As they look ahead at housing trends, developers and land bank specialists don't much like what they see, and they're not about to wait out the current mess before they start putting their own Plan Bs down on paper and, in some cases, into action. Some of those contingency plans include donning new hats, diversifying their businesses to generate dollars while the lot-selling game remains largely dormant. Ironically, in spite of all the talk of excess new-home inventory to burn through, some developers are entering the home construction business to try to turn at least some of their own lot inventory into cash.
Only 24 months ago, owning, developing, and offering tracts of land just about anywhere was like owning a press that prints money. Now, across the country, as land-based revenue forecasts trend downward and lot take-down projections shrink from a torrent to a trickle, land mavens face a hand-wringing moment while the real estate cycle runs its course. Near term, land bankers and developers are stuck shouldering infrastructure expenses and carrying costs that cash flow from lot sales would normally offset. That's not the big problem, however, as most developer and land banker business models build in cyclical swings. What's uncertain is how profoundly a sharper, more protracted down market than expected will materialize as a risk to even the most conservative pro formas that supported funding and underwriting communities over the past few years.
In other words, if the story of 2007's market gyrations is about restoring a measure of pain in financial risk, will that pain sting those who have been investing so zealously in the land equation?
All indications are for a bright future for housing. Still, many now predict it will be 2009 before the industry hits the recovery phase of this cycle. Even then, normalized growth will likely be slower than the supercharged pace of the boom just past.
It's not news that the investment in land development assumes a longer window than traditional home building to recoup and pay out to funds and other capital providers. In cross-collateralized arrangements, bottom line returns absorb the ebb and flow of market fluctuations and even bad judgment on land grabs. But what happens to the economics of these deals when home builders become paralyzed?
Faced with pro formas that have become increasingly elastic, Irvine, Calif.-based SunCal, a privately-held land developer, recognizes it's time for a new business model–and it isn't alone. Across the country, developers are implementing tactics to offset some of what's at risk. In SunCal's case, that means erecting home building operations to push through a land portfolio. Others are busy recalculating the velocity models and value propositions of their new and future master planned communities.
If you came across Jay Moss as he scouted office space in Los Angeles last month, you might think the former regional general manager of KB Home's Inland Valley division was channeling a former incarnation. He needed to move his growing new-home building operation, Mosiac Homes, out of SunCal's headquarters. One of his final choices is the office space he formerly worked in before leaving KB in 2006.
Moss's mission is to get something good going in of one of the country's hardest hit regions. Although he won't comment on the capital providers, multiple sources report that Mosaic is infused with seed money from SunCal and equity partners Lehman Brothers and Goldman Sachs.
While the vertical operation is structured as a stand-alone entity, it's clear that Mosaic–which will open 18 to 20 new communities starting in the first quarter of 2008–was created to conduct arm's-length transactions with regional land developing powerhouse SunCal. SunCal currently carries about 250,000 lots in various development stages across California, Arizona, Nevada, and New Mexico.
SunCal's take-no-prisoners land acquisition strategy frustrated competitors during the first-half decade run up. Frequently, the likes of LNR, Catellus, and The Irvine Company would bid on a site and stretch financially to make a deal work, only to discover that SunCal had outbid them by 15 percent or more. Even so, as land prices skyrocketed throughout the West, there seemed to be a lot of money to be made regardless of the price one paid.
Affordability and the mortgage crisis knocked the wind out of most California home builders' sails, especially in the southern part of the state. What's more, SunCal developed a reputation for not delivering communities on-time. As the market caved and delays grew rampant, it became evident that SunCal's financial projections may have been compromised.
SunCal has Lehman Brothers' financial backing. The capital structure tends to smooth over cycle gyrations, so that the higher exposure and risk of 2005 would normally be mitigated by greater opportunity from deals made earlier, at a lower cost base. The question now is: How long can SunCal continue to give back profits before its bottom line switches from a pipeline to a pipedream?
The way its management saw it, either SunCal could ride out the downturn at the mercy of the home builders it supplies, or it could try to assert control over its own destiny. In Jay Moss, management picked an operator with a track record of wins. Among them, he led the start up of KB's Las Vegas division, as well as the restructuring of both KB's Northern and Southern California operations. Even with 35 years of industry experience and numerous leadership roles, however, launching a home building operation in Southern California today is mighty risky.
In the best of economic conditions, a residential developer's vertical designs would be fraught with risk. Land acquisition, envisioning, and entitling are skill sets entirely different than those it takes to successfully run a construction business. SunCal began discussing the prospect with Moss, but spent 12 months working through a variety of issues before committing. Since January 2007, Moss has been tempting talent, developing a series of homes designed to fit SunCal's lots, and planning the processes for Mosaic.
Creating a sales, marketing, and customer service operation from the ground up is daunting. But Moss, reputed as a leader who recruits and inspires great talent, has assembled what he describes as an "incredible team" from both public and private home builders. "The way we do business will be very systematic," Moss says. "We'll incorporate the best of technology and have advanced sales and marketing strategy and techniques."
Even as the wheels spin into motion, SunCal must counter claims that it is setting up a store to compete with its primary customers: production home builders. Initially at least, Mosaic's goals are modest. "Every market has its threshold. We aren't just going to build inventory and try to chew up the land," says Moss. "We are looking for strategic places to get product in. We'll strategically pick communities where we can set a good price and compete with resales."
The first deals Moss will conduct will be on SunCal lots. However, Moss vows that Mosaic's pricing will come in at market value rather than at a price that reflects SunCal's land holdings advantage. He scoffs at the suggestion that Mosaic would receive special terms not available to the market. "Times are different today," Moss explains. "Terms are more negotiable for everyone right now."
"That's the way deals like that have worked in the past," says John Burns, president of John Burns Real Estate Consulting Inc., recalling the business model of California Pacific Homes, which was a home building operation set up for, and by a family member of, The Irvine Company. "[That company] had to pay the same price as everyone else."
Other land developers such as Bonita Bay Group in Florida and La Jolla, Calif.- based Newland Communities have considered the vertical strategy. To date, however, they haven't been able to structure a process that works through the challenges.
Still, Moss is focused on the opportunities. "This is the perfect time to put a home building operation together. It's a fresh, new company full of people committed to building a brand and unencumbered by what is going on today."
Considering both the enthusiasm and the equity partners, it's likely that there are big builder ambitions for Mosiac. Capital didn't enter into the deal without an exit strategy in mind, and considering the size of SunCal's land base, it's clear they have the capability to ramp up a builder very quickly. Given that, it's no surprise that market sources speculate that Moss and company will quickly become a home building powerhouse with aspirations to go public. "We're thinking of everything," says Moss in response to the query.
Learn more about markets featured in this article: Los Angeles, CA.