Ara Hovnanian steps to the podium, looks his audience of Wall Street investors and analysts, and fesses up. The evening before, the president of K. Hovnanian tells them, in a pre-earnings call among shareholders, his company made a stunning announcement that it will take a $300 million charge against fourth-quarter earnings for land write-downs. The industry is facing tougher times, he tells the gathering at the UBS New York conference in early November 2006. But the company is tightening its belt, looking for better opportunities, and keeping a tight rein on every new project.

He estimates that half of the write-down will trace to cash deposits on land K. Hovnanian took control of via options, which it will likely forfeit, and will chalk the other $150-million loss to fully owned land that has declined in value as home prices plummet in several of its key markets.

SHOWS LAND HAND: Ara Hovnanian stunned investors and analysts with his announcement that K. Hovnanian will take a $300 million charge for land write-downs. Photo: James Kegley K. Hovnanian's land headaches are symptomatic, to varying degrees, of what all home builders with a land pipeline are experiencing. As home prices spiraled up and demand grew, big builders scarfed up land at prices that climbed meteorically–by as much as 16 percent per year. Now, many face having to walk away from the very land they were so keen to lay dibs on. They also have to reset their fully owned land inventory at a dramatically lower per-lot value. All this pain because home buyers suddenly stalled, production didn't slow in time, and inventory soared.

What's more, accounting regulations require public companies to act immediately to re-calculate the value of all land holdings so that shareholders, bondholders, and lenders can fairly see the risks and opportunities of their investments. So, as the market switches from rising to falling, every asset gets a new dollar value–values that are dramatically lower in most cases.

"Any land bought in the last two or three years is suspect whether or not it needs a write-off," says John Burns of Irvine, Calif.?based John Burns Real Estate Consulting. "What's occurring right now is widespread. Builders were generally very smart to secure land with options rather than cash, which is allowing them to take write-offs and get out of bad deals."

The lessons of land deals will continue to resonate as the industry goes through a period of painful price corrections. Companies that didn't buy a lot of land in the last two years are likely to be in better shape than those that charged ahead buying large tracts of land far more expensively than they had done so previously. In 2007, what happens with write-offs depends on the complex matrix of real home prices (factoring in all concessions) and real absorption rates (factoring in cancellations).

Once builders regain the terra firma of being able to reliably predict the selling prices for their homes and the genuine rate of speed at which they will sell, builders will be able to restructure "structured lot takedown" agreements with sellers on both price and timing terms. Until then, everybody's taking wild guesses at how low the price point will have to move to get home buyers off the sidelines and back into the market. To date, K. Hovnanian's calculus is perhaps the most dramatic among its peers, as it is assuming losses on both land it owns fully and on land it secured options to purchase with cash deposits ranging from 3 percent to 15 percent of the total land value.

Like so many other big builders, K. Hovnanian rushed to place marks on more lots at higher and higher prices. Housing analysts predict that land prices will return to 2003 prices–a 27 percent drop–and that means that every parcel purchased in 2004 and 2005 may be far more expensive than a builder wants to calculate into the cost of a new home.

At the end of 2005, K. Hovnanian had 85,700 lots under option–23 percent negotiated in 2003, 44 percent in 2004, and 33 percent in 2005, the most expensive in its stable, according to "Wonder-Land," a report by Ivy Zelman of Credit Suisse First Boston. So, K. Hovnanian now faces the hard reality of having to abandon options where its original price and volume projections no longer apply.

Steve Smiley, a principal consultant at Hanley Wood Market Intelligence, says K. Hovnanian, like other big builders, is embarking on exit strategies for many deals it made in the past 24 months. And sometime in the future, they will opt to re-bid for options at lower prices.

"Whether they expect to get it back or not is not an option. They are dropping them because it's too risky now," Smiley says. "K. Hovnanian will be in a better position in a year or two."

Investor Reaction

So far, Wall Street seems oblivious to the charges builders are taking to straighten their books for the new year, according to housing analyst Steve East of Susquehanna Financial Group.

"Generally speaking, the Street hasn't reacted to write-offs because [it] believes that most builders will continue to grow their book value through the downturn," East says. "The charges will be smaller than the earnings. I believe we will see a couple more quarters of this action."

While K. Hovnanian's biggest hits were in California, Minnesota, and Florida, the company also took charges for properties in New Jersey and Pennsylvania. "In most of our markets, we did walk away from land options," says K. Hovnanian spokesman Jeffrey O'Keefe.

In Minnesota, it abandoned plans to build 139 units on 50 acres in Woodbury, Minn., 15 minutes from downtown St. Paul, according to Eric Searles, associate planner for the city of Woodbury.

But K. Hovnanian is not just walking away from land, it is also walking away from a half-built mid-rise condo in Orange County, Calif. It originally advertised condos starting at $400,000, but pulled out of the deal in August.

While K. Hovnanian isn't disclosing exactly what it has already dropped or will walk away from, local newspapers across the country are reporting real estate woes and point to builders canceling their plans to develop. K. Hovnanian walked away from a 70-acre site in New Jersey where it had planned to build 280 homes. And it withdrew plans to build 175 homes in another Jersey locale, according to local news accounts.

"We feel it is better to take the pain now than to have hundreds of millions of dollars in 'sunk' land," Hovnanian told the UBS conference on Nov. 8, 2006.

Hard Hit

And that pain includes dealing with the situation in some of K. Hovnanian's hardest hit markets, including San Diego, Orange County, Minneapolis, and parts of Florida. The land in Minneapolis is "underwater," and Fort Myers, Fla., is not doing very well either. But "if you take those out of the picture, our impairments are not very significant at all," Hovnanian points out.

But, the problem is that you cannot take those markets out of the picture because they represent important contributions to K. Hovnanian's overall volume and profitability plans. Florida, especially the Gulf Coast, was hit hard by investors fleeing the state. Minneapolis, where the company was testing the waters, was in the same straits as most of the country in mid-2006. California represents almost 14 percent of the company's business; Florida, nearly 8 percent; and Minneapolis, 4.5 percent, according to Wachovia's October 2006 report, "The Lay of the New Home Land."

Meanwhile, Florida-based land developer Jim Kraft says big builders are pulling back from buying any land. "Huge deals are just sitting on the fence right now. Anyone who is trying to sell land at 2006 prices is finding that we are reverting back to 2003. That is more of a reality in terms of the market if people are interested in purchasing at all," he says.

Hovnanian and CFO Larry Sorsby were expected to lead a senior management team of division presidents and land acquisition specialists in reassessing its land holdings to solidify its write-off plans by the end of the fourth quarter, according to O'Keefe.

But home builders may not be out of the woods just yet. There could be serious consequences to this land dance, warns Robert Curran of Fitch Ratings. If home builders are forced to take more extensive write-downs of existing inventory, it could trigger Wall Street's attention and lead to violations of covenants with a company's bondholders. And that would cause the Street to sit up and pay attention, Curran says.

"If we come to a point where there has to be more extensive write-downs of existing inventory, that becomes a much bigger issue," Curran says.

–Judi Hasson

Learn more about markets featured in this article: Los Angeles, CA.