Spring a Bust for Housing Market

Shaky confidence and falling home prices combine to snuff key selling season

The hoped-for rebound in home sales failed to blossom this spring, with the housing market caught in a downward spiral as falling prices continue to sap consumer sentiment and keep would-be buyers on the sidelines.

The all-important sales season that unofficially kicks off after the Super Bowl again failed to lift the residential market out of its doldrums. Although a surprising jump in April housing starts was reported Friday by the Commerce Department, enthusiasm was tempered by the fact that the gain reflected a jump in multifamily units. Starts of single-family homes lost nearly 2% to the lowest rate since 1991.

There are other reasons why it's not yet time to break out the champagne to celebrate a bottom in the housing market. The sagging confidence of home builders points to more pain this summer. On Thursday, the National Association of Home Builders said that its sentiment index fell close to a historical low. "The housing market has shown no evidence of improvement thus far," said David Seiders, chief economist for the builder trade group.

The final nail in the coffin for the spring-selling period came this week after luxury-home builder Toll Brothers Inc. (TOL) reported dismal sales figures for the quarter ended in April. The company's chief executive, Robert Toll, said traffic levels at its communities were "the worst that we have ever seen."

Toll distilled the housing market's woes into two main problems. First, price declines and buyer anxiety are feeding off each other. For example, some customers are putting down deposits on homes, but are then getting cold feet and backing out. These cancellations are only adding to the inventory of unsold homes on the market, and economists say demand can only begin to return once the market works its way through the glut.

Most buyers are canceling because "they go to their friends and neighbors and say, 'We just bought a new home,' and everybody says, 'What, are you crazy? Prices are dropping,' " according to the chief executive.

The median existing single-family home price in the first quarter was down nearly 8% from the year-earlier period, the National Association of Realtors reported Tuesday. Some of the steepest declines have been in formerly hot markets such as Arizona, California and Florida.

Meanwhile, economists continue to look in vain for signs that falling home sales are stabilizing, which brings up the second main problem for home builders -- especially those that cater to move-up buyers like Toll Brothers. Many potential buyers are finding it nearly impossible to sell their existing properties.

Another home-building giant, D.R. Horton Inc. (DHI) , said earlier this month that it lost more than $1 billion in the latest quarter and cut its dividend in half.

"It appears the spring-selling season was a bust for Toll, just like all the other builders," commented Morningstar analyst Eric Landry.

But you wouldn't know that by looking at the recent performance of Toll's stock and the builder sector. Shares of the Horsham, Pa.-based company were up more than 18% for the year to date through May 14, handily outpacing the S&P 500 Index (SPX) amid a rally in home-builder stocks, which historically tend to bottom before the housing market itself.

Housing Headwinds

Residential-housing stocks are seen as a leading indicator, yet there are many reasons why the volatile sector's recovery could be premature. "Continued negative market sentiment created a rather dismal spring-selling season, and buyer traffic is at reportedly low levels," said Anna Torma at Soleil Securities Group.

"Starts will need to continue to come down as builders need to further reduce excess inventory. In addition, the high level of foreclosures continues to weigh on the industry," she added. "The current credit crisis is keeping lending standards very tight, creating further headwinds."

Other worrying signs for the housing market and home builders include the following:

• The skyrocketing costs of energy are crimping families already nervous about a slowing economy and inflation. Many think the United States is already in a recession, or are bracing for one. Consumer sentiment dropped in May to its lowest level since 1980, according to a Friday report, as higher fuel and food prices, coupled with declining home values, weighed on confidence.
• Home builders continue to wrestle with cancellations and inventory impairments. Some companies have been forced to renegotiate terms with lenders, and if their banks cut them off, it could spell trouble and lead to industry consolidation. Builders facing the greatest pressure have weak balance sheets and cash flows, higher debt levels, and more exposure to soft markets and joint ventures.
• Many borrowers are finding it difficult to qualify for mortgages under tighter lending standards as a result of the subprime mess and credit-market turmoil. Banks and financial institutions want lower loan-to-value ratios and better credit scores.
• Strapped homeowners are in danger of defaulting on loans as their adjustable-rate mortgages reset higher. Another problem is negative equity as a result of falling prices, where borrowers owe more on the mortgage than the home is worth. Foreclosures are the last thing a market already saddled with a massive inventory overhang needs. On Tuesday, Irvine, Calif.-based RealtyTrac said that foreclosure filings in April rose about 65% from a year ago.
• Even though lower home prices could lure bargain hunters, mortgage rates are expected to climb, which adds to the overall cost of a home.

Rays of Hope

Despite the gloom, there are a few encouraging signs emanating from the U.S. housing market. Here are some bright spots on the storm's horizon:

• Falling housing starts means home builders have been scaling back construction, which is gradually reducing their backlogs and the supply glut. This will help the market work off inventory. Also, builders are steadily scaling back their book of "speculative" homes, or those without a buyer due to a cancellation.
• Some of the hardest-hit markets are finally starting to show a pulse. For example, Toll Brothers recently said that it raised prices in Naples, Fla. -- one of the epicenters of the housing bust.
• Builders are attracting traffic and sales when they run promotions featuring price reductions, incentives or other concessions.
• The government is taking a more active role in providing support to the housing market, which helped fuel the first-quarter rally in home-builder stocks. Additionally, the Federal Reserve has slashed interest rates and pumped liquidity into mortgage markets. Limits on conforming-mortgage loans have been raised, and there is also talk of tax incentives for home buyers that could provide a lift.

Still, any hopes for a recovery in 2008 have been dampened by more weak housing data, and Toll Brothers' latest results "brought further confirmation that this year's spring-selling season has again been a letdown," according to Deutsche Bank analyst Nishu Sood.

"It is clear we have not yet hit bottom in the housing market," said Richard Syron, chief executive at mortgage giant Freddie Mac (FRE) , during a conference call this week. He estimated that home prices have fallen 9% so far during the housing downturn, less than Freddie Mac's forecast of a 15% national decline.

"We want to take a better look at the spring-housing market to see whether or not the data is beginning to firm up," he added. Although Syron pointed out that it was premature to make a formal change in the estimate, "at this point we must say that the risk to the forecasts is strongly weighted on the downside."

Former Federal Reserve Chairman Alan Greenspan, speaking at an investment conference in Asia this week, said that U.S. home prices won't bottom until 2009 when the excess supply of homes is eliminated.

Robert Toll, the colorful chief executive, summed it up this week: "We don't believe this will last forever, although I can give you no indication that the end is in sight, or that the light at the end of the tunnel is not the train coming toward you."

John Spence is a reporter for MarketWatch in Boston.