Basic Economics for Homebuilders

Let's dispense with the good news first: Housing starts fell by 14% in December as builders were scrambling to cut back on inventory. Groundbreakings remained at their lowest level in 16 years. As a whole, residential construction dropped 40% in 2007.

Yes, that was the good news. Here's the bad: Homebuilders can't sell their existing inventory, yet 1 million homes are under construction. That December decline in housing starts still left the annual rate at 1.006 million homes. The fundamental problem with the homebuilders today appears to be basic economics.

The fundamental law
When supply exceeds demand, prices decline. To reverse the trend, you either cut back supply or create new sources of demand.

The problem with the homebuilding industry is that existing inventory is still high, so any additional supply at this point slows the recovery process. And homes are a funny product. Once a company sells a new home, that home competes with homebuilders for buyers of future new homes. One has to scrutinize real estate inventory a little differently from how you'd assess, say, automobiles. Cars generally depreciate in value and head to the scrapyard after about 25 years or so, but homes usually last a lot longer, and an old one can be just as valuable as a new one.

With the value of real estate on the decline, homebuilders aren't doing themselves a favor by putting new homes on the market. In fact, they have to sell those homes for less.

Still tough
Many subprime loans will be adjusting in the near future. And with nearly $17 billion and $18 billion in asset writedowns coming from Merrill Lynch (NYSE: MER) and Citigroup (NYSE: C), respectively, there's still lots of pain ahead.

OK in the end
In the long run, most homebuilders will be fine. NVR (NYSE: NVR) has a rock-solid balance sheet, and Toll Brothers  (NYSE: TOL) and Pulte (NYSE: PHM), with their strong management teams, will no doubt weather the storm. What's more, populations will gradually grow, and if U.S. economic history is any guide, the standard of living will move in tandem. Translation: More people will need new homes. Still, with so much existing supply from both the homebuilders and existing homeowners, housing starts right now need to just about stop. Homebuilders would benefit tremendously from putting all of their efforts into simply working the inventory they have on hand.

Sure, I understand there's a lag-time effect from site selection to groundbreaking to completion. If the demand for homes is set to go up in a year, then, yes, you ought to be building up for that demand. But let's face it: Homes today can be built a whole lot quicker than before, and I'm assuming that most housing-company executives are smart enough to know when to restart building. I'm no economist or homebuilding expert, but most industry insiders are now saying that the market will stabilize at best in late 2008 or early 2009.

Be patient and very selective
Patient investors might find some attractively priced homebuilders at this juncture. But as we can see, not all homebuilders are created equal. There's no doubt some will fare much better than others. Until housing supply decreases substantially, your patience might be put to the test.

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