The Construction Conundrum

Well, not really a conundrum as you'll soon see. But, that sounded like such a good title, and now that it is cast in bold type directly above, with alliteration spanning not one or two, but three letters, where those three letters have wildly divergent, in some cases devilish or naughty alternative uses ... brief consideration is now given to ceasing our scribbling at this point, knowing that the best hope to amuse for this day has already been proffered.

OK, back to work.

Before explaining the home construction conundrum, that really isn't a conundrum, there is some new Southern California real estate sales data to review. The monthly DataQuick report came out the other day and the now familiar sales and volume charts have been updated with the January data.

Clearly visible in the most recent data is the much talked about December to January decline for Orange and San Diego Counties. Ventura County suffered a sharp decline as well.

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As mentioned a couple days ago, this is not that unusual for this time of year. The January data showed a few four to six percent declines in median price from the previous month, and elsewhere on this chart can be found numerous declines of three or four percent, most of them at the same time of year as indicated by the dotted lines.

So, everyone should just calm down about the December t0 January price action.

The year-over-year changes to median home prices below show San Diego County once again threatening the x-axis after what may prove to be a three-month long "head fake". Registering a 2.5 percent increase from last year at this time, the next few months have easier comparisons to year ago prices (see chart above), but after that it gets more difficult.

Notably, Orange County joined San Diego County with a single digit yearly appreciation, marking only the second time that two counties have simultaneously fallen below the 10 percent line in recent years. Prices in most other counties remain buoyant.

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The sales volume chart below is full of intrigue this month because, with the exception of Riverside County, sales volume has dropped off to multi-year lows.

Note that the seasonal pattern here is for January and February sales to drop off significantly then rebound in March. As the March data does not get reported until two months from now, there may be a lot of people counting For Sale signs in their neighborhood trying to get a feel for how this year is going to shape up.

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This may prove to be a long, anxious two months for sellers, but don't be surprised if sales rebound in a big way proving nay sayers wrong again for a while longer. The California real estate market has defied reason for so long, why stop now?

The Conundrum

So, the construction conundrum - not really a conundrum, really just business. Everyone who follows real estate today has probably heard that housing starts nationally were up over 14 percent month-to-month yesterday after a decline of eight percent for the previous month.

[Again, this is a good example of why one shouldn't read too much into the monthly data. The previous month's decline in housing starts was completely offset by the new data yielding a healthy increase for the two month period.]

But, this is not necessarily a good sign for house prices.

Remember the housing starts statistic measures new home permits, which indicates the builders' intent to build. But amidst the still rising housing starts are both rising inventory and declining sales volume.

What are the homebuilders thinking at this stage of the real estate boom?

As discussed a couple days ago, it seems that the "sticky down" part of a real estate market does not necessarily apply to homebuilders. Builders are in the business of selling homes and can't simply decide not to sell. They can decide not to build more, but how would they come to that conclusion?

Today we take a look at some homebuilder calculus (calculations really, it just looks funny to put those two words next to each other) to get an idea how the math might look if you were in the business of building homes in the Los Angeles area.

The table below uses actual median prices along with a reasonable guess at building costs over the last six years. The 2000 cost-to-build was estimated such that the builder had a net of $24,000 per house built, then future building costs were calculated with an eight percent per year increase from that starting figure.

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The accuracy of these cost estimates is really not that important for the point that is trying to be made here - if anyone has better information, the chart can be updated, but the conclusions are not expected to change significantly.

The point of this exercise is to demonstrate a likely explanation for why builders may be all too willing to cut prices to move inventory. While it may be uncomfortable for Phase Three homeowners to see Phase Four models offered at prices lower than they paid, the builder has no such discomfort - the builder is still making good money.

And, the bad news for the Phase Three owner is that there is a lot more room to cut prices to move inventory during Phases Five and Six.

In the example above, it would seem reasonable to think that the builder could cut the $490,000 price down to, say, $350,000, still making over $100,000 per copy, and happily go on doing what they were doing. That is, building even more new houses. Why stop? They're still making good money.

To the Phase Three owner, the comparable value against which their home is measured has declined almost 30 percent. Oh well - this will not be good for homeowners expecting to extend their home equity line of credit indefinitely into the future.

If you've wondered about highflying housing stocks in the last few years, this is the reason why - the sale price increases have far outstripped their material and wage cost increases, resulting in huge profits - profits that will still be large for a while longer as prices are reduced to move inventory.

Up next in the price cutting battle - the panicky speculators, many of whom don't have the luxury of taking their homes off the market and living in them. As homebuilders reduce prices, at some point, this crowd may realize they can no longer carry a money-losing investment and will be competing with the homebuilders for the dwindling number of buyers that are still considering real estate purchases.

This has the potential to get ugly.