Sunday, August 5, 2007

Some Things Home Builders Did to Get Into the Current Situation

Excerpts from a WSJ article explain some of the things that builders did to get into their current situation. As stated before in previous posts the longevity issue for any business is to position themselves so you can ride through the inevitable troughs. Afterall, anyone can make money in good times.

It wasn't supposed to happen like this. Today's home builders were thought to be better-capitalized, savvier and more geographically diverse than many of their predecessors in the last downturn, in the early 1990s. While many are expected to weather the slump, concern is mounting about the balance sheets of a growing number of companies. . . .

. . . . What's going wrong? An array of business assumptions that both builders and housing analysts propagated have turned out to be misguided.

Issue #1

One big assumption had to do with their cash flow: The common wisdom among some analysts was that builders would turn into "cash machines" in the event of a housing downturn, because they would pare construction and land buying.

In reality, most builders haven't been able to stockpile as much cash as expected. That is partly because they have had to keep building large housing developments, even though demand dropped off sharply.

"Once you start putting in the plumbing hookups and the roads, you can't abandon these projects halfway," says Nishu Sood, a housing analyst at Deutsche Bank, because a half-built development risks angering homeowners and local officials. (my emphasis)

Who does the risk management for builders?

Also eating into that cash flow: the sharp drop in sales and home prices. After several years of double-digit annual increases, some builders say their average prices are down 7% to 12%.
The incentives that companies are using to sell homes are so large that they are crippling profits.

Issue #2

One thing that tripped up builders during the previous slump was that they owned too much land. This time, builders protected themselves by using options to secure land, rather than paying for it outright. In many option agreements, a builder puts down a deposit on a parcel with the option to buy the land in the future at a set price.

In theory, this should have let builders buy land only when they needed it, while giving them the right to walk away if they didn't need it. The builders would also be helped by the overall scarcity of developable lots in many markets, Citigroup analyst Stephen Kim wrote in a bullish March 2006 research report.

"The linchpin to our bullish thesis has been the emergence of land constraints," Mr. Kim wrote at the time. "This will allow the builders to outperform expectations in any given demand scenario."
Many companies were also acquiring land based on growth rates of as much as 15% and 20%. The options helped reduce some risk, but many builders still bought lots of land outright because they could get higher returns.

Once again, who does risk management for builders?

Issue #3

Builders believed they could protect profits by building in numerous markets across the country. With geographic diversity, they figured that if some markets slowed, others would likely remain stable.

But while the biggest builders did achieve geographic diversity, many didn't achieve profit diversity. In other words, much of the builders' profits came from the markets hardest-hit by the recession.

According to a Credit Suisse analysis, 32% of the builders' profits at the peak of the boom in 2005 came from one state: California. Florida, also an extremely strong market during the boom, was responsible for 14% of profits, and Nevada was responsible for 10% of profits.

Markets that were doing relatively well, such as Texas, bring only moderate profits, in part because home prices are low and those markets are open to enormous competition from thousands of small builders.

What analytical group is looking at the portfolio effects of the profitability of the builders?

Issue #4

Until recently, many analysts believed banks would be forgiving of the builders. But it now looks as if some companies could run into trouble with their banks. (my emphasis)

I was in banking a long time, why would someone think this? Where is the risk manager or CFO for builders?

That is because some builders' net worth is eroding so quickly -- as they write down the value of land -- that some may be getting close to tripping contractual agreements that limit their level of debt in relation to tangible net worth, which is typically their assets minus liabilities, goodwill and intangibles such as trademarks.

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