Fitch: Light at the End of the Tunnel in Sight for U.S. Homebuilders

With various macroeconomic housing and related statistics bottoming about mid-year 2009 and subsequently moving forward in fits and starts, a four-year downturn has evidently come to an end for U.S. homebuilders, according to Fitch Ratings in its outlook report for the sector.

While Fitch maintains a Negative Outlook for U.S. homebuilding in 2010, the expected conclusion of the national housing credit has positively influenced housing data over the last few months. Pending home sales, existing home sales, single family housing starts and single family new home sales have been generally showing improvement after bottoming out earlier this year. The same holds true for new home inventories, home pricing and consumer and builder sentiment. Importantly, the U.S. economy apparently moved from recession to expansion in third quarter-2009 (3Q'09). However, challenges remain, especially the expected upcoming surge in delinquencies and foreclosures for both Alt-A and option adjustable-rate mortgages (ARMs).

Fitch raised its forecasts for starts and new home sales earlier this year, the first positive adjustments in these metrics in over three years. Nevertheless, Fitch anticipates that the early stages of this expansion may be more muted than the average.

During the first 12-15 months off the bottom, the recovery may appear jaw-toothed as substantial foreclosures now in the pipeline present as distressed sales, and as meaningful new foreclosures arise from Alt-A and option ARM resets. High unemployment rates and the probable tightening of certain FHA loan standards (higher minimum credit scores for new borrowers and greater upfront cash requirements) will be notable headwinds early in the upcycle.

'The continuation and expansion of the national housing credit should partially help offset expected seasonal declines during the winter months through the spring of 2010,' said Managing Director and lead U.S. homebuilding analyst Robert Curran. 'The federal government's continuing efforts to moderate foreclosures may also show some success in 2010.'

Despite having fewer competitors, public builders will continue to be challenged and need to maintain tight controls over costs and expenses during 2010.

Ratings Rationale:

Housing continues to be weak. Fitch expects that the public builders by and large to typically stabilize their aggregate land positions over the next 6-to-12 months or selectively add to owned, developed lot holdings. The still irregular flow of appropriately priced land from banks and others tends to support this conclusion.

'With operational and financial pressures moderating to some extent, most public homebuilders have to operate successfully within this still challenging environment or wither away,' said Curran. Companies have to at least maintain current cost profiles or continue to downsize to the point where they can remain/be profitable (excluding nonrecurring real estate charges). That means possible further moderate cuts in staffing and other overhead, as well as other cost reductions.

The builders' gross profit margins and selling, general, and administrative (SG&A) expense/sales ratios will confirm the success of their efforts.

The public homebuilders cannot significantly influence revenue trends and profitability at present, but they can manage their balance sheets and their liquidity. In a period when liquidity is still an issue for all U.S. companies, Fitch believes that, overall, the U.S. homebuilding sector has adequate liquidity. However, some weaker companies face greater liquidity risk. Many companies in this sector have generated meaningful free cash flows (FCFs) over the past 12 months while terming out borrowings, and for some maintaining access to committed bank facilities, which together provide room to handle maturities and fund working capital needs over the next year and beyond. Admittedly, most facilities have been substantially slimmed down as builders sought covenant relief in amendments.

For certain builders, cash flow has been enhanced by relatively recent debt offerings, large land sales, tax refunds, and even some public equity offerings (e.g. Meritage Homes Corp.; Hovnanian Enterprises, Inc.; Lennar Corp.; M/I Homes, Inc.) or other external cash infusions (Standard Pacific Corp.). Recently passed legislation that extends the net operating losses (NOL) carryback to offset taxable profits from the previous five years will result in meaningful tax refunds for most public homebuilders early in 2010 further enhancing liquidity and tangible net worth.

Compared with the last major housing downturn in the latter 1980s into the early 1990s, leverage was lower during the later part of this past upcycle and at the peak. Fitch notes that during the past two years primarily non-cash charges against tangible net worth (TNW) have raised debt/capital ratios. For the majority of public homebuilders, debt composition 15-to-20 years ago was mostly, or all, short-term construction loans and possibly a secured credit line. By contrast, today the debt often is weighted most heavily to well-laddered public debt (a more appropriate balance with longer lived real estate assets), and, to a lesser degree, to an unsecured revolving credit facility.

All the public homebuilders in Fitch's coverage that have revolving credit facilities have unsecured facilities, except for Beazer Homes U.S.A Inc., M/I Homes and Standard Pacific, which have secured or partially secured revolving credit facilities. D.R. Horton, Inc., Ryland Group, Inc., Meritage and Hovnanian recently terminated their revolving credit facilities. Beazer and Standard Pacific have sharply lowered the size of their credit facilities.

Fitch will continue to assess each homebuilder's approach and performance relating to land and development spending, balance sheet (inventory) contraction, FCF generation, and debt reduction when considering its ratings, as well as builders' credit metrics, liquidity, size, geographic and product diversification, margins, and the frequency and the size of real estate writedowns and option writeoffs.

Despite the Negative Outlook for the sector, continued progress in industry and company metrics could prompt a reassessment and possible revision of some of the U.S. homebuilder Rating Outlooks.

2009 and 2010:

Some of the key drivers of the downturn remain in place although the worldwide and U.S. recovery have begun. Notably, U.S. households are deleveraging and retrenching at a rapid pace, in response to significant job losses, ongoing declines in certain asset prices, and tight credit conditions. In combination with sharp cutbacks in corporate spending and ongoing declines in residential investment, Fitch forecasts U.S. GDP to fall by 2.5% this year, and unemployment to possibly touch 10.3% in 2010.

With unemployment still rising, consumer confidence at low levels and household wealth until recently still being affected by real estate and equity price declines, there seems limited prospect that the deleveraging process will end in the near term. Fitch's forecasted 1% decline in consumer spending in 2009 implies a further increase in the saving ratio.

Fitch expects the economy to return to positive growth next year, primarily reflecting the impact of the fiscal stimulus package, but also some likely stabilization in housing investment and a weakening inventory overhang. The CBO predicts federal government spending grew by 34% in nominal terms in fiscal 2009 (ending September), which should have an important subsequent multiplier effect on wider spending. Lower household tax rates should also help ease the pace at which consumers deleverage through cutting expenditures, while lower commodity prices will also support consumers' real income.

However, while the forecast assumes that policy measures aimed at stabilizing the financial sector gain traction, ongoing household deleveraging will weigh on private sector demand, keeping GDP growth in 2010 well below potential.

Rates on 30-year fixed mortgages averaged 6.03% in 2008, off 31 basis points (bps) from the 6.41% in 2006 (and 6.34% in 2007). Fitch expects rates to decline as much as 90-100 bps for all of 2009 as the Fed continues to execute its plan to buy mortgage securities and the economy struggles.

Fitch's initial outlook for the housing sector in 2009 started quite bearish due to the influence of a softening economy, even tighter credit standards for homebuyers and the effect of late 2008 disruptions in the credit markets. However, by mid-year the outlook brightened, prompting lesser forecast declines for a number of housing metrics. Fitch most recently forecast a contracting economy during first half-2009, with a mild recovery beginning in 3Q'09 and continuing through 2010. Real GDP is forecast to decrease 2.5% for all of 2009. Investment is expected to plunge 17.6%, with consumer spending to fall 1%, exports to drop 11.6% and imports to see a 16.6% decline.

Government spending (up 5.1%) was the economic positive in 2009. Inflation is expected to be a negative 0.2%, compared with a positive 3.8% in 2008. As noted earlier, interest rates are expected to meaningfully recede.

An economy in the midst of a severe recession has been another blow to housing. In particular, a deteriorating economy further eroded consumer confidence and accelerated job losses, and consequently, foreclosures. The MBA and John Burns Real Estate Consulting forecast 2.76 million annual foreclosure starts in 2009, up from 2.27 million in 2008, and project 2.94 million foreclosure starts in 2010. The Center for Responsible Lending forecasts 2.43 million foreclosures in 2009 and 8.1 million foreclosures over the next four years. Various programs from Washington are designed to stimulate the economy, stem foreclosures, and improve housing demand. However, these actions are unlikely to stabilize and then boost housing demand until later in 2010 or beyond.

In 2009, total housing starts are projected to fall 41.1% to 530,000 with single-family volume declining 30.6% to 430,000. New home sales are forecast to decrease 23.1% to 373,000, while existing home sales are flat at 4.91 million. Average and median single-family new home prices are projected to fall 8.7% and 8.6%, respectively, in 2009.

Fitch is forecasting a stronger economy in 2010, although still noticeably below the historical trend line. Real GDP is projected to grow 1.8%. Consumer spending and government spending are forecast to expand 0.3% and 10.8%, respectively. Investment should fall 4.9%, while inflation is expected to be about 0.8%.

Total and single-family housing starts are forecast to grow 15.1% and 18.6%, respectively, in 2010. New home sales should expand approximately 20%. Existing home sales should increase about 7.5%. New home prices could average 2%-to-3% higher in 2010.

Implications for the Companies and the Ratings:

For the full year of 2009, homebuilders' revenues could drop 42% on average. For those builders who are profitable, EBITDA before real estate charges could fall approximately 55%. Current credit metrics (LTM EBITDA/interest incurred, debt to LTM EBITDA, and FFO interest coverage) are considerably lower than at 3Q'08 end and that will also be the case at calendar year-end 2009. Debt/capitalization ratios have deteriorated for the majority of builders over the past three years, largely as a result of erosion in TNW from sizeable real estate charges and FAS 109 adjustments.

Although some builders have been more proactive than others in reducing inventories and lowering debt levels, most, in retrospect, started relatively late during this cyclical downturn. For most, inventories and debt are now meaningfully lower than at their peaks: owned inventories down 64.5% from the peak; debt down 35.5% from the peak.

Given Fitch's macroeconomic forecast for 2010, public builders are likely to experience a mild recovery next year. On average, revenues should expand low double digit despite lower home prices due to a mix shift to smaller, often entry level homes. Gross margins should improve 150-200 basis points reflecting earlier real estate charges and lesser selling incentives. With higher volume the typical SG&A expense/sales ratio may diminish. As a consequence, most public builders should report modest profits on an EBITDA and pretax basis in 2010.

That being said, Fitch still expects modest to moderate land value write downs in 2010.

Excluding tax refunds, average CFFO is likely to be lower in 2009 relative to 2008 and to be neutral to modestly negative in 2010.

On average, credit metrics, particularly profit related metrics (LTM EBITDA/interest coverage, debt to LTM EBITDA), should stabilize and then start to improve later in 2010. Tangible net worth should grow. Debt leverage should at least modestly improve.

Since credit pressures will persist, at least in the intermediate term, it will be imperative that builders continue to manage their balance sheets, selectively reducing or stabilizing land and development spending, with the exception of markets where lot positions dip below minimum acceptable levels and land (preferably rolling option, developed lots) is available on a sharply discounted price basis.

Fitch expects homebuilders to reduce debt where possible and to exercise restraint as to share repurchases, dividends, and company acquisitions in these still uncertain times. Builders should be cautious about reacting prematurely to a market bottom and early-stage recovery with overly aggressive real estate purchases.

Fitch rates the builders within the context of a typical cycle. In the midst of a non-typical upcycle, as took place in the 1992-2005 period, a number of builders realized higher credit ratings. Conversely, due to this sharper than expected contraction, which has lasted longer than the norm, and as builders' operating and credit metrics have been even more stressed, ratings have been lowered.

While the possibility remains for a few additional company downgrades, the likelihood of such action has diminished. Continued progress in industry and company metrics could prompt a positive revision of a number of Rating Outlooks.

The following is a list of Fitch rated U.S. homebuilders and their current Issuer Default Ratings (IDRs) and Rating Outlooks:

-- Beazer Homes USA ('CCC'; Outlook Negative);

-- D.R. Horton, Inc. ('BB'; Outlook Negative);

-- Hovnanian Enterprises, Inc. ('CCC'; Outlook Negative);

-- KB Home ('BB-'; Outlook Negative);

-- Lennar Corp. ('BB+'; Outlook Negative);

-- M.D.C. Holdings, Inc. ('BBB-'; Outlook Stable);

-- Meritage Homes Corp. ('B+'; Outlook Negative);

-- M/I Homes, Inc. ('B'; Outlook Negative);

-- NVR, Inc. ('BBB'; Outlook Stable);

-- Pulte Homes ('BB+'; Outlook Negative);

-- Ryland Group ('BB'; Outlook Negative);

-- Standard Pacific Corp. ('CCC'; Outlook Negative);

-- Toll Brothers, Inc. ('BBB-'; Outlook Stable).

Additional information is available at 'www.fitchratings.com'

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