build or die: must builders build even in bad market?
On one level it seems perplexing that home-builders continue to churn out product (albeit at a lower rate) even as the housing market declines. It's been hard for me to get my head around why any builders would continue to put up homes in places like Phoenix or Las Vegas, where the market is already tanking in a big way.
However, as I think about this more, I wonder if builders even have the option to "pull back"? For example, I've read that the loan covenants for many of the biggest builders REQUIRE that they maintain a certain amount of revenue. This could even create perverse incentives leading builders to create even MORE product to keep over-all revenues high since the sale prices are lower.
Do builders find themselves in this kind of a death spiral, where their hands are tied, and pretty much have to keep building manically regardless of what the market does? Or is it just that builders are knuckleheads who refuse to recognize that the sky is falling?
However, as I think about this more, I wonder if builders even have the option to "pull back"? For example, I've read that the loan covenants for many of the biggest builders REQUIRE that they maintain a certain amount of revenue. This could even create perverse incentives leading builders to create even MORE product to keep over-all revenues high since the sale prices are lower.
Do builders find themselves in this kind of a death spiral, where their hands are tied, and pretty much have to keep building manically regardless of what the market does? Or is it just that builders are knuckleheads who refuse to recognize that the sky is falling?
Comments
I think it is actually quite simple. The builders make money, building houses on land they already own (or on land they have the option to own). I would assume that the builders will continue to build, as long as the cost of building a house, and selling it for less than the comparable existing home, will turn them a profit.
Once that cycle is over, we'll probably see the home building industry completely slaughtered.
I am sure this is true. However, even if they can't build and sell a home for a competitive price, maybe some of these builders would be FORCED to build anyway simply to keep their revenue at a set rate that they had committed to with loan covenants?
The other is that the market for raw land has fallen through the floor. The only way they can sell the land is to put a house on it. There are more suckers willing to buy houses, when they toss in the granite and the High Def, than the more savvy investors on the raw land side.
Are you thinking they'd still be able to move the homes by throwing in such as "Free Cars" and "Lots of Cash Back", to compensate for the competitive prices in the existing home market?
If things get really bad, we may see two primary sellers - banks and builders - chasing each other down to move inventory, while normal humans won't be able to competitively sell their house.
Both builders stop. One of them realizes that nobody is building and the glut of homes isn't as bad as before. That builder starts building again. The builder who isn't building is a) loosing money b) loosing market share and c) loosing expertise (workers leaving) to the builder that is building.
It's easy to see that building is actually preferable to not building even if you've already overbuilt. This is especially true if you are able to turn a profit. If you can sell a house that cost $270k to build for $500k, that's a profit for a long ways down.
What gets interesting is that there may even be a point where you are better off selling for a loss than not selling at all. You could be loosing more money not building than building at a loss.
Even after new and existing homes have hit rock bottom, I could see the Builders continuing operation as long as they can cover the expenses (pay themselves, their employees, and if need be, the contractors).
It can actually be worst than that. There's a very simple formula in economics. Given two choices A and B, choose whichever produces most profit (or least losses). If A is build and B is don't build. It is possible that you can loose money on every house built and still loose less money than not building.
Here's a good example. For a couple years, GM and Ford have lost money on every car they sold. The problem is that selling less cars would not fix the problem. They had pensions to pay out. So it makes more sense to loose money than to loose more money. It is conceivable that builders could sell for a loss for a few years before it put them out of business. Unlikely that it will come to that, but as a fundamental bottom to building, that would be it.
With that in mind, I look at new condo construction in places like, for example, Ballard as being simply bad timing. They should have started their project a year earlier...
On the other hand, don't underestimate the ability of developers to con people into investing in construction projects in a market that already has an oversupply. I'm sure deals go down all the time where the promoter gets paid up front, and the investors are left holding the bag when nothing will sell.