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Homebuilders Buried in Land

A housing downturn could result in writedowns for the huge amount of land on their books.

Ed Wachenheim, a long-term value investor, agrees with the general view that homebuilder stocks are cheap right now. But the money manager, who was once a major owner of the sector, has sold off most of his positions because he's worried about the huge amount of land on builders' books.

"My fear is that many of the companies took on too-large land positions at too-high prices. And that means that should the industry turn down that there is risk that there will be some impairment of land values," says Wachenheim, who runs Greenhaven Associates, a Purchase, N.Y.-based firm that manages $3.7 billion of capital, mostly for wealthy individuals.

It's difficult to determine if Wachenheim's concerns are justified and builders have been too aggressive in taking on new land. Builders report the dollar value of their total land holdings in quarterly filings, but nothing is usually said about the prices paid for individual parcels.

There also is no geographic breakdown to determine whether a builder like

Pulte Homes

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, for example, has too much exposure to a frothy market like Las Vegas. All the public knows is that Pulte's total inventory of owned land was $5.3 billion for the quarter ending Sept. 30, up from $4.49 billion a year earlier. That amounts to 170,000 home lots, or roughly three years of supply, the company says.

But what if that's too much land to be holding in a slowing housing market? Some fear that builders in the end will have to adjust their balance sheets and take big charges if their land drops in value.

The issue is of particular note since builders have spent the bulk of their earnings over the past few years buying land for future building. Although most builders have at least 50% of their lots controlled through options, a large amount of purchased land continues to be placed on balance sheets. As a result, the sector in general has seen negative cash flows for some time now.

"I have never seen a group, in 20 years of analysis, post negative cash flow from earnings for four of the last five years and prosper as a stock group without having to pay the piper," says Jim Poyner, an analyst for Palladian Research, an independent New York research house. Poyner thinks land impairments could begin popping up over the next year if builders start slashing prices on new homes for sale.

Robert Curran, a Fitch Ratings analyst who covers the builders, says it's premature to worry about land impairments now, but grants that the issue could arise in the future.

"There isn't anyone who really stands out as being overloaded on raw land on the balance sheet that is just sitting there," Curran says. It would take an economic recession or a really problematic regional housing market for there to be large land impairments, he adds. "If home prices come down, it doesn't mean you will write down land assets."

Wachenheim, the money manager who sold off the sector, admits the probability of large writedowns is small, but says the consequences could be very detrimental if there are massive impairments. He notes, though, that his firm is very risk-averse and that the average investor might have held on to the sector given the builders' low P/E multiples, making them nice value plays. The sector has recently been trading at 6 to 7 times 2006 projected earnings.

But the land issue worried Wachenheim enough to sell off nearly all of Greenhaven's homebuilder stocks -- a process that started in July, he says. He declined to provide more detail since his firm still has to update its filings with the

Securities and Exchange Commission


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As of Sept. 30, nearly 22% of the firm's $2.7 billion stock portfolio was still in homebuilder stocks. Most of the positions have since been sold, Wachenheim says. Greenhaven's largest homebuilder position was



. At the end of September, Greenhaven was the second-largest institutional owner of Centex, holding 6% of the company's outstanding stock, or 7.68 million shares. The firm also owned smaller positions in


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KB Home

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, Pulte,


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Toll Brothers

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Standard Pacific



So who has the most conservative land positions, according to Fitch?


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tops the list. Since it emerged from bankruptcy years ago, the company controls all of its lots through options.


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M.D.C. Holdings

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also are considered conservative, controlling much of their land through options.

Companies with the least conservative positions would tend to be those whose owned lots represent several years of supply. This would make

M/I Homes

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the least conservative, since its owned lots represent 4.7 years of supply, according to Fitch. Others ranking lower on the conservatism scale include Pulte (3.9 years of supply) and Toll Brothers (3.8 years of supply).

While the land position issue might pose some risks down the line, it's of little concern to many investors right now. Just add the land worries to the list of risks already baked into homebuilders' valuations, supporters of the sector say.

"If there were no worries about this

sector, we couldn't buy things at 8 times earnings," says Ron Muhlenkamp, who runs the $3 billion

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Muhlenkamp Fund. Homebuilders have represented 15% to 20% of the fund's portfolio for the past five years, and Muhlenkamp remains a fan of the sector, saying the builders offer compelling valuations based on today's multiples.