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Housing's Hidden Headache

By JACQUELINE DOHERTY

HOME BUILDERS HAVE THRIVED IN THE PAST five years as easy money fueled enormous demand for houses -- as well as abundant supply. The role of low interest rates and novel loan structures in helping buyers enter the market -- or trade up to McMansions -- has been well-documented. Less understood is the potentially problematic financing that has enabled developers to increase their supply of land to meet, and perhaps exceed, this unprecedented demand.

Unlike in past housing cycles, when they borrowed heavily from banks, home builders today also use options and off-balance-sheet joint ventures to buy land. When times were flush, these financing vehicles enabled the industry to expand without bulking up its debt. But now that the housing market has weakened, land options and joint ventures could come back to haunt some companies, their financial partners and the broader economy -- not to mention stockholders.

The pain could be twofold: If orders dry up and home builders are forced to write off their option deposits or joint-venture investments, which are considered assets, some could face substantial hits to book value. Alternately, builders' earnings could be nicked if joint-venture gains turn to losses.

Housing bulls argue that concerns about the deteriorating health of the residential real-estate market largely are reflected in building-company shares. After all, the Standard & Poor's Supercomposite Homebuilding Index is down 41% from its high of July 2005. If the housing recession proves mild and short-lived, the stocks could rally, much as Barron's argued in a cover story in late August ("Big Ripple," Aug. 28, 2006). So far, that's been a savvy call: Most are up almost 20% from their lows this past July.

If the downturn is severe and protracted, however, as it may be in locales where home prices and speculative development have soared, the industry's use of options and joint ventures is likely to prolong the pain. "The home builders are going to abandon a significant amount of their options and attempt to dissolve the joint ventures that no longer meet their return requirements," Ivy Zelman, an analyst at Credit Suisse, predicts.

Most housing companies today trade at slight premiums to book value, which is considered a more reliable indicator of their worth than price-earnings multiples. And any impairment to book (roughly defined as assets minus liabilities) could result in similar markdowns in the companies' shares.

FOR SOME COMPANIES, the problems of Technical Olympic USA (ticker: TOA) may be a sober warning. Last week the U.S. unit of the Greek construction company announced that, because of softness in the Florida real-estate market, the revised sales and delivery projections of one of its residential joint ventures won't be adequate to support the JV's capital structure. The company is requesting waivers from its lenders regarding potential defaults, among other things.

The JV was created in August 2005 to buy the assets of Transeastern Properties of Coral Springs, Fla., and was financed aggressively, with equity equal to only 20% of the purchase price, versus the 40% common in most JV deals. News of its problems sent Technical Olympic's shares down about 15% on the week, to 9.83, though it had been trading below book value before the disclosures.

The company's senior and junior debt fell to levels implying its equity in the JV and loans and advances to the JV, which total $141 million, could be wiped out. The company, which has said it does not intend to contribute additional capital to the venture, declined to comment. But Technical Olympic's parent acknowledged in a press release that in a "worst-case scenario," its sub would take an after-tax charge of $89 million, or $1.50 a share. It estimates book value will decline 4% from the June quarter.

"This won't be the only company that will affected," says Alex Barron, a senior housing analyst at JMP Securities in San Francisco. "All the other home builders will have writedowns of joint ventures, option deposits and land on their balance sheets."

BULLISH INDUSTRY ANALYSTS BELIEVE concerns about option-deposit and joint-venture writedowns are overblown.

But that might not be true for some companies with large exposure. At NVR (NVR), a Reston, Va., builder, $642 million of option deposits account for as much as 64% of book value. With the shares trading at 553 apiece, or 3.2 times book, investors appear to have given little consideration to the possibility of writedowns. The company declined to comment.

Hovnanian Enterprises (HOV) and Beazer Homes USA (BZH) also could be vulnerable; their options deposits each equal at least 20% of book. Other companies, such as MDC Holdings (MDC) and D.R. Horton (DHI) have little exposure.