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New Homes, New Questions

When two CEOs of two of the nation’s largest home builders choose to use the exact same word to describe the housing market on the very same day, there’s not much room for argument. "The operating environment for homebuilding continues to be challenging with orders and closings remaining under pressure," said Pulte CEO Richard Dugas, as his company forecast quarterly earnings, estimating a 21% drop in new orders from a year ago.

"It will continue to be challenging, certainly, in the next six to twelve moths," echoed D.R. Horton CEO Donald Tomnitz, as his company posted a profit plunge of 85% for its fiscal second quarter.

But investors may be asking: Is now the time to jump into a new home or to a homebuilder stock? With stocks trading at one times book value, "we think that the stocks have largely anticipated and reflected and discounted the disappointment so far that’s been articulated by the builders," says JP Morgan analyst Michael Rehaut. In the near term, there is some potential further downside, but Rehaut says that as order trends moderate in their declines and potentially turn positive late this year, "that should be a major catalyst for the group."

Still, inventories for new homes are high -- eight months worth of supply according to statistics, -- but that does not include cancellation rates. Cancellations for new homes, which had been moderating in the last few months, may begin to climb up again soon. "Our numbers show that the cancellation experience is once again worsening for the big companies because of the way that the mortgage market is heading," says Dave Seiders, chief economist for the National Association of Home Builders.

The subprime mortgage meltdown was clearly unforeseen by the big builders and led to crushed expectations in the spring market. "Going into the end of ‘06 with the price cuts that they had already taken, they were hopeful that the market would begin to show signs of stabilization and even improvement as we enter the spring selling season," says Rehaut. "The subprime issue and the liquidity crunch certainly I think was not factored into their outlook."

For a new home buyer today, that could present an opportunity. The big builders have been relatively stubborn about lowering prices, instead choosing to offer incentives and assistance with financing. New home prices are in fact still rising, while existing home prices are estimated to fall nationwide this year for the first time in decades. But that could change, as builders face higher cancellation rates and growing inventories.

One possible chink in that investment strategy is the subprime problem. Tightening lending standards are having an effect up the chain of buyers, so while new home buyers may not be subprime borrowers, they too may feel the subprime pain. For the builders, "it's not just subprime borrowers buying their homes, it's the people that were planning to buy their homes maybe selling their existing home to a subprime borrower can't sell the home at that level, so the problem moves up the chain," says Seiders.

Anecdotally, real estate agents say that while traffic is a bit better this spring than in the fall, potential buyers are waiting it out, choosing to see how the market shakes out before they sign on the dotted line. That could mean higher new home sales figures in July that what home builders were hoping to see in April. As for the home builders stocks, most analysts see them as relatively healthy.

"We continue to operate in a very difficult home-building environment," says Horton’s Tomnitz. "In spite of this, we are improving our already strong balance sheet while we continue to manage our business profitably." In other words, the builders seem to be saying, they’re up to the challenge.

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