For L.A.’s homebuilders, the current economic recipe of rising mortgage interest rates, flattening appreciation levels and dwindling sales seemingly would give Wall Street indigestion.

But institutional investors aren’t losing their appetite for KB Home and Ryland Group Inc. despite falling orders for new homes with several analysts still advocating buying more shares.

“Most of the concerns about a slowdown in housing have been overdone,” said William Mack, an equity analyst at Standard & Poor’s, in comments on the U.S. housing market. “There is little doubt that there is a slowing but it’s not as bad as people think.”

Still, the slowdown in the nation’s housing market is becoming visible in the homebuilders’ bottom lines and their share prices. Both homebuilder share prices were over $80 in early January but last week were in the upper $60s.

This month KB Home reported that fiscal first-quarter earnings rose 42 percent. Outside of possibly the energy sector, that number would have wowed investors, but it was the smallest gain in four quarters and made some analysts nervous about how the company will fare if the housing market continues to cool, as most economists believe it will.

The fifth-largest U.S. homebuilder by market value, KB said net orders for new homes fell 12 percent in the first quarter, compared to a 23 percent gain in the year earlier period. It was the first decline in home orders since the second quarter of 2002.

Perhaps more ominously, in the company’s announcement Chief Executive Bruce Karatz attributed the drop in net orders to cancellations. “Some housing markets have moderated from the over-heated and, in some cases, speculative pace of growth of the past few years,” he said. “Tempering of demand to more sustainable long-term levels is a good thing.”

Much of that falloff has been in the regions where KB and Ryland have seen much of the companies’ recent booming business: Nevada, Arizona and Texas, among others.

Home prices in Phoenix have been flat for more than two months and prices have declined from levels reached six months ago. Same goes for Las Vegas, where prices have dropped for two consecutive months.

Still, Southern California, another region where KB is active, has been resilient, according to Sacramento-based listings Web site Foreclosures.com. “There is no crash coming (in Southern California) because the excess inventory just isn’t there,” Alexis McGee, the firm’s president, said in a recent report. “We’re just getting back to normal.”

Spreading risk


If more regions where KB and Ryland are building stay resilient than those areas that falter, the homebuilders could fare well over the next several years. Even so, KB recently entered markets that some analysts believe are risky.

The homebuilder opened a new office and entered into partnerships with other homebuilders to construct subdivisions in the metropolitan Washington, D.C. market, which has experienced appreciation levels on par with Southern California.

KB also has made a bet on the rebuilding of hurricane-ravaged New Orleans. The company has entered into an agreement to build homes on 3,000 acres southwest of the city, and earlier this month KB announced it would build 75 homes near the city’s tony Garden District neighborhood in what is believed to be the first major residential project close to the center of New Orleans.

Standard & Poor’s Mack told Bloomberg News he believes KB will be successful partly because of the shift in its regions, but also because of how the company is changing the mix of the homes it builds.

Instead of relying on first-time homebuyers, who are likely to be more affected by a slowing economy and rising interest rates, the company is building more higher-end residences that attract established homeowners.

KB’s partnership with Martha Stewart is one such example of this strategy. The homes, designed with flourishes from the kitchen and crafts mogul, sell at a higher price and have so far been well received. The company’s first Martha Stewart branded community, a 650-home division in a Raleigh, N.C., suburb, attracted interest from 3,800 families.

And KB announced earlier this year that the company plans to build 1,800 of the homes in markets located in Southern California; Atlanta; Houston; Charlotte, N.C.; Las Vegas; Orlando, Fla.; and Daytona Beach, Fla.

Karatz agrees the Martha Stewart brand could inadvertently help the homebuilder weather the effects of a cooling national housing market. “While that wasn’t our primary motivation, there’s no question that these Martha Stewart communities create excitement in a marketplace that is less buoyant,” he told the Business Journal earlier this month.

Still valued


Bargain-hunter investors are loading up on homebuilder stocks, including Ryland and KB, because the sector’s shares have fallen 26 percent since a July 20 peak.

Ryland, for example, is trading at one of its lowest prices relative to earnings in the last two years. Investors selling their stake expect profit margins to shrink due to rapidly rising land and development costs. They also believe the industry will begin offering discounts and promotions to counteract rising inventories of unsold homes.

Still, bulls point to the industry’s large profits and competitive advantages compared to private companies. Indeed, while Ryland’s share price is falling, the company continues to report record earnings. (Ryland is scheduled to release its first-quarter earnings on April 20.)

For that reason, value funds have swooped in. Bloomberg News reported earlier this month that Legg Mason Inc. has been buying shares of Ryland and other homebuilders. The Baltimore investment bank is now the second-largest outside owner of Ryland.

Funds like the one operated by Legg Mason believe public homebuilders like KB and Ryland will continue to grow market share because of easier and cheaper access to capital and higher economies of scale.

Publicly traded homebuilders have tripled market share during the last 15 years to about 30 percent of all newly built homes, Argur Oduma, a Morningstar equity analyst told Bloomberg News. In the long-run, Oduma believes public homebuilders will continue to grow and expand making them a good bet.

“When the market slows, the first people to suffer are the mom-and-pop shops that rely on credit lines for financing,” Oduma said. “When they suffer, they might sell out to the larger builders.”