Builders drop incentives as new-home inventory declines

By DAWN WOTAPKA as seen in the Wall Street Journal

OCTOBER 6, 2009 – Home builders are scaling back on the incentives offered to attract buyers, putting an end to such freebies as sports cars and tropical vacations.

With new-home inventory falling as home sales in many markets pick up, builders say they no longer need to offer eye-popping inducements to move homes.

"I don't know of any examples, at least in our system, where we're offering the kind of huge incentives that were being offered two or three years ago," said Brent Anderson, vice president of investor relations for Meritage Homes Corp., based in Scottsdale, Ariz.

In 2007, Meritage offered shoppers at its Valley Vista community in northern Phoenix $60,000 of incentives, including a free pool, gourmet kitchen or a reduction of the $349,000 ticket price, for a three-bedroom home with two-and-a-half baths. But the company is now building smaller, simpler houses that sell for about $245,000. Today's buyers are more likely to get Meritage to pay their closing costs, worth about 6% of the closing price, or about $15,000 at Valley Vista.

Builders acknowledge that incentives are a part of doing business and they will never disappear completely. And the moves to cut back could be reversed if home sales stall again, which some housing analysts and economists are forecasting. These pessimists warn that new-home sales could slow when the $8,000 federal tax credit for qualified first-time buyers expires later this year or when a possible wave of foreclosed homes hits the market, which will compete with new homes for buyers.

For the time being, the pullback in construction and the reduction in inventory means more builders can sell homes without cutting as deeply into their profit margins. According to Jeffrey Laverty, an analyst with independent research firm Oscar Gruss & Son, single-family home supply whittled from 570,000 at the 2005 peak to 261,000 as of August. Supply, meanwhile, has fallen from 12.4 months in January to 7.3 in August, nearing the six-month mark considered a healthy balance between buyers and sellers.

During the housing boom, incentives weren't really needed. Loose lending standards fed what seemed to be insatiable demand. With buyers willing to pay more, builders added square footage and tacked on profitable incentives, helping boost the gross margin to an average of 26.2% in 2005 -- nearly double current rate, according to J.P. Morgan Chase analyst Susan Berliner.

During the housing bust, builders were stuck with a bloated supply of oversized and overpriced houses. They initially resisted price cuts, fearful of angering current owners who paid boom-time prices. Instead, builders moved to incentives that helped to mask pricing discounts.

The sector then resorted to slashing prices to move completed-but-unsold homes and get cash in the door. About two years ago, Hovnanian Enterprises Inc. offered the 72-hour "Deal of the Century," shaving six figures off some home prices. In California, some neighborhoods from San Diego to Bakersfield -- one of the markets hardest-hit by the downturn -- carried incentives valued at as much as $100,000, plus other upgrades.

As the market deteriorated further at the end of 2008 and into early 2009, builders offered anywhere from 15% to 25% of the sales price in incentives, said Mollie Carmichael, senior vice president of John Burns Real Estate Consulting. Currently, the average ranges between 5% and 10% of the sales price depending on the area. And more often, incentives include offers of closing costs and reduced interest rates.

For example, luxury builder Toll Brothers Inc. earlier this year offered buyers a fixed rate of 3.99% on 30-year fixed-rate mortgage. Lennar Corp., one of the nation's largest builders, went further with 3.625%. It is currently touting 3.99% on its Web site, a slightly higher rate, but one below the current average of 5.13% for a 30-year fixed loan below $417,000, according to mortgage-market analyst HSH Associates.

To offer lower mortgage rates, builders make upfront cash payments to mortgage companies, a process known as a "buy down." On a $200,000 loan, it typically costs about $8,000 to buy down the mortgage rate by a full percentage point on a 30-year mortgage. Homeowners often make similar payments, known as points, to obtain a lower interest rate. For the builder, the buy-down is treated as a cost of sale.

But gone are the days when Lennar was offering vouchers for a Ford Mustang in some Florida communities, something it tried in 2006. Hovnanian, meanwhile, says its "Deal of the Century" won't be repeated. The current "Pounce Before the Bounce" campaign urges buyers to act before the market recovers and prices climb, offering specials including lower mortgage rates and discounts on options and upgrades. Deals are now customized to move specific floor plans or lots, instead of a sweeping price reduction or promotion communitywide.

"The incentives certainly aren't crazy," said Laura VanVelthoven, Hovnanian's corporate vice president of marketing and sales. "They're incentives that make sense."

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