Builder 100: Painful Year

Credit: Jonatahan Barkat

After the dust settles and the downturn that began in 2005 finally shifts into an upswing, the largest builders will have gained market share. But it’s not evident yet, as many companies saw massive declines in closings, revenue, and assets over the last 12 months during the economic tumult.

Once the shaking stops, many companies, large and small, will be in shambles. But the public builders will have the financial backing, thanks to partners on Wall Street, to start building as soon as there’s a call for more homes. And that is what will turn the tide for them. Smaller builders, on average, will either close their doors or not have ­access to funds quickly enough to start building in advance of an upturning market, unless they were among the few who managed to squirrel away cash and available debt.

Yes, 2007 was a disaster, with credit tightening like a noose, skyrocketing foreclosure levels, a dying market for mortgage-backed securities, plummeting home prices, and the devaluation of the dollar. It is no wonder that Centex CEO Tim Eller, when told he was being interviewed for the Builder 100, quipped, “Are there 100 builders left?”

Punch Drunk

Thankfully, most builders are still standing, but virtually all of them are hurting. In reaction to market forces, many companies hacked and slashed their personnel in quick-fix overhead cost-cutting moves.

For Bloomfield Hills, Mich.–based Pulte Homes, the problem of employee and company morale is being met head-on. Having cut over 55 percent of its full-time workforce from its peak size, Pulte has dispatched its CEO, Richard Dugas, to meet with every division. Dugas held the town hall–style meetings in each of his first four years as CEO, but this year marks the first time he is meeting with groups as small as 10 to 20 employees, he says.

“The workforce doesn’t see you hiding behind your desk, and you can speak to their questions, and most of them are questions that I can answer very directly,” he says. “It’s been ­effective to get the therapeutic effect of people being able to express their minds and get their questions answered from the horse’s mouth, so to speak.”

Downturns are old hat for Hovnanian Enterprises, which was founded in 1959, says Ara Hovnanian, CEO and son of founder Kevork. The company is following a strategy of selling inventory at often drastically reduced prices, generating cash, renegotiating land deals, and trying to reduce loan balances, Hovnanian says.

“While we’re leveraged more highly than I’d like to be, if you compare it to the major housing corrections of 1975, 1981, and 1991, we’re actually at a much lower level of ­leverage than we were,” he says.

One Hovnanian tactic was dubbed the “Deal of the Century,” a nationwide September sale that saw Hovnanian offer free incentives valued up to $100,000. The promotion generated 2,100 sales. But its cancellation rate for those sales was the same as its annual cancellation rate of 29 percent. Many months later, Hovnanian still seems unsure how the gambit played out.

“I’m sure we did cannibalize some sales from the subsequent months,” he says. “It wasn’t a failure in that we’re not any worse off for having done it, and whether or not, net-net, we were better off, it’s hard to tell at this stage. It’s not a perfect world to make those decisions.”

In such an imperfect world, builders must rethink how they do business and how their companies are put together.

Change Up

Centex cut its employee count and is reducing its number of divisions from a peak of 44 to 30 by 2009. But Centex’s striving for a leaner company also applies to its building ­processes. The Dallas-based home building giant cut its floor plan count from 4,500 to 700 and is now redesigning many of those 700, Eller says.

“We will be generating new and more-efficient floor plans that are designed for manufacturability,” he says. “Our products will reflect our customers’ desires, as well as our ability to efficiently build.”

Centex is also applying lessons learned in other manufacturing fields to home building.

“Building homes is a manufacturing process.” Eller says. “So things like schedule adherence, first-pass yield, those kind of metrics, we are beginning to apply to our processes.”

Redesigning floor plans is something Arthur Rutenberg Homes, based in Clearwater, Fla., does to one-third of its plans each year. ­Arthur Rutenberg Homes is a franchisor with 32 independent franchises in Florida, Georgia, and South Carolina. The franchisees get their home designs, software, and business intelligence on pricing from headquarters.

In the last 12 months, the company established a program that assigns a senior designer to a group of the same-model houses and the families that live in them. The designer talks to the customers, gets feedback, and uses that information to guide the evolution of that floor plan to better suit customer needs, says Alan Weiner, co-CEO of Arthur Rutenberg Homes.

“The focus here is less of a ‘Batten down the hatches,’ and more of a ‘We’re going to get better.’ The goal is to be better on the other side of this cycle,” Weiner says. “To come out of it with better plans. To come out of it with improvement to our systems.”

Not Standing Still

The builders who survive the downturn are not holding out hope that reports of increased home sales in February are the first sign of a market rebound. They have assessed both the market and their companies realistically and are adjusting accordingly, says Hovnanian.

“Every day you see home builders cutting back their overhead, dramatically renegotiating land contracts, consolidating operating divisions, re-bidding their subcontractors costs,” he says. “Nobody is just sitting around waiting for a rosy day. Everybody’s taking actions in every which possible direction.”

Home building consultants spent much of 2007 goading their clients into making significant changes to their companies, not to hold out hope, because “hope is not a strategy,” as consultant Chuck Shinn, president of Shinn Consulting in Littleton, Colo., often reminds his clients. Those consultants may spend 2008 trying to get the same builders to cut just a bit more.

“Most companies have downsized to the right levels to support the volumes they sold last year and are hoping that their volumes don’t decline very much in 2008,” says John Burns, president of John Burns Real Estate Consulting in Irvine, Calif. “But that hope may be overly optimistic. 2008 is most likely going to be a recession. At best, 2008 is going to be a slower year of economic growth than any year in the last six or seven years.”

Demanding Issue

Any upturn in the market for new homes will require a sea change in demand, which fell in 2005 and still hasn’t gotten up. Eller, Dugas, and Hovnanian all agree with the Harvard Joint Center for Housing Studies’ estimate of a sustainable level of new-home total starts of 1.9 million units per year.

But considering the current economic climate, can it really be that high? The U.S. Census shows total new-home starts in 2007, single-family and multifamily, was 1.35 million units, 34.4 percent down from 2005’s total of 2.07 million.

“They’re way too high. The sustainable level of starts is 1.6 million,” says Burns, who believes where Harvard and most of the large builders go wrong is in their estimation of the number of old homes that get replaced.

Ivy Zelman, CEO of Cleveland-based Zelman and Associates, has researched birth rates and projects that a sustainable level of starts, based on birth rates, would be the same 1.6 million units.

Demand also has faded through the disappearance of speculative home buyers. But while most builders acknowledge that the speculative buyer is currently out of the buying market, they continue to believe pent-up demand for their product is strong.

“There is a pretty good reservoir of buyers out there, waiting not to be made fools of,” says Bob Toll, CEO of Horsham, Pa.–based Toll Brothers.

Builders are seeing increased traffic in their weekly sales reports, and while the visitors are not buying, traditionally, increased foot traffic is an indication of pent-up demand, Toll says. But can they buy when their underlying financial situations are not improving?

“How can you talk about pent-up demand when the number of adults with jobs is going down every month?” asks Burns. The U.S. Labor Department reported 63,000 job losses in February and 299,000 manufacturing job losses between February 2007 and February 2008.

Centex’s Eller says that buyers are still adjusting to a new reality. “We’re finding there are a lot of want-tos, but they have to save money for a down payment, and they have to repair their credit to some extent,” Eller says.

Zelman, who believes the homeownership rate in the U.S. is going to decline from 70 percent during the boom to 65 percent or 64 percent, sums it up best.

“There’s a difference between realizing that pent-up demand versus there is always going to be pent-up demand in terms of homeownership desire,” she says. “Homeownership rates today have been inflated because of easy money, and easy money is gone.”

Lessons Learned

Builders continue to learn valuable lessons during the housing downturn. But in reflecting back on the boom period, Kim Shelpman, CEO of Holiday Builders, based in Melbourne, Fla., thinks maybe the best lesson is the simplest. “If it seems too good to be true, it generally is,” ­Shelpman says.

“To have dirt appreciating so rapidly, it should’ve put a red flag up,” she says. “Never in history has that ever occurred, that dirt escalated that fast.”

Hovnanian also sees appreciation as a guide for land purchases; if ­appreciation spikes the way it did ­between 2003–2005, “it’s in general a time to be much more cautious on land purchases, in every way, shape, or form,” he says.

While Pulte wasn’t as focused on being the largest builder in the country the way Fort Worth, Texas–based D.R. Horton was, says Dugas, the company did fight hard for growth and will again when the market picks up. Still, Pulte may have been too focused on growth during the boom.

“We did, candidly, push the growth button very hard. Potentially too hard, given the fact that this is a cyclical business,” Dugas says. “[But] don’t lump us all in Horton’s bucket. With all due respect to Horton, we’ve never been super public about wanting to be the biggest. It’s about being the best. I do think the market share growth game is not over, so look for us to grow again, but not to be blinded by just growth desires.”

While all the promises to be more cautious once the good times return sound good, the bottom line is that people have short memories, says Hovnanian. It was a long time between the last bust in the early 1990s and now.

“What happens, realistically, is the lessons are remembered in the short-term memory banks,” he says laughing. “So, we’ll remember for a while. But if it’s another 15-year run with a strong market, chances are we’ll forget 15 years from now. I bet in 2023, many of us will have forgotten these lessons.”