The article below is an interview with CAPS member FloridaBuilder2, who is not a representative of The Motley Fool.
In August 2007, a mysterious blogger who called himself FloridaBuilder2 started to post a series of blogs on Fool.com about the collapse of the real estate market. Armed with data that only an industry insider could have, he identified the builders he thought would be hit with a wrecking ball versus those he thought would survive the bursting of the real estate bubble. His blogs immediately caught fire within the Fool community, and more than a few homebuilder executives wondered what his agenda was.
He accurately predicted the demise of some of the most troubled homebuilders -- including bankruptcies for ToUSA Inc., Orleans Homebuilders, and WCI Communities. His top hold pick, NVR Inc. (NYSE: NVR ) , was up 34% during the worst residential real estate crisis since the Great Depression. And then he announced that he was retiring from blogging until it was time to start talking about a rebound in real estate.
Well he's back to blogging, and we thought it would be a good idea to revisit the crisis of 2007/2008 with him and discuss the outlook for homebuilders over the next three years.
Motley Fool: You built your reputation at The Motley Fool by identifying the best and worst homebuilders after the real estate bubble burst. What was your role in the industry?
FloridaBuilder: Mainly I was responsible for doing the pro forma write ups for land acquisition deals. I worked with builders in Tampa, Orlando and The Space Coast. As a CPA, I had two skills that made me successful:
- I understood the value of the land and the expected rate of return for my clients.
- I could manipulate input data to get the results that would be approved by corporate headquarters.
The more I was pressured to perform skill No. 2, the more I knew the industry was in trouble. Of course, trouble creates opportunity. After the market collapse, I also ran pro formas for private equity and understand what distressed buyers expect as a return on investment.
Motley Fool: During the meltdown, you seemed to have insight into strategies of public builders that typical Wall Street analysts missed or certainly don't disclose. Why doesn't Wall Street do a better job of covering the industry?
FloridaBuilder: Four years ago most of the Wall Street analysts were clueless about the industry. However, the downturn has forced the best analysts to really get a strong grasp of how the industry works. The best analysts today have a much better understanding of how various strategic decisions drive the income statement and balance sheet of home builders -- and of the risk/reward of various development strategies. For example, insiders know that all the risk is in land and not in the homebuilding. NVR is a pure homebuilder that only options the land and thus didn't get burned in the downturn. Too many analysts overlooked this type of distinction prior to the meltdown.
It's critical for investors to understand that you CANNOT simply take macro industry data and extrapolate to individual companies without diving deeper into the business practices of a particular builder. Compare the business models of Pulte (NYSE: PHM ) and MDC Holdings (NYSE: MDC ) . Pulte homes believes in huge land plays that generate large up front negative cashflow that pays off when the housing market is on an upswing with outsized gross margins. MDC, on the other hand, never buys more than 2 years of finished lots, doesn't develop land, and thus doesn't get the gross margin expansion of Pulte because they are only obtaining builder profits, whereas Pulte obtains both a builder profit and land development profit in every house sold. So you can see how macro conditions will impact Pulte and MDC quite differently.
Motley Fool: Now that the bubble has popped, what condition is the real estate industry in? What's your outlook for the next 1-3 years?
FloridaBuilder: A few submarkets are actually seeing improvement today because they are Grade A locations. However, I think residential real estate is going to have a choppy bottom that won't see a sustainable upturn until 2012. People are in for a rude awakening when they find out the huge rally we saw in residential housing was a result of the government buying down mortgage rates and tax credits. There was also a lot of investor activity (cash buyers) buying homes and renting them.
The bottom line is that the industry can't grow until foreclosures subside. January was not a good month for new home sales (which is the real indicator of industry health not existing home sales). Home prices aren't headed higher (minus inflation) in 2010, and I think you are going to see some homebuilders miss their earnings outlook. I know of several public builders who are already nervous about what they told Wall Street and what is actually happening after 2 months -- because there is so much uncertainty in the economy.
Motley Fool: How much is the government propping up the industry?
FloridaBuilder: It's a massive prop job ... When I read macro data I think it is not giving enough credit to government intervention -- and this is confirmed by my industry contacts. Although there was real demand, you have to understand that we pulled forward a lot of that demand. I understand this concept from my days in the auto industry. Watch what happens when the government stops buying down interest rates and eliminates the tax credit.
Motley Fool: When the real estate crisis occurred, you helped Fools determine the winners from the losers by walking through the process of dissecting builder writedowns, housing starts, lots owned, price of bonds, cash on the books, and most importantly analyzing location. Is there anything in addition to these key factors that investors should be focusing on for recognizing when the recovery is under way?
FloridaBuilder: Fools should be focusing on the following going forward: Quarter-over-quarter community count. D.R. Horton (NYSE: DHI ) , Meritage Homes (NYSE: MTH ) , and MDC Holdings have been very aggressive in growing communities.
Debt is important but only comes in play the longer the industry is sucking wind. And companies with land positions beyond three years are subject to future write downs -- companies such as Pulte, Lennar (NYSE: LEN ) , Beazer Homes (NYSE: BZH ) , Brookfield Homes, and Avatar Holdings. People don't realize that almost all of the write downs were finished buildable lots. Many of the builders haven't even begun to write down the raw land that they bought at the peak.
So, quarter-over-quarter community count, debt, and land positions held beyond three years; those are three big ones.
I cannot emphasize enough that if a person did a chart with the community count of each homebuilder quarter-over-quarter, that this indicator alone would be the main key to stock price appreciation.
Motley Fool: Which builders now look like best buys? Who should we avoid?
FloridaBuilder: Avoid Meritage Homes, which had been [one of] my top outperform picks on CAPS. They are making huge strategic blunders right now and Wall Street is going to punish them. Look for some of the top analysts to downgrade it. Pulte is saddled with really deep positions of land and this is going to be a constant drag on earnings. By deep I mean this. Would you rather own 10 communities with 100 lots each, thus 10 selling efforts? Or would you rather own one community / selling effort with a lot of overvalued land 1,000 lots deep. Pulte has big land positions!!!!!!!!!!!!!!
I believe the market is going to eventually have a nasty correction and I would buy MDC Holdings, M/I Homes, Standard Pacific, or NVR. Just note that my opinion changes each year based on the execution of their various strategies.
Right now all the builders are overvalued except for MDC.
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