Housing: That Sinking Feeling

Homeowners are getting slammed as builders slash prices. The big question: Will this shock treatment help hasten the end of the painful downturn?

Las Vegas was once the hottest of the red-hot real estate markets. But when sales really started choking up last year, developer KB Home (KBH) did something drastic. Determined not to be caught with a big backlog of unsold homes through one of the industry's notorious down cycles, the builder started slashing prices. A lot. In the 1,400-home Huntington community, a subdivision of two-story stucco houses west of the famed Strip, homes that started at $320,000 a year ago are now listed for $270,000--just a starting point for potential deals.

Those sorts of discounts seem to be attracting buyers. Pending sales contracts jumped 23% after KB cut list prices by $25,000 in May, one of the recent price breaks in the Huntington subdivision, according to the market research firm Hanley Wood. That may be good for KB, or at least less bad than holding on to a lot of unsold units. It may also be good for current buyers who snap up homes at huge discounts to recent asking prices. "We try to make prudent decisions regarding pricing," says Jim Widner, regional general manager for KB in Las Vegas. "Prices are going to rise and fall over the short term, but long term a home is one of the best investments."

For homeowners who jumped in at the height of the boom, the discounts aren't so good. In Quayside Court, a quiet cul-de-sac in Huntington, many residents who bought last year suddenly own homes worth a whole lot less--making it hard for anyone who has to refinance, sell, or borrow against the equity. "When we first moved here [in the summer of 2006], the housing market was incredible," says Tammy Elder, a mother of three. "Unfortunately we bought a house that was overpriced, and we don't know if we'll ever break even."

KB's extreme strategy at Huntington is playing out across the country--even in places like Minneapolis and St. Louis that were bypassed by housing mania. For the first time, big builders are offering massive, often six-figure, price cuts in overbuilt developments nationwide, giving the industry a kind of shock treatment designed to move inventory off the books fast. It remains to be seen whether these radical measures will revive the market or deepen the slump, but it's certainly having an impact on the local communities. On Sept. 14, Hovnanian Enterprises Inc. (HOV) kicked off a 72-hour Deal of the Century, in which it slashed prices by as much as $100,000 in 19 states. That same day, Standard Pacific Corp. (SPF) launched its Mission: Possible campaign in 49 communities across Southern California, promising $20 million in total discounts. And on Sept. 29, D.R. Horton Inc. (DHI) auctioned off 53 homes in San Diego with bids starting at $150,000, half off the list price. "We wanted to get the message across louder," says Hovnanian CEO Ara K. Hovnanian. "Customers needed a stimulus."

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Builders' balance sheets needed a boost, too. Even though the five-largest publicly held residential builders have cut the value of their land and unsold homes from $49.7 billion in 2006 to $41.9 billion today, that inventory as a percentage of sales has soared 33% during the past year, according to Banc of America Securities (BAC). Those idle assets have taken a toll on the industry's health. A year ago builders' debt payments were roughly the same as their cash flow. Now debt is 2.5 times cash flow. Profits are disappearing as well, with KB Home, D.R. Horton, and other big builders all reporting losses in the third quarter. On Sept. 25 the country's No. 2 builder by homes sold last year, Lennar Corp. (LEN), reported a $513.9 million quarterly loss, the biggest in its 53-year history. And while there have certainly been other influences on the market, builders bear a lot of the blame for their woes.

The real question is whether the drastic price-cutting will short-circuit the usual long, painful downturn builders seem destined to undergo in this economically sensitive business. This is the first housing slump in which the industry has been big enough and well enough capitalized to even consider such extreme measures. And they are extreme. Margins, which ran as high as 35% at the peak of the housing boom, are close to nil when builders sell at fire-sale prices. If by doing so the builders can force the market to accept the reality that housing values have fallen--and accept it fast--there's at least the possibility of emerging from the current bust sooner than in earlier down cycles. "The discounts depress the market, and that's why we think home prices have got more to fall," says David Wyss, chief economist for Standard & Poor's, which like BusinessWeek is owned by The McGraw-Hill Cos. (MHP) "But rather than a prolonged bust, you take the pain up front." A fast recovery in the housing market wouldn't just be a tonic for builders; it could also give a much needed boost to the overall economy.

There is, of course, much that could go wrong. Indeed, potential risks with this untested strategy abound, especially for smaller players. If the price cuts aren't deep enough or builders don't rein in production enough, they won't clear out the glut of unsold homes. Then there's the worry that the discounts lower prices too much, forcing builders to write down even more of the raw land held on their books. And if prices keep falling, buyers could decide to cancel contracts in hopes of getting a better deal later, as they've already started to do. There are also broader markets forces at play, ones that builders may not be able to surmount even by slashing prices. For example, the rising number of foreclosures could add to the backlog of unsold homes faster than they can clear them out. "It's a losing battle," says Jim Belfiore, president of Belfiore Real Estate Consulting, a research firm.

Still, builders figure they're better off cutting supply fast rather than letting it drag down earnings for months or even years. "You have to keep moving inventory," says John F. Eilermann, Jr., chief executive officer of McBride & Son Homes, a privately held regional firm that's offering discounts of up to $100,000 and hosting block parties with pig roasts to lure buyers in St. Louis. "Our biggest cost is the land sitting out there. You have to get yourself in a better position for when the market does turn."

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