Home Builders' Cancellation Rates and Impairments

Part 2 - Land Impairments

The headlines that have gained some traction from the national home builders since Q4 2006 have been standing inventory, cancellation rates, and land impairments. Yet, the Philadelphia Housing Sector Index (^HGX) has been up 10% since mid-December, and this increase takes into account the 10% February drop for the index.

The market appears to place greater weight on the latest headlines declaring reduce inventory and lowered cancellation rate (even though I question how those number are presented) and lesser weight on the issue of land impairments. What exactly are land impairments? Periodically home builder must review the value of the raw land (among other things) held in inventory. Under accounting rules, when the value of the land has decrease at the time of the review, a land impairment must be entered as one-time non-cash expense against earnings. Well, many home builders were snapping up raw land at ever exorbitant rates in the last few years with the expectation the housing boom would continue for years to come. Unfortunately, the housing market has slumped and many home builders are sitting on land options that are not going to be exercised and raw land that has greatly decreased in value.

In Q4 2006, these were the land impairments and options write-downs reported by selected home builders:

Hovnanian Enterprises - $336M (12/2006)
Pulte Homes - $88M (2006 Q3)
Toll Bros - $60M (projected in 12/2006); revised range of $60M to $160M+ (2/2007)

It is this last example that has piqued my interest. The markets have treated these write downs as one-time charges and have not punished the stock. Given the continued housing slump, these write downs going to continue. What also worries me is the methodology in calculating these land impairments. Land options losses are relatively easy to calculate as the money used to purchase the options is lost.

So is there a standard in which the home builders use to value their land impairments? It's apples to oranges comparison but this reminds me of the accounting irregularities during the dot com era when companies would hold back reporting of revenue if the company knows they will meet the current quarter's earnings estimates. The held back revenue would be used in future quarters in case the company did not meet estimates.

Home builders could decide that since the current quarter is already "lost", they could apply more land impairments during that quarter. The thought is that if they're already going to miss earnings estimates by a significant amount, what's another few millions dollars recorded as a lost? If more is written off now, less can be written off later. Or conversely, if the home builder is close to meeting the newly lowered earnings estimates based on recent land impairments, why not report less land impairments now to meet estimates, and record the impairments in a future quarter?

It's appears to be a giant loophole home builders can exploit to manipulate their stock price, especially during earnings time.