Rocky Road Ahead for Homebuilders

Friday's press release from Lennar (LEN - commentary - Cramer's Take), in which it updated its third-quarter earnings estimate, mentioned certain land adjustments as one factor that contributed to the warning.

I believe we'll start hearing a lot more about adjustments in land values, although I don't hear anyone talking about it now. Instead, the market seems focused solely on home sales.

At some point, homebuilders like D.R. Horton (DHI - commentary - Cramer's Take), Hovnanian (HOV - commentary - Cramer's Take), KB Home (KBH - commentary - Cramer's Take), Toll Brothers (TOL - commentary - Cramer's Take) and Pulte (PHM - commentary - Cramer's Take) will be unable to sidestep Statement of Financial Accounting Standards ("SFAS") Rule 144 any longer. This rule requires revisions in the value of assets when it becomes obvious that they are worth less than stated book value.

A Closer Look

Here's how it works. Housing projects and land held for development and sale are stated at cost. It is assumed that a builder pays fair value for land. However, if facts and circumstances indicate that the fair value of the assets is "impaired" -- that the carrying amount of the land is not recoverable from the sale of the finished product -- then the asset value must be adjusted downward.

This type of revaluation requires a lot of internal research and work, so it doesn't happen overnight. Because the big national homebuilders consider each region to be a separate reporting unit, they rely on the information they receive from each division in the company. As I have previously noted, the executive talent pool at the divisional level is questionable at best. Many highly paid executives are breathtakingly young and are byproducts of a prolonged bull market. Many of them have no experience in down markets, so they assume that buying interest will pick up shortly -- just like it has done before. With 2006 bonuses right around the corner, we won't likely see any asset write-downs until early 2007.

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At the time of publication, Fitzpatrick had no positions in any of the stocks mentioned in this column, though positions may change at any time.

Fitzpatrick is a freelance writer and trading consultant who trades for his own account in Encinitas, Calif. He is a former co-manager of a hedge fund and teaches seminars on technical analysis, options trading and asset-protection strategies for traders and business owners. Fitzpatrick graduated from the McGeorge School of Law and was a fellow at the Pacific Legal Foundation, a nonprofit public interest firm specializing in constitutional law. He also practiced law in the private sector before pursuing trading as a full-time career. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.