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Stopping the Cleansing

Tags Booms and BustsFree MarketsU.S. EconomyInterventionism

02/19/2010Doug French

The business end of the business cycle does the dirty work of clearing away the malinvestments made during the previous boom. These malinvestments are a stark reminder of what was hot and now is not.

Cheap and abundant money flowed into real-estate projects after the tech bubble burst and the Fed hit the monetary gas. Sand states like Arizona, California, and Florida, as well as the hub of the Southeast, Atlanta, attracted homebuilders large and small.

The builders believed they were supplying much-needed housing for aging retirees and the like, who were moving to find sunshine and lose their snow shovels. But a glance out the airplane window when landing in Atlanta or Phoenix reveals ribbons of blacktop, lonely street lamps, and the distinct outlines of individual building lots forming quadrilateral pieces of unimaginative puzzles. The lots are in undifferentiated shades of brown instead of having colored roofs surrounded by green lawns framed with white picket fences or red block walls.

While the wind blows dust from these fallow sites, the market does not look bright for completed homes. This is despite $6,500 and $8,000 tax breaks for homebuyers and mortgage interest rates around 5 percent (kept low by the Federal Reserve's buying of mortgage-backed securities). Studies by Standard & Poor's Financial Services and John Burns Real Estate Consulting, Inc. point to continued supply pressure from the foreclosure market. The John Burns study estimates that five million homes will be taken back by lenders over the next few years. The government-mandated loan modifications will just delay the process, with Standard & Poor's pointing out that if current trends hold, 70 percent of modified loans will eventually be foreclosed upon.

This overhang of foreclosures will continue to force housing prices down. And, with so many people owing more on their homes than the homes are worth, family mobility is at a historic low: it's back to the levels of 1949–1950, when the nation's population was half what it is today. All of this and high unemployment is making it hard for home builders to sell homes profitably.

Homebuyer demand is clearly not encouraging enough to motivate builders to stockpile lots again. After all, it wasn't but a few months ago that many of these same builders were dumping lots to whoever would buy them, no matter the price, in order to clean up their balance sheets. And with new-home sales falling to a national annual rate of 342,000 units in December, there is no business reason to invest in the highest stages of production. The current depression in home construction still has work to do in clearing away the malinvestments of the last decade's housing boom.

A year ago, Atlanta Business Chronicle reported that the vacant developed-lot inventory in metro Atlanta exceeded 150,000. That's a lot of lots. Assuming the 2009 number of new-home sales — 14,000 in Atlanta — holds constant, the city has more than a decade's worth of finished-lot supply. Even if the Atlanta market returned to yielding 30,000 sales per year, the area has 5 year's worth of supply.

The Arizona Business Gazette reports the finished-lot inventory in the Valley of the Sun to be approximately 50,000 (a 4-year supply). According to RW Real Estate Advisors, the Chicago area has nearly 65,000 vacant lots, a 17-year supply based upon the 2009 new-home sales rate.

"There is no business reason to invest in the highest stages of production. The current depression in home construction still has work to do."

But along with the highly publicized interventions of below-market interest rates and homebuyer tax credits, homebuilders have been thrown another lifeline that will further hinder the depression's healing process. Last November, President Obama signed the Worker, Homeownership, and Business Assistance Act of 2009, which, as many people know, extended unemployment benefits and the first-time-homebuyer tax-credit program. But quietly included in this legislative lasagna was a provision allowing big businesses to offset the losses of 2008 and 2009 against profits made as far back as 2004. This provision will generate corporate tax refunds of $33 billion, the New York Times reports. Previously, only small companies could offset losses against past years' profits.

Big home builders are the prime beneficiaries. After racking up monster profits during the housing boom, the industry has booked huge losses in the bust, accentuated by write-downs of their land positions totaling $28.5 billion for the 14 largest publically traded homebuilders. Now these large homebuilders are recapturing some of what Uncle Sam took away during the boom years. According to the Times, Pulte Homes has a refund of $450 million coming, Hovnanian Enterprises will get back $250–275 million, while Standard Pacific and Beazer Homes will recoup $80 million and $50 million of their profits respectively.

And while returning taxes to businesses is a wonderful thing, home builders are reading the distorted economic tea leaves. These seem to say that low interest rates and tax credits will eventually bring buyers back to their subdivisions, while many of the big builders' smaller competitors were washed away for good by the housing tsunami — so ramp up the higher-stage and durable-production process by investing capital in building lots.

Jim Belfiore, president of Belfiore Real Estate Consulting, a market-research firm in Phoenix, told BusinessWeek.com that he sees companies such as Meritage Homes, Beazer, Lennar, Hovnanian, and KB Home aggressively buying up subdivisions in the Phoenix area now that a lot of small and midsize privately held builders have gone out of business due to bankruptcy or site foreclosures. "Prices of lots in these subdivisions have been bid up aggressively in recent months," says Belfiore.

The Wall Street Journal's Dawn Wotapaka live blogged from a Hovnanian Enterprises earnings call in December that the company "is reloading its supply, snapping up lots that make sense at today's depressed prices." Hovnanian's CEO said that "land deals are finally starting to make sense." Admittedly, he did also say that hedge and equity funds had outbid the company on larger land deals. But it's not as if Hovnanian doesn't have any lot inventory: the company has 7,600 "mothballed" lots, waiting patiently for the market to improve.

And hope springs eternal. As Wotapaka sardonically put it, "Wait. Here's the true news of the call. Attention job hunters: Builder says it is hiring in its land acquisition departments."

On Hanley Wood's Builder Online blog, the editorial director, Boyce Thompson, writes,

Word is filtering in from markets throughout the country: The biggest builders are paying too much for finished lots. Critics, mostly the private builders who bid too low, worry that this could lead to another cycle of home price over-heating, with calamitous results if builders fail to sell homes.

Author Steve Bergsman writes that residential-lot investment is the next big boom. According to Bergsman, cities in the West "have about a two- to three-year supply of lots. By the time house prices recover, which optimistically could be as early as 2011 or 2012, developers will need to start building again."

By then, supposedly, the lot overhang will have evaporated, "and because developers over this period hadn't been buying land, they are going to suddenly wake up to the fact they need lots and at that point they will be paying a premium. At least that's the scenario most investor groups are counting on," Bergsman writes.

Bergsman quotes Scott Clark, the president of lot-buying Americap Development Partners, who says, "We are concentrating on buying at below finishing costs, leaving virtually no land cost whatsoever." Americap has picked through the northern California markets and now has its sights set on hard-hit areas like Southern California, the Inland Empire, Denver, and Salt Lake City.

"Home builders have been competing with one another to pay cash for finished lots as they reload for 2010 inventory turn and cash generation opportunity," Hanley Wood's HousingCrisis.com writes. "Is end-user/home buyer demand so encouraging that home builders should be tripping over one another to secure finished lots?"

Despite the government's efforts, housing demand does not warrant the demand from builders for lots. Since the mid-1960s, the homeownership rate in America has been around 64 percent. During the boom it peaked at over 69 percent, but it is now dropping rapidly. Even as vacant rental units are absorbed, the Calculated Risk blog estimates that there are still 1.8 million excess housing units in the United States.

The lot-buying homebuilders may be irrational, but they aren't yet exuberant. The National Association of Home Builders' housing-market index rose just 2 points to 17 in February — far below the bullish readings of 50 that haven't been seen since April 2006. But the 528 residential developers surveyed say that the tax credits being offered along with low mortgage rates are spurring some demand.

In fact, builders are "ramping up speculative construction to attract last-minute home buyers who want to tap a soon-to-expire tax credit," the Wall Street Journal reports. So inventory should climb during a "spring selling season on steroids," says Jody Kahn, a vice president with John Burns Real Estate Consulting.

"Like a shark has to keep swimming or it'll die, it's the same thing with builders," Hanley Wood's Kathryn Boyce told Bloomberg. "They have to keep building or they'll die."

As Murray Rothbard pointed out in Man, Economy and State, if the government interferes at all in the cleansing process of the depression, it will only prolong it. While the government attempts to prop up the demand for housing and land prices, the needed readjustments are only delayed. Consumers' needs are not being met. More housing is not needed, and no more land needs to be scraped and plotted for future homes.

If government continually props up demand and in turn prices, it will only bring about a permanent surplus of lots and houses. "The more these readjustments are delayed," Rothbard explained, "the longer the depression will have to last, and the longer complete recovery is postponed."

For capitalism to work its magic of providing goods, services, and prosperity, some of the sharks must die.


Doug French

Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth. He received his master's degree in economics from UNLV, studying under both Professor Murray Rothbard and Professor Hans-Hermann Hoppe.

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