One of my holdings in home builders, Lennar (LEN), has reported its 1Q earnings a few days ago. The CEO's summary of the housing market is worth paying close attention to (my emphases).
... While the new home market and housing in general still faced serious headwinds from current economic and legislative conditions, the market and overall economy appear to be continuing to stabilize and are generally in recovery. As we have expected, at least as it relates to housing, the recovery is not presenting itself as a V shape, return to better times, but instead is proving to be a rocky, stabilizing bottom with visibility obscured by more questions than clear answers.
The overhang of foreclosures and the prospects of additional delinquencies ahead continued to moderate recovery, as shadow inventory continues to be absorbed and then even replenished. Unemployment and a generally sluggish economic bounce back combined to full demand at traditionally low levels. And the prospects of a pullback driven by elimination of legislative and fiscal incentives limit visibility and create pending uncertainties about the immediate future of the strength of the market.
And finally, the debate over whether inflation or deflation lies ahead and the impact of sovereign credit risks add uncertainty to the view ahead of interest rate. Nevertheless, as we reviewed our operations from the field geography-by-geography, there are some common themes that appear to be validating the current trend.
First, prices are not free-falling and in fact in many markets are continuing to stabilize and even recover. In most of our divisions, there continues to be a meaningful reduction in the incentives used and the sales process and that fact is reflecting itself in higher gross margins. For the company overall, incentives were 12.5%, down from 13.2% last quarter and 17.1% last year. And margins improved on a pre-impairment basis to 20.3% from 17.8% last quarter and 14.3% last year. While these trends are vulnerable to the upcoming elimination of the $8,000 tax credit and the elimination of fiscal stimulus to the lending market in the short term, it feels that the momentum provided by consumer confidence and home affordability will likely equalize their impact over a short period of time.
These government programs work very well as a kick-start to a free-falling housing market, but it now seems that the free market is positioned to take over in orderly fashion. Second, inventories of new homes remains significantly reduced. While there has been a great deal of talk about potential spec building of new homes to beat the end of the tax credit, we are finding that, that as limited. In most markets, new homes are still being built to order and for the segment of the market that wants a new home, there are limited immediate opportunities to choose from, and that is helping to reduce incentives.
Next, while foreclosures continue to be a significant driver of absorption and pricing, the effect is continuing to decline as the bulk of foreclosure activities is situated in areas that do not compete with new home construction, such as the inner city or the extreme outskirts of markets in which we operate. The better situated foreclosure homes are being absorbed in an orderly fashion and the market is clearly in the inventory overhang in many locations. The $8,000 tax credit has facilitated that clearing process and has helped enable a return to normalcy. In our operating meetings, we found that a number of our markets were no longer effective at all by foreclosure homes as they had already been absorbed. I have noted many times that housing is a localized business and inventories in micro markets, not broad geographic markets are most important in considering demand trends.
Finally, we have heard that unemployment rates in many of our markets is at least stabilizing and in some instances beginning to recover. Accordingly, a general sense of confidence has returned to the consumer and there is a tangible sense that with prices and interest rates low, now is the right time to purchase a home for future security.
This is perhaps the most important element driving the future of the housing markets as the threat of losing one’s job has deterred many from the housing market for some time now. With the ground now firming beneath us, and with solid foundation of our balance sheet, we are able to find new acquisitions of home sites to build new communities where homes can be delivered at responsible profit levels at today’s price level and given zero market appreciation and Rick will give further color on our operations will talk about our acquisitions.
As you can see from our press release this morning, at Lennar, we have continued to position our company to return to fundamental profitability in 2010. We have made meaningful progress in preparing our company for a stabilized and ultimately recovering housing markets. That preparation is primarily reflected in our balance sheet and is now – that is now well positioned for the future. Through the end of last year, we aggressively impaired or disposed of assets that would not add to our profitability in the future. This process enabled us to both clean up our balance sheet, while maximizing the tax benefits derived from the net operating loss carry-back extension that Congress enacted last year.
This in turn has enabled us to move forward with additional liquidity to make strategic purchases and to begin to add back jobs that were lost as the markets deteriorated. In the first quarter, we made meaningful investments that we believe are positioning our company for success. After a rather long four-and-a-half years of mending process, we are pleased to finally be using our cash again to invest for future profitability rather than support impaired property.
Our balance sheet remains fortified with a homebuilding and Rialto debt-to-total cap ratio net of cash of 45.9% and homebuilding cash of approximately 1.15 billion, which includes the 230 [ph] in cash taken in two days after the end of the quarter. The number of joint ventures has fallen to 58 currently and that’s down from 62 last quarter. Many of the remaining ventures are good ventures that have already been reworked and have solid access to the position for the future. We expect to continue to reduce this number as we go forward into 2010. Additionally, we have continued to reduce our maximum recourse debt for the company to $279 million.
Finally, on the opportunity side, we have made our first strategic investments in the Rialto segment of our business. As I noted in prior quarters, we have been preparing to be a significant participant in the distress opportunities that naturally present themselves in down cycles. We have been incubating and operating team of experienced professionals for the past few years. The team is now formed and we have begun the process of actively investing in unique distressed investments. Mid-quarter, we announced the acquisition of over $3 billion of face value of loan in partnership with the FDIC, and we described our progress no our PPIP program with AllianceBernstein.
While I will let Jeff Krasnoff update you on those programs, I will note that we have made meaningful investments that we believe will add significant shareholder value. This is a tough business, but we do it exceptionally well. Yesterday evening, we had our weakly asset managers meeting, and as I reviewed assets with our managers from around the country, I was enthusiastic to see just how comfortably we operate and manage this very unique segment. We are clearly beginning to see more opportunities present themselves in this area and with our unique expertise, we expect to be an active participant in this part of the market recovery, as we feel these investments can add outsized return to our recovering homebuilding operations.
At the end of the day, we are very pleased with the progress that we have made to date and the very exciting position that our company is currently in. Our balance sheet is strong and positioned with adequate liquidity to support investment for our future. Our core homebuilding operations are positioned for success and beginning to grow again, adding communities and leveraging our right-sized overhead. And our Rialto Investments segment is now fully operational and investing capital to create strong returns as we build profitability.
While we have recognized that the current economic environment is fragile at best, we feel today that we are extremely well positioned to navigate the rocky bottom and ultimate recovery that lies ahead.
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