How to Handle the Homebuilders 'Rally'

Homebuilders have been rallying, on favorable analyst commentary and glimmers of hope that housing may be hitting a bottom. The WSJ recently had an article about the effect of California's new home buyer credit of $10,000, which is working as intended, stimulating sales. The last time I wrote on homebuilders, in December last year, I planned on selling covered strangles of about 6 months duration. The thinking was, the homebuilders keep trying to rally, but the long expected housing recovery keeps receding into the future. I am long-term bullish on homebuilders, but continue to advocate selling out of the money covered calls in order to either 1) collect rent while waiting on developments, or 2) have the stock called away if the rally continues.

Buy land – they ain't making any more of it. The primary asset of homebuilders is land. To the extent that the land is well-located and suitable for development, it is a scarce resource and will eventually increase in value. It will also do well in an inflationary environment, like any physical resource. Historically, it was always possible to make money by buying homebuilders at a Price/Tangible Book ratio of less than 1.0 and selling for something in excess of 1.5. That strategy developed problems as the housing market went into a deep downward spiral. The homebuilders kept writing down their assets, decreasing book value. To the extent that it was goodwill from acquisitions, it was not that upsetting, but when it got to be land that they still owed money on it was cause for concern. Also, many of them were forced to write off the value of deferred tax assets, on the grounds they were unable to project sufficient profits going forward.

On the other hand, write-downs shield cash flow from taxation. If the land is kept and not sold, the lost profits may reappear further down the road when business conditions improve. In effect, the write-downs create “phantom” book value.

Shrinking Book Values. Here is a table showing how book value and tangible book value developed for the three homebuilders I follow: Toll Brothers (TOL), Ryland (RYL) and KB Home (KBH).

Symbol	Metric (per share)	4Q 2007	1Q 2008	2Q 2008	3Q 2008	4Q 2008	1Q 2009
KBH	GAAP Book	23.93	20.22	16.48	14.59	10.69	9.92
	Tangible Book	23.05	19.34	15.92	14.05	10.69	9.92
RYL	GAAP Book	33.89	25.92	20.10	18.41	16.97
	Tangible Book	Same, Ryland did not do acquisitions
TOL	GAAP Book	22.49	21.62	20.97	20.79	20.27	19.67
	Tangible Book	22.37	21.51	20.85	20.68	20.15	19.56

This table shows that the strategy of buying at less than 1X tangible book and selling at more than 1.5X has had its problems in the environment that has been in place for the past year or more.

Options strategies . Late last year I sold strangles, one contract for each 100 shares of all my homebuilders, using 3 or 4 month expirations. The calls expired worthless, and I bought back all the puts at a small profit. As the market started heading down in late February I wanted to reduce the cash devoted to backing the puts and avoid being squeezed if something horrible happened.

Then I turned around and started buying shares on 3/12 at prices somewhat higher than the strike on the puts I just bought back. Not too logical, and I gave up most of my profits on the puts. But it worked out OK: as Warren Buffett has said, selling puts will not get you into a stock at the bottom. So the strangles strategy, while logically appealing, didn't work out as well as I hoped it would. Buying at the bottom is more effective.

Last week I sold out of the money calls over about two thirds of my homebuilders, using 3 or 4 month expirations. I was a little early: they continued to rally, and I could have got more for my calls or sold at higher strikes if I had waited. I got disoriented with the stocks trading so low in March and lost track of my 1.5 X tangible book target. But if they continue to rally next week I will sell calls over the rest of them.

A Digression on Decompression. The sell-off in March created a situation that really has me disoriented. Many of the high beta stocks I follow have been so compressed that I temporarily forget what I think they're really worth. I loaded up in the days after the bottom, and I have been selling steadily into the rally, at this point building up a cash reserve.

But it feels weird to keep selling stocks at prices that seem way low on any of the common metrics. If I think in LIFO terms, I have wonderful profits on shares I bought a few weeks ago: in FIFO terms I am taking horrible losses on shares I bought a year of more ago.

The best I can come up with right now is I was buying at the bottom so I am going to be selling at the top. Every time the S&P goes up 1% I am going to sell off 2% of my portfolio, or sell another batch of covered calls. I spend some time thinking what to sell and why, but my discipline is: the market goes up 1%, I sell 2%. For now, value is relative.

Questioning the Homebuilders Rally . Most of the homebuilders have operations in California and the tax credit will probably help them for a few quarters. Other states are considering similar programs. But it really doesn't make a lot of sense to encourage the building of new homes when foreclosures are a glut on the market. It's a supply and demand issue, and creating more supply is not going to solve the problem. It's like putting out a fire with gasoline.

The mass production efficiency of building hundreds of homes in a short period of time in one development may not come back. The business is not going to go back to the way it was in 2005.

Houses will be somewhat smaller and it will be hard to pump profits by adding a lot of extra features – more likely the extra features will have to be discounted to provide buyer incentives.

Finally, there is still a large inventory of unsold homes, with many foreclosures coming out of moratorium. Some banks may have been holding foreclosed properties without putting them on the market, so there is inventory that isn't even being counted.

Disclosure: long TOL, RYL and KBH, hedged by selling calls as discussed.

Comments

[Steven Hansen:]

Not only is there an inventory of foreclosed properties not on the market, but there is a sea of homes which sellers want to sell but the seller's have decided to wait to put the homes on the market.

i am beginning to believe the new home builders might actually have bottomed. part of the problem is many existing homes are in the wrong place or wrong configuration for today's market tastes. in my opinion there is room for the new build marketplace to expand while the existing home market struggles to find footing. in any event, i doubt recovery in this sector would be described as vibrant.

my ability to short term guess market movements has been terrible recently. predicability is not a trait in today's market.

Tom, thank you for this analysis and your market strategy.

Apr 27 03:14 AM

[Bestsolutio...:]

You Gotta Luv CA.
They have the solution to the Subprime Mortgage Crisis,
all the foreclosures and short sales.To finally stop the falling
home prices and stabilize the housing market.
As per WSJ article( Google:Tax Credit Gives California Builders A Lift )
Some economists state it is doing nothing to help but it also generates
increased TAX revenues as well as Sale tax revenues on household items
and CREATES employment......THIS IS FOR NEW HOMES PURCHASE!!!

PLEASE APPLY THE SAME PRINCIPLE TO ALL THE UNDERWATER,
DEFAULTING AND SOON TO BE DEFAULTING LOANS and turn the "toxic"
bad loans INTO 100% asset based AAA loans.

The "EVERYBODY WINS PLAN" is simple and it is profitable.
A longer term loan at very low interest rates that


MAKE ALL THE HOMES AFFORDABLE.

As in California
They have added $10,000 to the $8,000 credit
to purchase new homes.

WHY NOT USE THE SAME TACTIC TO END
ALL FORECLOSURES AND SHORT SALES
AND TURN THEM INTO AFFORDABLE HOMES.
END THE MASSIVE INVENTORY ON THE MARKET
AND STABILIZE PRICES.

The "EVERYBODY WINS PLAN"

ALL LOANS TO BE MODIFIED AT 105% of
FAIR MARKET VALUE.
NEW LOAN GOES ON THE BOOKS
It is a 10 year loan at 4% with a balloon payment
of the balance.

THE LOAN
PER $100,000 will have a PITI payment of
$467 per month fixed for 120 Months.

YES,a $100,000 home will be an affordable residence
for an American homeowner for $467 per Month
..TOTAL PITI (PRIN. INT. TAXES, INS.

A $200,000 home will be $934
TOTAL PITI.

TOO GOOD TO BE TRUE?????

It just may be true using the California way-
Federal contribution of $100 per month for interest
instead of cash gift up front
and State contribution of $100 per month for taxes
instead of cash gift up front.
Both fed and state will benefit from giving.Yes If loans are
FDIC and Home Bank Loans they would be
"Stimulating the cash flow to banks and firm their assets.
The state will more than increase their tax revenues by
giving.Giving back on the 8% of homes in trouble will INCREASE
the income from the other 92%
EVERYBODY WINS!!!!

Too Good To Be True????

you will have to ask me for details of the "EVERYBODY WINS PLAN"
in order to find out how 120 payments of $467 with $100 (Fed) and $100 (State)
pays a $100,000 Note at 4%.

I await your request for free details: bestsolutionsfl at aol dot com

Carmen Basilovecchio
Best Solutions Fl Real Estate
9804 S Military Trail E-10
Boynton Beach,Fl 33436

Basics:
On new loan of $100,000.
10 years payments (120)
at $467,$100,and $100 equals $80,040
which is applied as follows:
PRIN -$15,000
INT -$40,000
TAXES-$15,000
INS -$10,000
THIS REDUCES THE AMOUNT OWED ON THE HOUSE
PER $100,000 TO $85,000.
THIS BALANCE IS PAID IN FULL with a new 30 year mortgage.
HOW THIS FOR "SMOKE AND MIRROWS:
*$40,000 paid to FDIC insured banks or Home Loan Bank
with no government stock issues
*$15,000 paid in property taxes,a net gain
*and if you really want to help the economy how about
$10,000 IN INSURANCE PRIMEUMS GOING TO AIG
TO HELP GET TAXPAYERS MONEY BACK.
HOW MANY JOBS WOULD BE SAVED AND NEW ONES CREATED.
And do not forget ,about 6 million homeowners with excellent credit with EQUITY
(the ignored part) in their home.What do you think they will do the the most
important part of the economy-CONSUMER SPENDING?


**********IF YOU THINK THAT WAS TOO GOOD TO BE TRUE
**********READ THIS SECOND PART.
Why NEW CONSTRUCTION SALES WILL MORE THAT DOUBLE even TRIPLE last years sales within the next 18 months!

All they have to do is read my ads:

"BUY NOW!
NEW CONSTRUCTION
PAY 50% DOWN and
HAVE NO MORTGAGE
PAYMENTS.NONE
FHA,HUD Guaranteed Mortgage
has NO PAYMENTS as long as you
live in the home,maintain it,and you are 62 or older.
ANYWHERE IN THE USA
PRICED FROM $50,000 up to $625,000

BESTSOLUTIONSFL at AOL dot COM


Best solutions Fl is not a government agency,but will provide anyone that requests the information,details free of charge.
Best solutions Fl is angry that everyone is aware of the $700
billion Bailout (TARP)
Everyone is aware of $787 billion Stimulus package.
WHY,WHY has it been hidden from the public that
THE ECONOMIC RECOVERY ACT OF 2008
allows FHA and HUD to guarantee TRILLIONS AND TRILLIONS
of dollars in EQUITY LOAN to senior citizen that are 100%
paid in full by NOT THE BORROWER BUT THE HOME.


I DARE YOU TO PUBLISH THIS!!!
OBAMA,SUMMERS,GEITHNER
ask for details-the housing solution above is based on
the 1930's solution.
LOWER INTEREST RATES WITH A LONGER TERMS.
IT'S PROFITABLE AT NO COST TO TAXPAYERS
and HELP BAILOUT THE LENDERS AT 100%
FAIR MARKET VALUE!
Bestsolutionsfl at aol dot com

Apr 28 08:29 AM

[jimmy46:]

They may not be making any more land, but you PAY PROPERTY TAX WHILE WAITING.
AND INTEREST TOO, OR YOU HAVE YOUR MONEY TIED UP IN SOMETHING GOING DOWN.

WHERE I LIVE HOUSES ARE DOWN 33%
LAND IS DOWN 66%

May 05 04:22 PM