HOME BUILDERS HARDLY lack strategic concerns. As recently sizzling markets lose heat here and there, and as the media interprets every hiccup as the “beginning of the end,” the press seems hell-bent on reporting on a housing boom gone bust. In a theater near you, Chicken Little is playing. The last thing you probably feel like doing is heading down to the multiplex to see it. After all, you've been seeing enough of it lately when you pick up the paper or turn on the television.
You can't block out the prophets of the housing apocalypse, nor should you. Downturns happen, so why not get ready to take the right steps when they do? Contingency planning is a strategic challenge. But it is just one of many challenges. Losing sight of the others can cause as much damage as failing to be ready to roll with the punches that the market dishes out.
Larger concerns underlie the need to be ready to take swift action when markets turn. How will you ensure a supply of land while managing your land risk? How will you drive margin improvement from cost reductions, cycle time reductions, and other efficiencies in construction? How will you attract the talent you need to run your business? All these basics of running your business demand constant attention.
TURNING ON A DIME Detecting the moment risks reach a point where pulling back might be smart is critical to both short-term survival and long-term success. For home builders, the big risks are falling demand and oversupply. These can lead to margin compression and, yes, even house price declines and losses.
Job loss is the No. 1 factor behind falling demand, but it's a risky indicator. Rising interest rates can cool things down, and at rare times, can even drive enough buyers out of the market to cause an inventory correction.
If you start to see sustained job losses, strap yourself in for a bumpy ride. Inventories that appear to be lean may quickly seem ample; time on the market may increase, and home prices can come under pressure. In this environment, if you have locked in or optioned land positions, you may be tempted to build more homes on speculation even as cancellations start to increase. With land still only about a fifth of finished costs, moving ahead with building will tie up much more of your capital and contribute to an oversupply of homes on the market. At best, this oversupply will lead to margin compression. At worst, losses could ensue, with a long tail before you can get your capital back out.
Even in the absence of job loss or reductions in demand, markets can suffer from overbuilding. In a sizzling market, builders are prone to believe conditions will stay strong. Builders can lose sight that slowdowns are likely. If they add too much inventory in markets that suffer a cooling rather than a downturn in economic activity, prices and margins can still shrivel. So keep your eyes on months' supply and population growth estimates as well as jobs.
A PIECE OF THE ROCK In an increasing number of metro areas, land is becoming—if not increasingly scarce—more time consuming and expensive to entitle. In a booming market with limited supply and heavy regulation, land is a key constraint to serving demand. Land is also a key risk. When house prices fall, the impact is telescoped to the land. In a market where home prices are down 5 percent, land prices are often down more than 20 percent. No wonder decisions about land acquisitions and development are being made at corporate headquarters.
It is not just tying down the land that matters to profits and potential losses, but also knowing when to sell land, which parcels in your land inventory to take down, when to maintain margins (since builders with several years of land have bought that land at very different times and prices), and how to handle maturing options if the land optioned is worth less than you agreed to pay for it. In markets where options are cheap it is easier to walk away from them. Where they are dear, it is for a reason: What you pass on this cycle may not be yours the next.
The good news is that softening land prices can provide opportunities for tomorrow's ample margins. Hence, figuring out how to diversify risk in land over time within a market is just as important as diversifying risk in land by building in multiple markets. In these matters, having longer maturity debt is a plus because it can take years for land markets to adjust, and you may be sitting on an inventory longer than you hoped.