Builders Not Yet a Safe Bet

The Federal Reserve's rate cut may have sent homebuilder stocks jumping, but the rally already is proving fleeting. Lower short-term interest rates will do little to help the beleaguered housing market or the builders.

Wise investors continue to stay away from these clunkers. Their reason: Why put money into companies that can't turn a profit, and can only shed homes at fire-sale prices to satisfy hefty debt burdens?

Hovnanian's(HOV:NYSE) weekend "deal of the century" price cuts exemplify the sad state of the industry. With the housing market continuing to deteriorate, Hovnanian and many other builders are finally paying the price for years of irresponsible land buying.

Now price cuts are the only way to clear inventory, and they hold ugly ramifications that the lower interest rates cannot solve.

After the Fed's rate cut Tuesday, the Philadelphia Housing Sector Index jumped 6%. It has already given back ground, falling 0.8% Wednesday, and recently sliding another 2.6% Thursday.

"I don't really think this Fed cut is going to help the fundamentals for the builders," says Alex Barron, senior homebuilding analyst at Agency Trading Group.

"I suspect a lot of people are probably going to use [the post-Fed rally] to come in and start shorting the builders again, knowing that all these weekend sales they are doing is going to cause them to report more impairment charges over coming quarters."

The essential problem for builders is that the housing market is suffering from a fundamental imbalance between supply and demand.

Oversupply of inventories and the continued building of homes without buyers are hurting one side of the graph.

Demand, meanwhile, remains anemic, since prices generally remain high and aggressive mortgage financing options for buyers have disappeared. And a lower fed funds rate will not necessarily create mortgage rate relief.

To clear inventories, builders are now being forced into pricing wars, as evidenced by the recent Hovnanian campaign.

The question is whether there is any profit margin left in the homebuilding business, says one veteran real estate hedge fund manager who remains bearish on housing. That makes valuing stocks today on future earnings a dicey proposition.

"It's like being in the middle of war and trying to figure out what it would be like in peacetime," the manager says.

Says Barron, the analyst: "You can't have a sustainable business model if you lose money on every home you sell. It seems that is what these weekend sales are about: Who can lose money the fastest."

Selling homes at discounted prices creates cash, but not profits. And if one builder cuts prices, then the builder across the street has to react in turn. This leads to builders recording more impairment charges, since land and communities for sale on balance sheets need to be written down to levels that allow for profits.

This quandary was raised by Ryland(RYL:NYSE) Chief Financial Officer Gordon Milne at a Credit Suisse investor conference Tuesday.

Milne said his company is offering price discounts ranging from 5% to 20% nationally at its communities. These prices are based on what the competitor is doing across the street.

"We have to match in order to keep business up," he said.

Land impairment charges, meanwhile, may continue at a rapid rate so long as prices keep falling. As Milne said, the builder either doesn't sell the house or it writes down the value of the community. The former, he said, is not really an option.

The declining fundamentals of the homebuilding business are being exacerbated by the fact that builders continue to build "speculative homes" -- houses for which they do not have a buyer lined up.

The idea is to immediately monetize land rather than just sit on it until the market recovers. Such moves are a classical prisoner's dilemma, where the best interest for each individual is not in the best interest for a whole.