Loss Profit Or Break Even Signpost Shows Investment Earnings And Profits
Loss Profit Or Break Even Signpost Shows Investment Earnings And Profits

Let's start with a positive thought. Maybe this slow-burn, pent-up fundamental demand-fueled, low-inflation recovery can continue. Except for potential anomalies--event risk, lame duck/pre-election paralysis--the United States economy's showing some pluck, puts and takes notwithstanding.

So, how to characterize a home builder's challenge for 2016? First thoughts might be of demographic barbells, pre- and present retirees and the pre- and present young adults. Let's hold that thought for a moment, and move the furniture around in our brains to focus on our own organization--large, medium-sized, or small--and its operating model.

There's a basic question here, with its own myth-vs.-reality arguments, which play heavily on how residential construction trends work. What is a home builder? Is a home builder, first and foremost, a manufacturer and engineer specializing in construction project management? Or, what about a real estate and residential property asset manager--is that not the primary skill-set? Or, not to be forgotten, especially in light of those aforementioned demographic "barbells," is a home builder not, primarily, a designer and marketer of a consumer's biggest-ticket hard-good purchase experience?

If you take these questions seriously, then a slow-burn, low-inflation, no-appreciation real estate market starts to intensify the spotlight glare on a home builder's biggest challenge for 2016. Profits.

This glacially slow recovery tries the patience, and is nerve-wracking in its iffiness, but who wouldn't take it over alternatives we've lived through too recently to forget. One of the more annoying consequences, however, will be that the question "what inning of the recovery are we in?" may well go on indefinitely.

However, underneath a bunch of assumptions about 2016--i.e. more communities opening, lower price-points offered, slightly easier credit access, more volume, faster inventory turns, etc.--is a strong reality-check sense expressed well by a trusted advisor who we've talked with over the past couple of days:

The absence of meaningful and broad-based home price appreciation has many implications, but most notably lower land profits. This hinders builder profitability, limits number of land developers, chokes off capital, caps m&a valuations..... Conversely, it rewards builders with lowest stick and brick, overhead and capital costs.

Another member of our brain trust puts the challenge this way:

I am beginning to see a wider and wider disparity between pretax net profits between some builders who operate with similar land strategies or in the same markets ... presumably, builders with longer land positions or more "develop your own lots" should have a higher-margin than those that mostly take-down developed lots (in order to mitigate the risk of developing your own, and in order to have a 'land profit' plus a home builder profit); that said, some do and some do not.

A third, very keen related insight comes in this way:

While the big builders are looking for standardization across markets, the market is demanding smaller niche developments for varied targeted consumer groups. In some instances, the depth of market is demanding that a single small community appeal to a broader range of targeted consumer groups to achieve an economic sales pace and generate an acceptable rate of return. In response to this downsized market, the big builders need more sites which have a shorter shelf life and therefore need to be replaced with new stores in the same submarket more frequently.

As in so many other businesses, the healing, or normalization, is toward revenues coming back to levels we can live with. At the same time, many of our organizations face the reality that while revenue's growing, it's not the highly profitable revenue we like, but the twitchy, slippery, high-maintenance, high-risk, low-margin revenue we have to learn to live with and love.

It's a challenge, no? So, back to the central question of the business model. What is a home builder best at? Construction management? Real estate asset management? Design and consumer marketing? Can a company be all three at its core?

Maybe some can. Maybe this next stretch of recovery will filter out insight into which of the three distinctly different skillsets your company should position for 2016 and beyond.