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How Hurricane-Resistant is U.S. Homebuilder Credit Quality?

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How Hurricane-Resistant is U.S. Homebuilder Credit Quality?

Homebuilders in the U.S. can be acutely exposed to natural disasters, such as with severe weather in key growth areas in the southern U.S. Hurricane Harvey flooded large portions of the Houston area, which is an important market for several companies, despite recent economic difficulties stemming from sharply lower oil prices. That said, S&P Global Ratings expects that homebuilders' geographic diversity will mute the worst effects of disruptions in Houston and potentially Florida in all but a few cases. Home closings have occurred since Harvey, but we expect the outlook for sales for the rest of 2017 will remain choppy because of a potential hit to consumer sentiment, as well as tight availability of materials and trades.

Homebuilders in the U.S. have increased their debt loads in tandem with improving market conditions in recent years, reducing their buffer for a potential downturn. Even so, it appears that damage is minimal to inventories in the Houston area and to overall profitability. In fact, the biggest risks to profitability might yet be ahead: Labor availability, higher materials costs, and potential constraints on land development could pressure margins in the region.

At the time of publishing, Hurricane Irma is bearing down on the U.S. east coast, potentially Florida. Some homebuilders have significant exposures to both Houston and Florida, most notably Lennar Corp. (BB+/Stable/--) and Weekley Homes LLC (B+/Watch Neg/--). Our recent upgrade of Lennar

is underscored by the company's good profitability and improving credit ratios, which position Lennar favorably to withstand most scenarios of localized business disruption. The company has national coverage and good geographic breadth, but Florida accounts for about one-quarter of its closings. We estimate that compared with other homebuilders, Lennar has double-digit market shares in the five largest Florida markets, where PulteGroup Inc. (BB+/Stable/--) and D.R. Horton Inc. (BBB-/Positive/--) combine for double-digit penetration of only one Florida market. Miami-based Lennar has considerable experience in these weather-related emergencies, however, which we expect will enable its expeditious return to full operations in the event of a storm.

S&P Global Ratings believes it will be useful to provide additional context about its views on U.S. homebuilders' credit quality and how it could be affected by this year's hurricane season.

Frequently Asked Questions

What's the immediate effect of the hurricanes on homebuilder ratings?

Our only rating action has been to place Weekley Homes on CreditWatch with negative implications. We had already assigned a negative outlook to the company because of elevated debt leverage, much of which came from previously weak market conditions in Houston. We estimate Weekley has about 20% of its inventory in Houston, although the preliminary damage assessment is modest, limited to only a few homes. Nevertheless, difficult conditions could impede the company's turnaround in Houston that would be necessary to improve debt leverage below our 5x threshold for a downgrade. Moreover, Weekley is about 20% exposed to Florida, which may yet emerge as another source of near-term profit pressure because of Hurricane Irma.

It appears that flood damage to homebuilder inventories in Houston might not be as substantial as initially expected. Homebuilders we rate suggest that damage to the communities has been limited to a few model homes, with street flooding in some communities. The largest homebuilders in Houston based on closings are D.R. Horton and Lennar. Their size and geographic diversification, however, insulate their credit ratios. Other exposed issuers, like Beazer Homes USA Inc. (B-/Stable/--) and Meritage Homes Corp. (BB/Stable/--), could only see a small effect on credit measures in the event of a few months of poor market conditions in Houston, and their financial performance should remain within our expectations for the ratings.

How exposed are homebuilders to the affected areas?

Weekley has 20%-25% of its 2016 closings from the Houston area, Hovnanian Enterprises Inc. (CCC+/Negative/--) about 20%, Beazer Homes and Taylor Morrison Home Corp. (BB-/Stable/--) each about 15%, and Meritage Homes about 10%. D.R. Horton and Lennar had the most closings in the Houston area in 2016, but this represented less than 10% of their total. Most of these companies have fairly low direct exposure to Florida, but Taylor Morrison, Meritage, and Beazer all have more than 25% of their revenue from southeast U.S. states, which could be affected by Irma.

Each homebuilder is still assessing damage, but we are not aware of any communities that have been especially affected. More to the point, we believe active selling communities that are mostly developed, entitled, and selling will recover quickly.

In our worst-case scenario, which appears unlikely, adjusted debt to EBITDA for Meritage could rise about one-quarter on weaker earnings, but would remain well within our rating thresholds. In this harsh scenario, Hovnanian and Beazer Homes could see their adjusted debt to EBITDA increase about 0.5x, although we do not expect any rating actions because of both issuers' already-high leverage. Our worst-case scenario is emerging as unlikely, because we reduced Houston revenues to zero for a month for the most affected issuers to simulate an uncertain path to weaker full-year results, rather than a specific one-month shutdown.

How have S&P Global Ratings' assumptions for homebuilders changed?

The most likely scenario appears to be some delay in closings and a gradual return of construction activity over the next few weeks, followed by an improved sales pace by late 2017. This is all predicated on resumed land development and a good pace of construction, which will be difficult given recovery construction activity and potential labor constraints.

If we assume a 5%-10% hit to Houston-area revenue in 2017 along with higher input costs and inflexible sales, general, and administration, we expect that credit ratios deteriorate only modestly in 2017 without breaching any of our rating thresholds.

Beazer Homes, with about 15% of its closings in Houston, had been performing well before the storm, but we estimate that the important EBITDA interest coverage could decline to about 1.4x, but still above our threshold of 1x for a downgrade.

Meritage Homes' adjusted debt leverage could increase modestly from 3.4x because of temporary earnings pressure, but will remain well below our threshold for a downgrade of 4x. Hovnanian Enterprises, with 20% of its closings in Houston, remains exposed to refinancing risk in the next 12-18 months, which is exacerbated by any such operating disruptions.

What will S&P Global Ratings be watching as the situation evolves?

According to the National Association of Homebuilders, we should not expect a massive surge in home building in affected areas, as replacing units destroyed by the storm will take place slowly over a number of years. That said, estimates vary, but tens of thousands of homes have been destroyed, which will boost demand from our previous expectations and provide a tailwind for exposed builders over the next 24 months.

We'll be watching profitability, as well. We believe that labor availability and land development substantially hinder normalizing Houston homebuilder operations and returning to steady volumes, while higher materials costs and lower overhead absorption will constrain margin improvements.

And we'll be watching Hurricane Irma.