Builders, Renovation, Design, Furniture, Decorate

There's little doubt that 2005 was a banner year for new home construction. According to the National Association of Home Builders, single-family home sales reached a record 1.282 million units last year, up 6.6 percent from the record set in 2004.

But if the full-page ads in my local paper are to be believed, new home demand has begun to flag. The issue is not how many units will be sold, rather it's the way they'll be priced. Recent ads have offered new home discounts ranging from $70,000 to as much as $100,000.

These new homes are being sold by major builders in one of the best markets in the U.S. The Washington, DC region includes some of the richest areas in the nation by income: Fairfax County, VA (#2), Loudoun County, VA (#3), Falls Church, VA (#8), Howard County, MD (#10) and Montgomery County, MD (#13). If builders are cutting prices in a region known for high household incomes, you have to wonder what's happening in other population centers.

In many areas across the country it's often paid to buy new homes at the earliest point in the construction cycle because as projects are built out prices tend to rise -- sometimes by hundreds of thousands of dollars.

As an example, last Fall the New York Times Magazine said at one New Jersey development, houses "that were selling for $560,000 when they first hit the market 24 months earlier were now going for at least $935,000." (See: Chasing Ground, October, 16, 2005)

But if builders are now offering discounts, then several thoughts emerge.

First, why offer price cuts unless demand is weakening? This is not a hideous thing to admit, it makes no sense to believe that each and every year will set a new sales record. What we have to this point is not a pricing collapse or evidence of a broken bubble, but rather moderation in the marketplace. On Wall Street they would call this a "correction" or "profit taking."

Second, price reductions do not mean builders are losing money. The basic cost to construct a house remains largely unchanged as projects are built out -- even though asking prices may increase substantially. Thus builders can drop prices and still profit, especially with established projects.

Third, if you're a builder you want to maintain unit volume because continuing sales allow you to retain skilled construction crews, a prized commodity.

If builders are openly discounting prices, it means they're competing with recent buyers who now wish to sell. While most owner-occupants tend to hold homes for a number of years, short-term owners include a large percentage of investors hoping to buy-and-sell as soon as possible.

The growing number of new-home contract cancellations may well be evidence of entrepreneurial discontent. Speculators may prefer to lose a deposit than to close on a home that costs money to hold each month and can only be re-sold in the short term with a minimal profit or no profit at all.

The appearance of builder discounts drives a fat wooden stake into the hearts of short-term speculators, but reduced speculation is not necessarily good for builders. If fewer short-term investors are looking for new homes, then discounts become a self-fulfilling prophecy -- discounts lead to fewer investors, there's less buzz, fewer investors result in less demand, less overall demand requires additional price cutting and so forth.

Traditionally builders have avoided price discounts because they wanted to maintain their pricing structure to protect past buyers and themselves. Rather than a reduced price, builders would rather throw in a finished basement, gourmet kitchen, fancy bathroom or some other upgrade that does not show up in price reports. Other approaches including paying some or all closing costs, buying down the mortgage and paying points.

Now that price reductions are appearing publicly, only builders with the most demand will be able to resist the discount trend. Just look at what happened with U.S. auto manufacturers: When one offered employee discounts to the public, others were forced to follow.

Someone buying socks from Wal-Mart and Target doesn't care about the price next week because the purchase is being made for reasons of comfort and utility and not much is at stake. With real estate the deal is different: Speculators in the past few years have routinely thought of new homes as sure-fire investments. If discounts mean the flames have gone out, then a lot of builders -- and a lot of speculators -- will have a tough time ahead.

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