Cover Feature March 2008

TREND report recently sat down with Southern Arizona’s top 4 home builders to get their outlook on the 2008 real estate market. Attending the roundtable were John Bremond of KB Home; David Greenberg of DR Horton Homes; Shawn Chlarson of Pulte Homes; and Steve Craddock of Lennar Homes. Despite the challenges they face in the year ahead, the overall mood was upbeat with David Greenberg injecting his keen sense of wit.

2007 ended with 6,185 new home closings according to “The Southern Arizona Housing Market Letter.” This is down 24% from 2006’s volume of 8,149 closings, the second highest number on record. New home permit volume ended at 5,098, a 40% decline over 2006’s permit volume of 8,579. The drop in 2007 permit volume means a further decline in new home closings in 2008. Experts are projecting almost a 50% decrease from 2005/2006 numbers in new home closing volume for 2008. Optimists are hoping for 4,500-4,600 closings, others are more guarded—projecting closer to 4,000 new home closings.

Lower ‘can’ Rates and Spec Inventory in 2008
Controlling spec inventory, unsold homes under construction, is a key strategy to help market recovery. This year, builders are focusing on building homes for solid buyers. Bremond indicated that KB Home’s Tucson business will be close to half of its 2007 business in terms of deliveries. This is due to controlling sales activity, by design, to allow excess inventory levels to be absorbed. In normal market conditions, a certain percentage of WIP (work in process) is spec inventory as a way of managing even flow production.

Last year, builders continued building spec inventory and then got hit with a high rate of sales cancellations (‘cans’) after the previously-purchased homes started construction. Pulte and DR Horton reported an average 40% ‘can’ rate in 2007, whereas a normal ‘can’ rate is closer to 15-20%. DR Horton’s ‘can’ rate on dirt sales (to be built) was astronomical while the can rate on specs was half what it was on dirt sales. Lennar’s business last year was inventory intensive. They got solid buyers later in the building cycle, after earlier buyers had cancelled, so the time from contract sign-up to closing was more finite, so the risk was minimal; can rate was 22%, was better than year before which was 26%; though not intentional, just in time deliveries. In many cases, builders could have 3 or 4 sales on the same house. Buyers that had been in backlog longer would want a lower price or they would cancel. The second half of last year, the builders did a better job of controlling their inventory down to a more manageable level. DR Horton’s not concerned about new home inventory—they’ve already worked their inventory down to about 70 specs, which represents approx. 15% of their 2008 closings. They are more concerned about the resale volume.

Market conditions are impacting stability of backlog orders. Entry level buyers, the largest portion of new home buyers, no longer have access to mortgage products they need and can’t qualify for loans. Move-up buyers can’t sell their existing homes because of the excess inventory in the resale market. Because of backlog instability and in an effort to control specs and cancellation rates, builders limit contingency sales and monitor them very closely.

Back to Traditional Mortgage Products
With sub prime products no longer available, it follows that can rates are improving. Builders have also tightened their approval criteria—they’re back to the traditional business of government lending, with FHA, VA and conventional loans. The builders reminisced about the “good old days” when people used FHA loans with 5% down, VA loans with no money down, or conventional loans with 20% and people saved money. They indicated that they still get people wanting 100% financing.

The builders agree that the big unknown is the impact of foreclosures on the market. The media has reported that somewhere around 2 million loans are coming due across the country. In order to get first time buyers into homes, a lot of these 2, 3 and 5 year ARM products were used. Now these loans are coming due and homeowners are completely upside down—owing more money than their homes are worth. Homeowners are abandoning their homes and, more importantly, their mortgages, rather than trying to keep up with rising payments on deteriorating assets. So many people are handing their keys back to lenders that a new term has been coined for it: jingle mail.

Bremond—“That has to be one of key points addressed by the administration as they look at addressing economic conditions, if they’re truly hoping to cut the recession off the pass, that’s one of the key elements that has to be looked at because the foreclosure rate could just terribly exacerbate the problem that we are in.”

The Fed cutting the interest rate will help in an effort to hedge off a complete disaster. There is concern how long they will be able to hold the rates down as there are so many inflationary indicators. The builders are concerned about the projected 10% increase in oil consumption this year with no slow down on demand. Supply is finite so it keeps the price up. Oil obviously has a significant impact on all consumer goods.

Higher Price Point Buyers Also Looking for Value
From the builders’ perspective, sales are challenging across all production home price points. Higher price point buyers are just as value-oriented as lower price point buyers. They want a higher level of standard features as opposed to just going after price. DR Horton has focused on attracting realtor business. Buyers are more educated now as they are able to spend more time shopping and they’ve developed a good sense of what the value equation is. According to DR Horton, their “rock bottom” pricing campaign worked for a while, until other builders dropped their pricing. The pricing adjustments just caused more problems with buyers in backlog who wanted the new lower price or would cancel their contract. Now, getting appraisals to support the sales price is becoming a challenge, especially in oversupplied sub markets, like Sahuarita and the southwest.

Challenging Locations
The farther out sub markets, such as Sahuarita and the southwest, are the most challenging places to do business today. Rancho Sahuarita was up 17% overall in sales last year, however, the home builder panel agreed that it is a challenging location for higher-priced new home sales. There are currently 6 builders with 17 different home series targeting families (too many stores and a lot of move-up product) for a limited pool of new home buyers. As a result, the environment is very competitive among the builders. In addition, builders are competing with foreclosures and short sales. According to the builders, the price isn’t the right price for the location right now and they can’t get buyers qualified. Madera Highlands is also struggling with an additional 3 builders offering at least 5 home series, plus Los Arroyos and Santo Tomas—the whole sub market has got some challenges in the near term. Move-up buyers are finding that they can buy a new home closer in for a lower price.

Going forward, master plan developers will try to protect their first phase builders by limiting parcel sales and providing more diverse segmentation within lot sizes and product offerings. One of the early adopters of this practice is Cottonwood Properties who limited the number of builders and parcel sales first at Rita Ranch and then at Dove Mountain. This type of development model creates greater value over the long-term for all parties involved.

Builders Looking at the Right Land Deals
The builders are in the market for the right land opportunity in the right location. Given the land buying trend of 2-3 years ago, many builders will be out of diversified land positions this year. Builders are primarily looking for land that is well-located and deals that are “light on the books”—in other words, minimal risk with take downs, rolling options, a few lots at a time to construct models. The builders feel that raw land is still priced too high—land sellers have not adjusted their pricing yet. In addition, development costs have not contracted much and therefore finished lots cost more than they are worth just to develop. So when you factor in house costs, there is no margin at today’s finished lot costs, especially in second tier sub markets. According to DR Horton, they had an opportunity to buy distressed lots in the southwest, but the price was not low enough and they couldn’t sell houses based on the finished land price. Pulte indicated that it might look to identify a couple of land opportunities by the middle of this year, but not close escrow on anything until next year.

If corporate offices won’t approve outright land purchases, the builders will need to look at strategically selling off lots from communities with deep supply in exchange for lots in other sub markets in order to continue to be well-diversified throughout the market. We have already seen some of this happening at Star Valley and Rancho Sahuarita.

Looking Ahead
The top 5 builders, which typically account for about 65% of total market volume, are looking at around 500 - 600 closings each this year, with Lennar at about half that. They project that we would probably see somewhere around 4,000 closings in 2008, but the optimists are projecting closer to 4,500 closings. The Tucson new home market is significantly influenced by the top 10 builders who typically account for 85% of total volume—which was also the case last year with top 10 builder volume totaling 5,249 of the 6,185 closings in 2007.

Each of the builders has a slightly different business strategy for handling the slow down. Lennar’s strategy, with a much smaller business in 2008, is to cut way back, take a wait and see approach, and make a move when the time is right. According to Craddock, Lennar’s worked to limit their exposure and they are going to wait until things look a lot better. DR Horton and Pulte’s strategy is to keep selling and building homes. They believe that strategy will get them their closing numbers this year.

Contrary to speculation, for the time being, large builders will continue to run their businesses out of Tucson. This is a smart decision given the unique characteristics of the Tucson market vs. Phoenix. There is speculation that regional builders who entered the market during the run up as well as smaller, local builders might not survive the year. We have already seen the departure of Standard Pacific Homes as well as the closing of AmericaBuilt.

Bright Spots in the Market
For Chlarson, Tucson is a bright spot relative to other markets—it’s good to be in Tucson vs. Florida, Michigan, Southern California, even Phoenix—so being in Tucson is a bright spot in relative terms. More specifically, in fill locations and areas that are well-priced and under supplied will fair well. A couple of the builders report that their year is off to a good start with sales, with Pulte reporting the highest sign ups in the market according to the SAHBA sales numbers. Bremond is hoping for stabilization later in the year, by third or fourth quarter, “don’t look for robust recovery by that time but stabilization. By end of third quarter, we’ll hopefully see the bottom and resale listings down to something under 6 months.”