The following analysis was presented earlier this month in the Short Seller’s Journal.

I agree with the title quote but it’s not mine. The CEO of luxury furniture retailer, Restoration Hardware ($RH), commented on the Company’s Q3 earnings call: “For the housing point of view, there is no soft landing…It’s looking more like a crash landing in the housing market. It’s looking like 2008, 2009…The housing industry is in a free fall.”  Furniture sales are highly correlated with the home sales. I was pleasantly surprised thus to hear the CEO of a company tied at the hip with the housing market speak candidly. This is in contrast to the CEO of every homebuilding company who put a positive spin on the prospects for their respective companies’ home sales in the outlook for 2023 in their companies’ latest quarterly earnings report.

In a sign that investors are fleeing from real estate investments, the largest real estate fund operator, Blackstone, restricted investor redemptions from its flagship private REIT. Shortly after this, Starwood limited withdrawals from its private REIT, which is the second largest non-traded REIT. Private REITs are funds for wealthy individuals and money managers (pensions, insurance companies, hedge funds etc). This is a sign of the degree to which the real estate – both commercial and residential – has become illiquid.

This means these residential REITs have run out of cash and are stuck with homes that would be difficult to sell quickly enough to meet redemption requests. This is very bad news for the inventors in these REITS, many of them pension and retirement funds. In all likelihood the next directional move in real estate will be a big, step-function move lower. (Note: between private equity and real estate, pension funds will eventually be forced to take rather large market-to-market valuation write-downs).

According to Redfin, 60,000 purchase contracts were canceled in October. That’s the highest monthly number since Redfin began tracking the data in 2013. The number of price cuts in October also hit a record high in October. Not all of the 60,000 cancellations were on new homes, but canceled purchase agreements on new homes become spec home inventory for the homebuilder.

Even worse, the cancellation rates for homebuilders seem to have accelerated during the fourth quarter compared to the third quarters, as I discuss below with TOL and HOV quarterly numbers for their FY quarter ended 10/31. As an example, TOL’s cancellation rate jumped to over 20% from 13% in the previous quarter.

With cancellation rates rising quickly and large pools of capital dedicated to buying and owning rental portfolios out of cash, prices are going to have to fall by what will eventually be a shocking percentage in order to balance out supply and demand. And this is before the next shoe drops, which will entail a surge in forced selling by individual investors (e.g. ABNB rental investors). This growing amount of unsold inventory on homebuilder balance sheets  will soon become a nightmare for these companies and their shareholders.

In fact, for Lennar (LEN) it already is a nightmare. LEN  announced that it is offering to sell around 5,000 homes in inventory in “block trades” to rental landlords, with an opportunity to acquire entire subdivisions. Most of these homes are available because of contract cancellations. However, it also suggests that LEN has some subdivisions in which most to all of the homes have not been sold. This will be interesting to watch as it would appear that many of the residential REITs with big rental portfolios and who might otherwise bid on these home packages have run out of cash.

Lennar announced its Q4 (FY Q4 ended 10/31) results on December 14th (Wednesday) after the close. I’m just going to review the key metrics from Q4 that will affect LEN’s financial performance going forward. New orders were down 15% YoY, while new order values were down 24.1% YoY. The decline in the value is attributable to LEN slashing the average selling price (ASP).

The YoY ASP decline at 10% was much steeper than other homebuilders’ FY Q3. Prices were slashed in an effort to move inventory ahead of the bulk sales announcement. I’m not sure they’ll move much unless it’s at fire sale prices. How would you like to be someone who who took delivery of a new home from LEN in Q4 before LEN announced its bulk-sales?

The Q4 new order ASP (contracts signed) was down 10% YoY and was it down 13.8% from the ASP of the homes delivered (as opposed to the ASP of a new order contract) in Q2 and Q3.   If you bought a LEN home that was delivered in Q3, you are down 13.3% vs what you paid, on average. The cancellation rate in Q4 jumped to 26% from 21% in Q3 and from 12% in Q4 2021. As with every homebuilder, the cancellation rate at LEN is climbing up to where it was during the worst of the 2008 housing bust. It will be worse this time.

Looking at the p/e ratios of homebuilders is not relevant right now because most of them will likely have earnings that swing to negative in 2023 and/or 2024. At some point the market will price this in regardless of where mortgage rates are at the time. I still expect LEN and the rest of the homebuilders to start selling off sometime this month or in early 2023. Q1 2023 could be bleak given the declining pool of potential home buyers who can afford a home.

TOL and HOV also reported their FY quarterly numbers through October 31st earlier this month. Both had worse new order numbers than LEN. TOL’s new unit orders for Q4 plunged 60% YoY and 50% from FY Q3 2022. This decline from Q3 to Q4 is not necessarily “seasonally” derived, because TOL’s unit orders in Q4 2021 increased 6% from Q3 2021. Similarly, HOV’s FY Q4 new orders during the quarter plunged 49.4%, the unit backlog fell 31.1% and the dollar value of the backlog dropped 20%. But here’s the money-shot: HOV’s cancellation rate was 41% vs 15% YoY.

The contraction in the housing market is just starting to build momentum. Witness the big decline in existing home sales in November – 7.7% from October on a SAAR basis (seasonally adjusted annualize rate) and the 35.4% plunge YoY. This is the 10th consecutive month of declining home sales and the biggest YoY decline autumn 2008. Not including the pandemic lockdown period, the November SAAR for existing home sales is the lowest since 2010. Of particular interest, the $1mm+ segment of the market had the biggest decline in sales (closings), down 41.25% YoY.

It’s not going to get better for the housing market. Despite an 80 basis point decline in 30-yr fixed rate conforming mortgages (20% down, minimum 740 FICO), the mortgage purchase apps index declined 0.1% this past week from the previous week. The not seasonally adjusted index fell 0.3%. Since mortgage rates peaked on October 21st and began to decline, the mortgage purchase app index is down 17.3% and down 36% YoY. The conclusion for me is that the housing market is in free fall.