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Abstract

The firm’s inventory-sales ratio prices exposure to the housing cycle with a predictable sign. The buyer of a new home holds a pre-construction contract at a guaranteed price with the right to cancel at any date up to delivery. The demand for contracts rises with falling user costs while lot supply is inelastic, leading to land bidding in booms. During busts sales decline and land bidding largely disappears. Delivery is from inventory at a cost of carry below that of construction. The firm’s inventory-sales ratio leads and is negatively correlated with its subsequent returns. For U.S. homebuilders over 1975 to 2009, a 1% increase in the inventory-sales ratio lowers next-quarter returns by five basis points.

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Notes

  1. The qualitative conclusion comes from average returns and inventory-sales ratios of U.S publicly-traded homebuilders. The inventory-sales ratio has been used in the previous literature, e.g., Kahn (1992) and Bils and Kahn (2000).

  2. This contract is used for new construction in the United States and across Asia. Deng and Liu (2009) discuss features of the new housing contract in China, where the buyer receives immediate long-term financing. In the United States there is a two-stage feature. The homebuilder rather than the buyer receives construction financing, taken out by the loan to the buyer on delivery and acceptance. From the production side the contract is similar in the two countries. The buyer is contracting with the builder, paying a deposit now for subsequent delivery and triggering construction.

  3. The Washington State highway department maintains a price index on state construction costs based on contracts funded regionally and nationally. See www.wsdot.wa.gov/biz/construction/CostIndex/pdf/CostIndexGraph.pdf.

    In 2003 this construction costs began to rise sharply, doubling by the middle of 2007 where it reached its peak. The construction cost index declined by 20% at the end of 2010. The regional index includes Washington, California, Colorado, Oregon, South Dakota, and Utah. A separate index contains the remainder of the country. The construction cost index includes prices of materials for fuel, concrete pavement, concrete structural, crushed surfacing, hot mix asphalt, road excavation, steel reinforcing bar, and structural steel. Adjustment is made for the status of competition and cost mitigation.

  4. The asset pricing factors include size, value, momentum and market factors, taken from Kenneth French’s data library. Demand is reflected in long-term mortgage rates and expected capital gains on new housing. The difference between the two variables is calculated as the user cost measure. Macroeconomic factors are the growth rates and volatility of output and house prices, the rate of unemployment and the yield on 10-year Treasury notes.

  5. The homebuilder data are a panel of pooled time series and cross sections. Granger-causality tests are conducted based on each firm’s data for the direction from excess returns to the lagged inventory-sales ratios. In more than 90% of the firms, the causality does not occur. When the lagged excess returns are added into the first-difference equations, the coefficients are not statistically significant.

  6. Direct disclosure is the actual sales and inventory reported on the firm’s financial statements with no adjustments. Indirect disclosure uses different definitions of sales and inventories.

  7. From www.census.gov/const/uspriceann.pdf, the median and mean prices of new houses constructed in the U.S. are reported since 1963, a series starting later than the 1959 date on the number of units.

  8. Quigley and Raphael (2005) find that house and land prices rose most rapidly in the California jurisdictions with the most stringent restrictions. Poterba (1991) use a construction supply equation based on the ratio of the price of new houses from the Census to the Boeckh building cost index. The Boeckh index for construction by Marshall and Smith, www.marshallsmith.com, covers more than a dozen property types over 200 metropolitan areas in the United States.

  9. In its annual report, http://www.tollbrothers.com/pdfs/TOL_2010_AR.pdf, Toll Brothers note that it is geographically concentrated between Boston and Baltimore and that firms with a higher geographic concentration in distressed areas were particularly affected by the downturn.

  10. An output expansion is associated with an increase in real marginal cost. The markup of price over marginal cost is countercyclical. This countercyclical markup results in a fall in inventory relative to expected sales during expansions.

  11. In Zegeye v. Boswell (2007), the buyer Zegeye agreed to purchase a $5.75 million house in Florida from the seller Boswell with a $275,000 earnest money deposit. The buyer failed to perform on the closing date but wanted to occupy the house. The seller agreed to occupancy on the provision that the purchase agreement be amended to increase the earnest money deposit to $1,000,000. The initial $275,000 was passed through to the seller. After occupying the house for several months, the buyer still failed to close and was evicted. The seller retained the entire deposit including the additional $725,000. The buyer sued, arguing that only the original $275,000 should be retained. This position was upheld by the Supreme Court of Florida. The decision was appealed by the seller. At the Court of Appeal of Florida, Fourth District the retention of the $1,000,000 was upheld as reasonable and was stated in an addendum to the purchase agreement (Boswell v. Zegeye (2007), 954 So. 2d 66).

  12. The International Accounting Standards Board (2008) is implementing a standardized international recognition of revenue from the sale of new houses by 2015. Revenue cannot be booked prior to cash receipt from the buyer. This provision changes the United States procedure during the sample period of 1975 to 2009. Under the percentage-of-completion standard in FASB 5 and FASB 67, the homebuilder recognizes revenues and profits proportionately during construction. This revenue occurs even though the buyer is limited to only the deposit or any other cash payments explicitly stated in the contract. The firm is incurring land and construction costs with only limited earnest money deposits, some of which state regulations require to be held in escrow. The homebuilder has negative cash flow during construction but books revenue and profits, particularly when markets are booming. There is no cash from sale other than any retained deposit and all the land and building costs are incurred. These various cash flow positions of homebuilders are accounted for in the empirical specifications.

  13. The result is that homebuilders report high profits during boom times. Since they cannot use transfer pricing for patents and royalties or for intermediate inputs to offshore subsidiaries, all their profits are domestic. Publicly-traded firms face the high United States corporate income tax rates with no overseas opportunities to park cash, since the land and houses are domestic. The response of homebuilders is to seek and receive carrybacks allowing them to set aside losses during bad times against previous profits and receive refunds of the taxes paid.

  14. Dyreng et al. (2008) show that oil, gas and real estate firms rationally delay revenue recognition to minimize tax liabilities.

  15. The price is quoted for a standardized unit of housing. Housing comes in different qualities. The type of housing quality shifts over time, including in square footage, amenities and lot size. The model focuses on ground-up construction as are the empirical results. Those units potentially differ in quality over time and are not distinguished in disclosures by firms.

  16. The quarterly sales data are annualized based on the previous four lags. Up to three quarter lagged inventory-sales ratios are used in the asset pricing equations, so the result is that seven quarterly observations in 1975 and 1976 are removed.

  17. See www.mba.tuck.dartmouth.edu/pages/faculty/ken.french/.

  18. The first differences up to a year lagged are tested in the asset pricing equation but only the results based on the first difference for a two-minus-one quarterly lag are reported. The results based on the change of inventory-sales ratio for two and three quarterly lags show that the coefficients are negative, while not remaining statistically significant. The impact of the change of inventory-sales ratios on the subsequent returns tends to burn off over time.

  19. The relation based on the capital-asset pricing model is tested, with similar results on the inventory-sales ratio variables.

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Correspondence to Zhonghua Wu.

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We are grateful to William Hardin III, Ravi Jagannathan, Xiaoquan Jiang, Selale Tuzel, Joe Williams and a referee for helpful comments and discussions. Participants at the University of Southern California and University of California-Los Angeles provided discussions. Asset pricing factors were obtained from Kenneth French’s data library.

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Chinloy, P., Wu, Z. The Inventory-Sales Ratio and Homebuilder Return Predictability. J Real Estate Finan Econ 46, 397–423 (2013). https://doi.org/10.1007/s11146-011-9340-1

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