Ratings Rationale
Fitch concludes that operational and financial pressures will persist and, probably, intensify for the public homebuilders during 2009. Profitability and cash flow will be somewhat weaker than anticipated earlier. Operational and financial ratios will suffer further stress. The consequence of the change in macro perspective resulted in Fitch's most recent rating actions for the homebuilders. The Rating Outlook for the sector is Negative.
The new ratings for the homebuilders reflect the most likely macro perspective for the balance of 2008 and 2009 as well as company-specific performance to this point in the cyclical downturn. As Fitch has noted in the past, a homebuilder's approach to land and development spending, inventory management, free cash flow generation and management and debt reduction are considered in its ratings in the midst of a housing downturn as are other factors such as credit metrics, ability to satisfy covenants, liquidity, size, geographic and product diversification, margins, and frequency of real estate write downs and option write-offs, etc.
Homebuilders have to successfully operate within this challenging environment or wither away. Companies have to continue to downsize to the point where they can remain or become profitable (excluding non-recurring real estate charges). That means further cuts in staffing and other overhead, as well as other cost reductions.
The public homebuilders cannot significantly influence profitability, but they can manage their balance sheets and their liquidity. Fitch Ratings believes that, overall, the U.S. homebuilding sector has good liquidity, although there are some weaker companies that face greater risk. Many companies in this sector have generated meaningful free cash flows over the past 12 months, while terming out borrowings and maintaining access to committed bank facilities which together provide room to handle maturities and fund working capital needs. As compared to the last major housing downturn in the latter 1980's into the early 1990's, leverage was lower during the later part of this upcycle, at the peak and currently (for some of the builders). For the majority of public homebuilders, debt composition 15-20 years ago was mostly, or all, short-term construction loans and possibly a secured credit line, while today the debt is often weighted most heavily to well laddered public debt (a more appropriate balance with longer-lived real estate assets), and, to a lesser degree, to an unsecured revolving credit facility. (All of the public homebuilders in Fitch's coverage have unsecured revolving credit facilities except for Beazer Homes USA, Hovnanian Enterprises, Inc. and Standard Pacific Corp., which have secured revolving credit facilities.)
Fourth-Quarter 2008 and Calendar 2009
The world economy is entering a severe recession. Output is falling in the US, Japan, Germany, France and the UK, and prospects are for this contraction in activity to intensify over the next 12 months. For the major advanced economies (the US, Euro area, UK and Japan) in aggregate, Fitch Ratings is forecasting the steepest decline in GDP since the Second World War at -0.8%, in part reflecting the unusually synchronized downturn expected next year.
Although the latest GDP figures for the third quarter of 2008 showed only a small fall, this disguised a clear trend of accelerated declines in consumer expenditure. Growth in the third quarter of 2008 was supported by an inventory accumulation and net exports. While imports will continue to decline, the recent pace of export growth seems unlikely to be sustained. Fitch projects fourth quarter GDP will decline at least 0.7%. GDP is expected to shrink by just over 1% next year. Unemployment is expected to rise in the 2008 fourth quarter and continue to increase reaching to 8.3%, some 3.5pp above its structural rate.
Fitch's forecast for the housing sector became more bearish as 2008 evolved. This is principally due to the influence of even tighter credit standards for homebuyers and the effect of disruptions in the credit markets.
Of course, most potential homebuyers, absent any real urgency to buy, are deferring the purchase decision, concerned that selling their existing home at a fair price may be challenging, and fearing that real home prices might further decline as builders increase the level of incentives being offered to the advantage of those who wait to buy.
The disruption in broad credit markets and media focus on accelerating job losses took a further toll on homebuyer confidence since September. Consequently, housing metrics are likely to be weaker in the fourth quarter of 2008 as compared to the preceding quarter.
Total housing starts are forecast to be 910,000 in 2008, 33.1% lower than in 2007. Single family starts are expected to be 0.62 million, down 41.0% as compared to a year ago. Multi-family starts should decrease 6.5% to 290,000. New single family home sales should fall 37.2% to 487,000, while existing home sales ease 13.6% to 4.88 million.
For the full year of 2008, production, as represented by housing starts (especially single family), is expected to fall slightly faster than sales (new orders), but unfortunately the supply of homes is expected to still be excessive entering 2009.
The average single family new home price is expected to drop 6.5% in 2008, while the median new home price decreases 5.5%. The 'real' price reductions are larger than shown by the government's published transaction prices (and our forecasts) as, for example, sales incentives are not included. However, in 2008 a greater portion of the "real" price reduction was due to overt sales price decreases than was the case in 2007. Unfortunately, home prices have still not yet reached market-clearing levels in most places. Home prices (especially existing home prices) definitely had been 'sticky' on the downside, but came down more sharply in 2008, at least partially prompted by aggressive pricing of foreclosures and distressed homes.
Fitch is forecasting a contracting economy during the first half of 2009. Real GDP is forecast to decrease 1.2% for all of 2009. Investment is expected to plunge 6.9% as consumer spending and imports decline 0.6% and 3.2%, respectively. Government spending (+2.3%) and exports (+2.2%) will be economic positives next year. Inflation is expected to slow to 1.5% from 2.7% in 2008. Interest rates are expected to slightly recede.
The economy in the midst of a moderate to severe recession is another blow to housing. In particular, a deteriorating economy further erodes consumer confidence and accelerates job losses and consequentially foreclosures. One source, RealtyTrac, is currently predicting 1 million foreclosures in 2009. Undoubtedly, another stimulus program will emanate from Congress early in 2009 and there may be national legislation to specifically and more effectively target the foreclosure problem, as well as accelerate housing demand. However, these actions are unlikely to stabilize and then boost housing demand until the second half of 2009 or later.
In 2009, total housing starts are projected to fall 22.0% to 710,000 with single family volume declining 22.6% to 480,000. New home sales are forecast to decrease 16.0% to 409,000, while existing home sales slip 3.0% to 4.735 million.
Average and median single family new home prices are projected to fall 2% and 1%, respectively, in 2009. The combination of overt price decreases and sales incentives should represent a less significant percentage of the base home price next year than was the case in 2008.
Implications for the Companies and the Ratings:
Through the three quarters of calendar 2008 builder revenues are down about 39%, home deliveries are off 33%, and EBTIDA margins (before non-recurring, non-cash real estate charges) are about 570 basis points lower than year earlier levels. Third quarter net new unit orders are down 34%, on average, and unit backlog at the conclusion of the third quarter, on average, is 46% beneath year earlier levels.
These companies have been contracting staffing as demand has evaporated with personnel typically down 50-65% as compared to peak staffing in early 2006. Just as important, builders have been reducing inventories in 2008, down 53% on average as of the end of the 2008 third quarter (or equivalent) as compared to the peak quarter end in 2006. (Admittedly, this is partially as a consequence of write downs). The companies have lowered debt - on average 28.5% since the peak, typically in 2006. Free cash flow comparisons have generally improved.
Credit metrics (LTM EBITDA/interest incurred, debt to LTM EBITDA, and FFO interest coverage) are considerably lesser than at this time last year. Debt/capitalization ratios have deteriorated moderately to sharply for the majority of builders when compared to one or two years ago, largely as a result of erosion in shareholders' equity from sizeable real estate charges.
Given Fitch's adjusted macro forecasts for the balance of 2008 and 2009, it appears likely that builders' financial pressures will continue unabated. For the full year of 2008 homebuilders' revenues could drop 40%, on average, while pretax losses, before real estate charges, will be reported for 12 of the 14 homebuilders Fitch tracks.
Price competition will likely persist at current levels well into 2009. Consequently, margins will remain under pressure and more land value write downs are a distinct possibility, although likely to be of lesser magnitude than in 2008. However, fewer option write-offs are likely.
Deterioration in credit metrics will continue during the fourth quarter of 2008 and next year, particularly for profit related metrics (EBITDA, interest coverage; debt to EBITDA). Tangible net worth covenants will again be challenged.
Most of the public builders that Fitch tracks have negotiated new revolving credit agreements or amendments to existing agreements that should prevent the companies from violating interest coverage covenants in the fourth quarter of 2008 and into 2009 as well as covenants applicable to speculative inventories and tangible net worth. Some builders may have to revisit their bank syndicates and request further covenant adjustments in 2009.
If Fitch's year-end forecast for 2008 is correct, then 2009 will start off with still considerable inventory over-hang. New home sales comparisons (year-over-year) would likely bottom late in 2009 with housing starts bottoming three-to-six months later.
There is a high probability that many public builders' revenues and profitability will fall further in 2009. Excluding tax refunds, cash flow from operations is likely to be lower in 2009 relative to 2008.
Credit pressures will continue. It will be imperative that builders continue to contract their balance sheets, further reducing land and development spending. Possibly more aggressive pricing may be necessary to lower inventories, especially specs. Positive free cash flow comparisons should result.
Fitch expects homebuilders to reduce debt where possible and to exercise restraint as to share repurchase, dividends and acquisitions in these uncertain times.
Although some builders have been more proactive than others in reducing inventories and lowering debt levels, most, in retrospect, started relatively late during this cyclical downturn.
Fitch rates the builders within the context of a typical cycle. In the midst of a non-typical upcycle, as took place in the 1992-2005 period, a number of builders realized higher credit ratings. Conversely, in this sharper than expected contraction, which it appears will last longer, and as builders' operating and credit metrics will be even more stressed, ratings again have to be adjusted.
Following last week's rating actions, Fitch's Rating Outlook is Negative for the majority of the homebuilders. Recent and projected credit metrics and other key metrics, such as inventory and debt contraction and cash flow generation, were taken into account relative to the new ratings.
