Submitted by Jeff Borack At Kerrisdale Capital
Housing Market & Construction Costs: Builders Can’t Justify Investment
At Kerrisdale Capital, we've written about the housing market before, but estimating the fair value of the US housing market is difficult. Two of the best ways to estimate fair housing prices are to compare housing costs to household income or rental rates. Obviously people can only spend so much on housing relative to their incomes, but secular trends in spending, tax rates, and cyclical trends in income make the data difficult to interpret. Likewise, comparable rental rates do a good job of showing the relative cost of ownership, but in an inflated market, rental rates are likely to be inflated as well.
A third way to estimate the fair value of the housing market is to look at the replacement cost of existing homes. If the cost of building a home is equal to the cost of buying a home, then the price to cost multiple is 1x, implying a breakeven level of profitability for homebuilders. If homebuilders can build a house for $300k and sell it for $400k (a 30% return) they will continue to build homes until they can only sell them for around $330k (a 10% return).
Unfortunately, construction costs aren’t easy to estimate. As usual, the best data comes from Robert Shiller, presented in a chart with home prices here:
The problem with this data is that the building costs are represented by the price of a basket of goods including 66.38 hours of skilled labor, lumber, steel, and cement. Not only might this fail to reflect the actual building costs and technological improvements in residential homebuilding, but it’s difficult to equate to home prices. A better way to determine the price/cost ratio for residential homes across the US is to look at the financial statements of the largest homebuilders and to get a sense for what their margins are.
We looked at the financial statements of Pulte Homes and Lennar Corp. In both cases, economic reality is distorted by impairments and writedowns which have crammed a decade’s worth of losses into the 2006-2010 timeframe. So when we consider the cost of building a house, we will look at the 2005 numbers, likely a conservative estimate compared to 2010 now that raw material and labor costs have come down. We can compare our cost estimates to the current price new units are selling for to determine if homebuilders can justify continued investment. The fact that all the main homebuilders (DR Horton, Ryland Group, Pulte Group, KB Home, and Lennar Corp.) have been operating cash-flow positive for the last three years is strong evidence in support of the continued profitability of homebuilders and reason to believe that continued construction will continue to add housing inventory and push market prices down. However, part of the reason for positive OCF is the contribution from inventory liquidation. The relevant financials can be found below:
What we see here is that compared to unit costs in 2005 of around $250k per unit, builders are just able to cover their costs. Lennar looks to be a bit worse, but it includes selling costs in COGS, whereas Pulte includes it in the SG&A line. When we factor in (S)G&A expenses, homebuilders will need to have a 2004 cost per unit and maintain 2009 prices and volume to approximately break even. The highlighted numbers show how many units each company will need to sell in 2010 just to break even (ie. to cover their SG&A expense) assuming 2009 is a good indicator of revenue per unit and COGS, and 2004 is a good indicator of the per unit building costs. Needless to say, breakeven doesn’t do much for shareholders, and it’s difficult to justify investment in new construction.
So from this analysis, it looks as though homebuilders will have a difficult time making ends meet unless we see some improvement in the economy. We could have guessed this given the low housing starts, but this data supports the position that building is uneconomical, not just distasteful to builders that have grown accustomed to fat margins. We shouldn’t see a recovery in housing starts without a recovery in housing prices. The good news is that it’s unlikely new construction will pressure the housing market anytime soon, meaning the main source of inventory should be foreclosures.
Kerrisdale Capital and its affiliates have no position in the companies mentioned above.