Each week someone attempts a new and encouraging prognosis of the housing industry, often revealing nothing more than wishful thinking about what is perhaps the worst recovery in our economic history. This good news is analogous to an airplane hurtling out of control toward the earth and a stewardess finding another box of peanuts to distribute to the terrified passengers. It’s too late.
Words of encouragement back in 2009 held hope that housing would at least be on the way to recovery by 2010 or 2011. In the latest pronouncements, economists are saying that prices in the housing industry will not begin to recover until 2014. They’ve not had it correct yet, so it could very well be around 2016 before we see substantial improvement.
When the bubble burst, so to speak, the price of housing began to collapse. That process has not stopped. While it is better in some areas of the nation, prices of existing houses continue to plummet and predictions are that it may continue for quite some time. This creates negative equity or makes the loan “upside down”. Basically, when prices fall, a point is achieved in which the house is not worth what it was financed it for. This makes it difficult or impossible to sell. For those that have maintained their mortgage payments, they may be unable to sell because they would have to provide for any differences between the original price and the new lower price. No equity in the house also means that the plans to move to bigger houses go away.
Robert Shiller, Yale economist and housing expert, recently announced that he sees an additional decrease in housing value somewhere between 10% and 25%. This is a devastating number. He goes on to state, “I worry that this is a real and continuing downturn, like in Japan... It had a boom in the 1980s that peaked in 1991. Prices declined in the major cities for 15 straight years after that.”
With prices declining and lack of potential profit, construction companies have little reason to build. There are niche markets, but they are few. CoreLogic a leader in business analysis has estimated that negative equity mortgages are gaining once more and are above 11 million or equivalent to about 23% of all U.S. homes. It is believed that the number will approach closer to 30%. While no one is certain how many of those will lead to foreclosure, the numbers are staggering. To make matters worse, there is the “shadow” inventory or approximately 6 million houses that are part of the foreclosure problem and are also selling for less than market value. This is one more reason for builders not to build.
Then, there is the economy which is starting to show indications of inflationary times ahead. If inflation takes hold similar to the 70’s, interest rates will be required to be raised, adding to the death knell of the building industry for even a longer period. We know that no recession has ever fully recovered without the housing industry playing a major role, so it’s imperative that the industry improve, but the probability of an easy or quick resolution is virtually zero. Some may argue that a few of the builders have recently shown improved numbers and that stocks have recently risen. Take a second look and you will see that most have gone back down. This is the typical “dead cat bounce” that we investors talk about.
Lastly, there is the strong possibility of another financial crisis on the horizon. Most people pay little attention to what’s going on in Europe. Greece, Italy, and Spain are closer to defaulting than many realize which could lead to worldwide economic chaos.
How are the construction companies managing throughout this? Is it a good time to invest in them? There are warning signs that should not be overlooked. We know that the recession and bubble hurt the entire industry. This is not about one company that is financially distressed; it is the entire industry.
Some of the ways in which we can determine the strengths or weaknesses of companies or see potential signs of trouble ahead are through various financial ratios or metrics. Let us examine some of the major builders. Below are some of the metrics that are often used:
Interest Coverage Ratio: This determines how well a company can pay interest on any outstanding debt. This ratio is calculated by dividing earnings before interest and taxes (Ebit) by interest expense. Any ratio less than 1 indicates that the company isn’t generating satisfactory revenues to pay the interest expense which can lead to serious problems. A number greater than 4 indicates a lot of financial strength.
KB Homes (NYSE:KBH)
Note that Ryland, Pulte and KB Homes all have negative earnings with interest coverage less than one, indicating potential major problems. Meritage is very close to 1 and Lennar appears to be the safest.
Altman Z Score: Created by Edward Altman, the score consists of five metrics designed to determine the likelihood of bankruptcy. A number of 3 or greater indicates financial strength. Numbers less than 3 to 1.8 indicate potential problems in the future and any company with a number less than 1.8 is in danger of bankruptcy. The score has a 72% accuracy rating of determining bankruptcy approximately two years in advance in tested models.
Altman Z Score
KB Homes (NYSE:KBH)
Leverage Ratio: One of the most used is the debt to equity ratio which shows how debt is being financed. Depends on each individual industry, so comparing 5 builders will give a strong indication as to which are the strongest or weakest. High debt to equity can lead to bankruptcy, therefore; the lower number, typically the better. Pulte and KB Homes have the highest debt/equity ratios.
KB Homes (NYSE:KBH)
Current Ratio: Is equal to current assets divided by current liabilities and indicates the ability of a company to pay its short term obligations. The higher the better. Value investors typically look for a current ratio of 2 or higher. Anything less than 1 indicates that the company would be unable to pay an expense that suddenly came due.
KB Homes (NYSE:KBH)
With the lack of a recovery and numbers like these, investors need to differentiate between distressed stocks and those that are in danger. Do your due diligence before investing and continue from here to study those that you may find good values.
These are extremely tough times for this industry and Ben Bernanke, Federal Reserve Chairman has also indicated that this will not pass quickly. Bernanke is another worrisome element to the entire equation, because his policies have not expedited the recovery and have increased the nation’s debt to a worrisome level. Many do not believe he has the expertise necessary to get us out of this predicament. Bernanke studied the Great Depression and was a speaker at Nobel Prize Economist Milton Friedman’s birthday. Interestingly, he admitted to Friedman, that the Federal Reserve was actually responsible for the Great Depression. His remarks concluded with:
“I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
I hope he’s right and not writing a new chapter.