to Net Worth ratios have increased from  138% to 220% over the last 5 years (Chart 1001). The range of increased  leverage varies from company to company
(Chart 1001), but is in the same  direction.

This form of measurement (Liabilities to Net Worth is broader than the Debt to Equity ratio measurement contained in most debt covenants.

Likely actions by debt holders:

• More active bond/debt holder groups, more activist lawyers
• Continuing losses bring more covenant defaults
  

Likely concessions demanded by debt holders include:

• Forced consolidation with other home builders
  
• Significant reductions in staffing and overhead
  
• Withdrawal from marginal markets
  
• Restrictions on advances to subsidiaries and JVs
  
• Forced land liquidations
  
• Changes in Boards and or top management
  
• Consideration of asset for debt exchanges
  
• Require very expensive equity raises

Cash balances have increased over the last 3 years, but reversed direction during 2010 as operating losses outpaced  tax refunds. (Chart 1004). Total Cash reduction is equal to the operating loss after tax refunds, plus the additional investment in joint ventures/subsidiaries/increase in land investment. Some companies have reduced WIP faster than others, which has resulted in a better cash to liability ratio (Chart 1002). This is the best measure of the adequacy of cash balances in a negative cash flow industry.

Reductions in WIP have not kept pace with reductions in unit sales volumes for the following reasons:

• Inert land inventories are not being sold or moved into production. Year’s supply of lots is bloated
  (Chart 1002)
• In spite of large land investments, builders face a shortage of buildable lots and are buying more lot inventory to keep unit sales volumes up. See Exhibit 1005, Analysis of National Supply of Finished Lots.
• As unit sales volumes go down, years supply of lot inventory goes up, increases allocation of working capital to support, increases risk of inventory obsolescence
• Land moving into housing production is the heavily written down type, and therefore the relief to WIP is smaller.

WIP went up instead of down, which should have been the case given the $18 Billion COS for home sales. This indicates a lot of money still being spent on inventory. Likely spent on existing land, new lots, or carrying costs like interest.

The allocation of WIP between houses and land is also an important issue to understand. As cash is squeezed out of WIP houses, it leaves more and more of an allocation to land and land development. This is a clear and troubling trend demonstrated in Exhibit 1003, even more dramatic when you consider how far land has been written down through impairments. With still overleveraged balance sheets, if an upturn in sales does come, builders will not have borrowing capacity to build more inventory since so much of their borrowing is now pledged for land inventories. (Exhibit 1003)

Investments in Joint Ventures and Subsidiaries have increased dramatically as home builders are forced to contribute capital for debt re margining or to satisfy bank guarantee requirements (see KBH et al court action in Las Vegas). This is simply more of the same exposure to land investments. Additionally, guarantors must face the incomplete land development obligations and completion bond requirements. Look for more pressure on  balance sheets as these situations ripen with the secured bank lenders getting more aggressive now that their construction loan exposure to the large builders has shrunk close to zero percent.
Senior Debt outstanding declined by $2.5 Billion, i.e. -14%. However, total interest paid did not go down by a similar amount as some debt is being refinanced for a longer maturity at a much higher rate.
Refinanced Unsecured Bond Holders (Senior Debt) getting preference on negative cash flow. When existing debt is refinanced at a higher interest rate in a company which has a negative cash flow and non appreciating assets, those creditors are getting preferred distributions  (probably not in the legal sense of the word in a Chapter 11, unless it can be established that the company was insolvent at the time of the new debt issuance) of available cash flow for their interest payments. EG, when a bond holder had a 5% interest payment and all others got around 5%, there is a fair sharing of available cash flow. When a bond gets extended but has the interest rate increased to 12% (and there is no subordination of priority of principal, and there is no new cash added to the enterprise), then that lender now gets a larger % of available cash flow. If and when the borrower files a Chapter 11, the extended loan will  have received some preferential distribution of cash flow for the pre Chapter 11 period. It is even more egregious if the new debt also gets collateral when it was previously unsecured.

Debt Capacity for Additional Capital Requirements is mostly not available.  High debt to equity ratios preclude the renewal of  bank credit lines. This will be particularly critical when new land development financing is required or there is an expansion of WIP if sales pick up. See Chart 1001 for which companies are most at risk of not having new debt capacity.

Cash Flow Statement Indicators
Exhibit 1006 has the consolidated Cash Flow Statement, in detail
Total Cash declined by $3 Billion during the year

Cash provided by operations has dropped by $3 B from 2009 to 2010, accounted for total change in cash
Increased investment in WIP
Increased investments in Joint Ventures and Subsidiaries
Less Gross Margin from house sales
In spite of tax refunds
Cash flow from Investing Activities has gone negative
Increased purchase of Property and Equipment
Increased capital expenditures
Why is so much money being invested in these activities     when working capital is needed for the main business and bank borrowing is unlikely at attractive rates?
Cash flow from Financing Activities has gone negative
Some debt pay downs
Very limited new equity issuance-market not friendly
Treasury stock purchases have finally ceased

Other Important Inudstry Data

Industry estimates indicate that there are approximately 600,000 finished lots in the US. Approximately 15% are functionally obsolete (too far out, environmental challenges, etc), and another 10% are for the wrong product (mostly for large expensive houses),  and estimating 250,000 to be absorbed in 2011, leaving about  200,000 lots available for construction through the end of 2012.
Our group of large home builders have about 584,000 total lots both owned and under control. Only about 30% of these lots are finished or near finished (which is why the HBs are out buying new lots), for a total availability of  175,000 finished lots. At a sales rate of 82,000 units per year, trending up, this demonstrates that at best there is a 2 year supply, through 2012.
Converting raw land to finished lots takes on average about 2 to 3 years for entitlement and land development, but before house construction is started. Processing and land development are very expensive. If there are 410,000 raw lots in inventory, and it takes $60,000 per lot for all costs, including permits and development costs, then the total capital requirement is $24.6 billion spread over 3 years, or $8 billion per year in additional borrowing or equity needed to bring these land parcels to finished lots. Of course to attract this capital, the house prices must have risen to a level where the costs can be justified to the investors (see break even analysis, Exhibit  1009). Attracting this much added capital will certainly be a challenge given the over leveraged condition of balance sheets today.

Having a Better Understanding of the impact of Foreclosures/Shadow Inventory  on Pricing and Supply

Traditionally, new homes have been favored by buyers, as they were better designed, made a statement on the success of the Buyer, and carried a 15 to20% price premium for the privilege.
Over the last 4 years, those relationships have changed, with a negative impact on new housing;
The excess supply of resale houses has caused pricing over all to decline by some 50 to 60%, dragging down the prices of new houses in the process.
Some 20 to 25% of all resale houses, some estimates are much higher,  are now held by investors. When prices go up a little, expect a flood of investor owned homes to be placed on the market, keeping a lid on price increases for at least 3 more years. Strange as it may seem, the early round of investors (2007 to 2008) are now underwater themselves, and must wait for price increases to bail them out.
In 2005, new houses were 20% of all sales (new and resale), but are now less than 10% as new houses cannot be profitably built (even at written down land prices) for the prices at which resale houses are trading hands. With this large a market share, it is now the resale houses which set the prices, and new homes must simply follow suit.
The shadow inventory is an un quantified reality. No one knows how many to be foreclosed houses are sitting on the books of the various categories of financial institutions, in great part out of the fear that proper disclosure will further panic the market. However, just like the underwater early investors, as soon as prices move up expect additional supply to come out of the banking system, which will also keep a lid on price increases.
As a consequence of the above items, we believe it is best to expect a limit on total home sales in the 3.5 to 4 million range over the next 3 years, and to have those transactions completed at today’s price levels, plus at a maximum price increase  of 5% for each year. The new home market share will be 5%, or 150,000 to 200,000  per year, pulled down by a lack of finished lots.  Any further disruption in the banking system could force more houses on to the market earlier, which would drive prices down rather than have a modest increase, and volumes would not be greater.

Solutions, Solutions, Who Has the Solutions?

In a situation where the main problem is extreme over capacity in a highly leveraged industry, solutions fall into 3 categories:

Debt Reduction back to break even operating levels
Shrink competition through consolidation or insolvencies
Create New Demand with enough profit margin to service the debt

Recent demographic and other industry trends suggest that a solution based on increased demand is very unlikely due to the size of the debt servicing problem. Exhibit 1009 makes it clear that operating margins based on a 100% increase in unit volume (same size houses) coupled with 45% increase in sales prices and a rise in operating margins to 20% of sales prices will just get the industry back to break even.  On sales prices alone, it is difficult to imagine a rise in the average price to $387,000 given the 5 year+ overhang in foreclosure inventory. Therefore, the first range of solutions must come from a reduction in competition through debt reductions (forced shrinkage of companies) or consolidation, either voluntary or involuntary. These 2 categories of ideas are not independent, so there are only 2 categories of solutions; debt reduction/consolidation, and new demand creation.

Methods of Debt Reduction/Consolidation
Asset for Debt exchanges, likely through pre packaged
Chapter 11s. Likely debt exchangers are bond holders
Exchanges of market positions, E.G. Lennar trades California to KBH, and KBH gives Florida and North Carolina to Lennar.
Chapter 11 for 25% of the sales volume
Forced asset reductions as a condition of covenant waivers and requests for additional borrowing
Senior management/CEO departures as required by new debt and equity holders

Forms of New Demand Creation
New products for delayed family formations-young buyers
Smaller, more urban, less expensive, mid to high rise
Higher densities closer to job centers
More work/live types of products
Closer to/integrated with mass transit
Convert SFR to higher density properties
Concentrate on parcels with roads and utilities in place
Avoid far away sites
Smaller projects, little or no amenities to keep prices down
Exchange up for density units in urban areas for unbuildable sites in distant locations.
Keep prices down where mortgage money availability is certain
When demand /supply are in balance, re cycle foreclosure inventory
Move land assets to newly organized home builders who do not have legacy debt and asset challenges

Request Expanded Report and Supporting Data

The full report is available in to download as a PDF or Power Point format at  http://blackswanadvisors.net/homebuilder_report_register.html
 
Other Charts and Data Series

The Power Point report contains substantial added data on housing starts,  housing permits by product type, new home sales and pricing, shadow inventory, resales volumes and pricing, housing industry impact on job creation, and other background data too voluminous to include in this summary report, but most helpful and necessary for a good understanding of current trends.