CALL IT BIG LEAGUE HOME BUILDING'S pain management. The genetic code of a percentage of home sales calls—like it or not—for failure, the exponentially more costly and annoying cousin of retail's merchandise returns. In an environment where a million or better new home sales occur each year, sales unraveling for one reason or another are bound to happen. So, rather than futilely pursue eliminating home order cancellations all together, smart volume builders are going to school on how to cut their losses.

While some home building statistics are easy to track and account for, other metrics are elusive. A good example is cancellation rates, which builders report in units or dollars, with varied data by quarter, product type, target buyer, and market. Not uncommon are rates in the mid-20 percent to mid-30 percent range. Some builders report cancellation rates in the low teens or even single digits.

The Securities and Exchange Commission doesn't legally require public builders to report cancellations in corporate accounting, so no standards for the data exist. Some companies specify to a tenth of a percentage point from quarter to quarter, others report a 10-point spread or such vague assessments as “the low end of the normal range” or “a drop of 300 bps (basis points) year over year.” Even then, only when analysts ask point blank for data do executives yield the information. Often, the answer is that “it all depends.”

During MDC Holdings' fourth quarter 2004 earnings conference call between industry analyst David Einhorn from Greenlight Capital and MDC Holdings' CFO, Gary Reece, the topic arose:

Einhorn: “Can you explain what the economic impact on the company is when a customer cancels or the cancellation rate goes up? And second, do you think that there is another quarter or two or more of higher cancellations to kind of work through what is evolving in the markets?”

Reece: “The economic impact really varies by time and by market because there has been a time up until the summer of this year [when] cancellations in Las Vegas, for example, and California were a good thing, because we were able to turn around and sell the same house at a higher price. That has been the case in Virginia. That has been the case even in Jacksonville. So that a more typical situation is if you, depending on the stage of the home, like to see a lot of your cans come before the house starts, but if you end up with some late cancellations, you end up with a spec and you usually have to sell it with a small amount of incentives. So it really goes both ways, David.”

Einhorn: “OK. Did you answer the question on the outlook for cancellations as we work through the markets?”

Reece: “I didn't. I thought you might forget. No, I'm kidding.”

Why Cancellations Matter Still, for industry analysts and lenders, cancellations are no joke.

Margaret Whelan from UBS Investment Bank consistently asks public builders about their cancellation rates. Because builders don't routinely report them, she keeps her own spreadsheet of the rates, based on comments during quarterly conference calls. “Relative to their historical performance, it's important,” she says. “If there's a meaningful rate of change, it may portend a change in profits from that market in the future.”