Fitch maintains an overall Stable Outlook for ratings in the homebuilding industry. Nevertheless, several issuers have the potential to rise to investment-grade level during 2006, and a few issuers possibly could move to higher ratings within the investment-grade universe. A growing economy, along with accompanying robust financial numbers and improving credit metrics relative to their peers, would be the trigger for any rating upgrades.
However, should the economy flatten or retreat, interest rates soar, or lending institutions sharply tighten credit standards, broad housing metrics could be sharply curtailed to the disadvantage of builders’ financials. Yet, the larger public homebuilders, from a debtholder perspective, seem to be relatively well positioned to weather even such negative events. In a mildly declining market, such as Fitch expects in 2006 and certainly in a more sharply impaired market environment, managements are expected to maintain the discipline necessary to pare land purchases and, consequently, inventory, as market conditions warrant.
Fitch is sensitive to concerns that liberal and innovative lending standards of recent years could become more of a problem when the economy dips again. Fitch also is monitoring the shift by larger public builders to greater off-balance sheet activities, options, partnerships, joint ventures, and, as information allows, integrates into its analysis the actual financial risk associated with these activities.
Current demographic trends support relatively stable demand, although the cyclical peak for most national housing metrics was probably realized in 2005. The growing importance of minorities, immigrants, and Echo Boomers, the children of the Baby Boom generation, should boost the share of housing production targeted to entry-level buyers in the years ahead, to the advantage of the large, conventional public builders and manufactured home producers that focus on that segment.
The Baby Boomers will continue to generate significant demand as some trade up or buy a second home in these peak earnings years or, with children grown, trade down. Soon, some of the oldest of the Boomers will seek out active adult communities for their retirement years. Housing and jobs should continue to generally migrate to the perimeters of metropolitan areas where open land is readily available, a pattern that plays to the strengths of the large public builders. However, in certain urban markets where land is in particularly short supply, some public builders should find growing acceptance of affordable and move-up housing offered in mid- and high-rise structures.
Fitch’s outlook for the sector attests to a larger trend: the evolution of the industry’s operating model to manufacturers instead of primarily land speculators. This evolution has reduced the risk profile and enhanced the balance sheet liquidity of many companies.
Fundamental changes within the homebuilding sector include continuing consolidation, a broader degree of management sophistication, and an increased proportion of the still relatively fragmented homebuilding industry that has moved to a return on capital focus. The adoption of standard corporate finance techniques and the movement away from a real estate orientation will continue to have a significant effect on balance sheet liquidity among the large builders, leaving them better positioned in the event of an economic downturn.
In recent years, homebuilders have moved steadily to higher credit ratings and, in a meaningful number of cases, upgrades into the investment-grade category. During the past 15 months, Fitch has raised the credit ratings on two homebuilders and assigned Positive Outlooks to two companies. Fitch has also initiated high yield ratings on a builder and assigned a Positive Rating Outlook to that credit. This improvement in credit standings is part of a larger trend relating to the evolution of the industry’s operating model, an evolution that has reduced the risk profile and enhanced the balance sheet liquidity of many companies. Financial measures also have improved due in part to the extended strength in economic conditions during the past 15 years and continuing low finance rates. However, rather than being the primary factor responsible for the improvement in credit standing, healthy markets have aided the broader transition that has taken place within a large sector of the industry.
Changes to operating models have occurred at a number of large builders, which has better positioned the top tier of this sector to weather a deterioration in economic conditions.
Since the last cyclical downturn, fundamental changes within the homebuilding sector include continuing consolidation, a broader degree of management sophistication, and an increased proportion of the still relatively fragmented homebuilding industry that has moved to a return-on-capital focus. The adoption of standard corporate finance techniques and the movement away from a real estate orientation have had a significant effect on balance sheet liquidity among the large builders, leaving them better positioned in the event of a down turn.
The cyclical nature of the homebuilding industry produces meaningful swings in demand in response to changing market conditions, largely fluctuations in mortgage rates, employment growth, and consumer confidence. Negative perceptions of this sector remain due to some companies’ performances during the recession of the late 1980s and early 1990s and earlier major recessions, as well as the lingering perception that the next consumer-led downturn could produce similar stress in the industry. The homebuilding industry’s performance during the largely industrial 2001 recession helps moderate this perception somewhat. However, for the time being, homebuilders may continue to pay a penalty in capital markets, particularly as reflected in equity multiples, compared with similarly rated companies in other cyclical industries.
Fitch’s position is that although the risk of financial stress in a downturn will always be present in the industry, the largest national builders, from a debtholder perspective, seem to be clearly better positioned to weather economic downturns. The other public builders and the largest private builders also appear to be capable of withstanding typical economic downturns better than they did in the past.
Industry Notes
— Fitch estimates that single-family housing starts for 2005 will reach 1.70 million, a 5.6% rise from 1.61 million in 2004. Single-family starts may shrink to 1.62 million for 2006;
— Multifamily housing starts are expected to edge down 2.9% to 0.34 million in 2005 and then slip to 0.33 million next year;
— Fitch estimates new home sales for 2005 will reach 1,266,000, a 5.2% increase over the prior year’s 1,203,000 and approximate 1.205 million for 2006;
— The average and median new home prices are expected to be $288,400 and $227,100, respectively, in 2005. These increases of 5.1% and 2.8% will not be matched next year. We do not expect prices to decline nationally, although prices could flatten or, perhaps, slip a bit in some of the most overheated, typically coastal markets. Nationally, we forecast that average new home prices will inflate 3.5% in 2006, while the median prices rise 1.5%;
— The relatively modest decline in housing activity projected for 2006 reflects anticipated moderately higher interest rates (including mortgage rates). But this should occur largely because of a steadily growing economy (real gross domestic product up 2.8%), which should generate a healthy level of employment growth and stimulate relatively high levels of consumer confidence, as well as from long rates catching up with short rates and the Fed’s continued push for higher rates;
— Almost all of the major public homebuilders will report substantial increases in revenues, home deliveries, margins, and profits in 2005 – typically all records. Current backlogs, market share momentum, and geographic positioning suggest that new records for at least revenues, deliveries, and profits will be established for most of the public builders in 2006, although the gains are likely to be less pronounced than in 2005. Credit metrics generally improved in 2005 and should be relatively stable next year;
— Acquisition and consolidation activity has accelerated over the past several years as builders continue to pursue growth to provide returns to shareholders. With interest rates expected to rise and stock multiples low, conditions favor private company acquisitions by public builders rather than combinations with other public companies.
— In response to the recent sharp sell-off in homebuilder stocks, many companies have enlarged their share repurchase authorizations and some have stepped up actual repurchases. As long as companies are selectively moderating land commitments to support their repurchase activity and not funding this activity with debt, credit metrics should remain relatively stable.
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