South of Phoenix along Route 84, the city of Casa Grande, with a population of about 45,000, was clearly poised for growth. There were four master planned communities in the city's pipeline, among them a project called The Legends, a community with 7,000 contiguous acres that would eventually include 23,050 residential units, 450 acres of commercial development, and more than 10 new schools. The project would single-handedly more than double the city's population, albeit over an estimated 40-year build-out.
The Legends, at least as envisioned by developer D.R. Horton's Continental division, is now just that–a legend, having fallen victim to the housing recession. In mid-November, D.R. Horton sold the entitled land in Casa Grande to a joint venture real estate investment entity formed by Scottsdale-based The Wolff Co. and Gilbert-based Langley Properties for $70 million. People with knowledge of the local market say it could be the largest land sale ever sealed by a public builder in the Phoenix metro area.
Horton, like its peers in the public builder sector, is shedding land in an effort to clean up its balance sheet amid the worst new-housing market in decades.
In 2006, 43,657 permits were issued in the Phoenix market, and Horton, the nation's largest builder, boasted 5,607 sales and a 13 percent market share. Pulte, the market's second largest builder with 4,581 sales, lagged by a full 2 percentage points.
Throughout 2007, inventory clearly became the enemy of public home builders. More than 1,300 projects were active in Phoenix alone. "The total of all the lots available in all those projects [including lots in unreleased phases] is approximately 107,255," says John Fioramonti, senior managing director at Meyers Builder Advisors. "That translates to 80,000-plus lots in active communities of the national builders."
In June of this year, Horton's Southwest division still carried 45,000 owned lots on its books. Then, already suffocating under the heavy blanket of available inventory, the subprime mortgage crash hit. In late summer, Phoenix became a virtual "no-bid" market–meaning a continued effort to drop prices and load on incentives was still not effective in stirring demand in many of the market's communities.
In the months since, the pressure has intensified for public builders to shed excess property in an under-performing environment. That has led to a flurry of recent land deals across the Phoenix metro.
In terms of sheer dollars, Horton's sale may seem relatively insignificant. Yet, with the sale of its nine square miles in Pinal County where Casa Grande is located, Horton has effectively cut its position in the region by more than 50 percent.
That doesn't seem to concern Casa Grande city manager Jim Thompson. "We have a history with Horton here in the area," he says. "They are active in five other projects. When the market comes back, the developers will open the project up to multiple builders, so we'll get more diversity that way."
Still, Thompson is assuming that the market will return to where it was. Historically, builders have been able to make a lot of money in the land business; therefore, liquid companies maintained an upper hand due to their ability to go out and gobble it up. But today's environs underscore the dubious task (not to mention expense) of being saddled with the burden of controlling land early in the process. Shepherding the right parcel through the process and delivering the right site, at the right time, in the right neighborhood, has become far more difficult.
The theory is that, to survive this downturn, builders will need to scale back geographically, redefine their regions, tighten up operations, and allow land prices to trough and competition to ease. The tactical question remains as to where and when demand for land and lot positions will come back. And once demand does re-enter the picture, what are the strategies that will enable builders to capitalize on the opportunities?
The word "core" is bandied about during investor calls, industry conference sessions, and even internal home builder meetings. It's the term du jour used to describe everything from operating strategy to skeletal human capital structures.
"In hyper-competitive situations, organizations rationalize strategies by focusing on core markets and products; home builders do the same thing," says Steve Benson, executive vice president of Acacia Capital Corp.'s housing division. "There is no distinct difference between home building and other industries."
What exactly makes a market "core" for one builder and not another? While many builders cite potency in the Carolina Triad, Centex made the decision to abandon the marketplace. And being deeply entrenched in a top MSA with long-term demographic and economic strength wasn't enough to keep Horton from selling the entitled Legends that would support its footprint.
At first blush, some would say a determination of what's core is dependent upon market indicators–those factors within the country's MSAs that provide a foundation for growth. Investment metrics are certainly another key consideration. And while competency within a market is a more elusive metric, its measurement is key to evaluating and comparing the viability of individual divisions.
The first test for core market consideration includes the basics: Does the MSA exhibit positive job growth, favorable demographic trends, and availability of land that support the relationship of supply and demand?
Using this test, national builders look at both their short- and long-term inventory in the context of current and projected market demand to evaluate whether or not they have enough land/lot inventory to ride out the next few years.
Each company applies its own threshold for tolerance as it relates to market share as a percentage of total permits. Sustainability can typically be justified if a company can garner anywhere from a 7?10 percent share of total permits. Though there is no uniform standard for viable market share, the calculation eventually boils down to raw numbers. For example, competitive sources say that Centex, for one, won't support divisions that aren't likely to produce fewer than 800 units per year. For Ryland, the threshold is said to be 500.
Land holdings, sales price, affordability, and compressing margins are all part of the ever-shifting financial metrics as builders continue to evaluate core markets.
According to research by JMP Securities, total impairments taken by public builders since January 2006 have exceeded $15 billion. JMP recently raised impairment charge forecasts, increasing the projected amount of total "at risk" inventory from 20 percent to 25 percent.
The question remains as to how much more land is to be impaired.
"The big struggle in the industry today is how to set all the assumptions going into these," Benson says. "That's why you can have one quarter go by and, under a certain set of assumptions, believe [that] you don't have any impairments. But over a 90-day period of time, we have seen that the market erodes so quickly. All of a sudden, the assumptions that you are going to use to do your next impairment calculation are going to be radically different, and that could result in a significant impairment."
Only after competing an impairment analysis can builders apply strategic tactics at the community level–and visibility remains murky as to the decision to offload, mothball, or take the impairment pain.
According to Benson, the best strategy to employ in individual submarkets is determined in large part by an intuitive process he calls the peak-to-trough-to- peak analysis. "When looking at market cycles that move from peak to trough to peak, builders attempt to determine (either intuitively or, for some, empirically) for any given market where we are in the peak-to-trough phase of the cycle," Benson says. "If the builder can get a grip on where they are in the curve, the next question is: 'How long, and at what speed, will it take to get to the trough, and what is the acceleration rate of the market as it goes from the trough to the next peak?' The assessment as to whether to continue to build in a project, not build for a period of time, or mothball the project–it's all in the builder's perception of what those market conditions will be."
Aside from assessing the market's strength and doing the due diligence on financial metrics, each company must evaluate its organization's ability to design and execute a strategy within the various disciplines that make up a production home builder.
"When we look at issues in the industry, we separate home building into three distinct core competencies: land and asset management, construction management, and sales," says UBS analyst David Goldberg. "If you are going to be really good at manufacturing, focus on manufacturing. If your strength is in land procurement and bringing assets through the process [and] less focused on turning capital, do that. But to combine both is very difficult."
For Centex, that means dramatic change as the company shifts its real estate business model to become more exclusively a manufacturer and marketer. The justification? As the company buys land further into the process, eventually it will become more of an input cost, like lumber–just one of many raw materials needed to build homes.
Some industry veterans and experts speculate that, after the downturn, many builders will no longer engage in land development. On the upside, builders that don't take on land development minimize their risk. But as market conditions improve and land developers are once again expected to bear the brunt of the shifting risk, they'll expect to be duly compensated. Builders will then be forced to decide whether they are willing to hand over that premium or go back into the land development game.
In some markets, builders are opportunistically buying finished lots for great prices as other builders become more willing to take haircuts to generate cash. In Phoenix, for example, local industry sources who would not speak for attribution report that finished lots in several well-located Engle communities have sold for as little as $35,000 each.
For some builders, the land-as-input-cost model has been the strategy all along. Today, the NVR model that was criticized as conservative during the upswing is widely lauded. At Meritage, the strategy has been to secure land positions using options and keep land off the balance sheet. However, since it effectively borrowed the options from land banks, the company paid a price–which equates to a 2?3 percent cost to its gross and net margins–because it had to pay interest to land banks on the borrowed options. Today, that strategy is showing some savings over owning the land or options outright.
"We are seeing land banks reduce pricing when we do go back to renegotiate," says Meritage vice president of investor relations Matt Moyer. "In some cases, we are not giving them any yield, and they are actually losing money. ? That strategy has been saving us money."
Perhaps the most important evaluation a production builder must perform, however, is competence within markets. "When I hear a builder say they are going to focus on their core markets, I think what they are communicating is, 'Where do I have people and resources that really understand the market and have a demonstrated capability to profitably rationalize changing market conditions?'" Benson notes.
It is that question that has led analysts, both on Wall Street and in home building, to predict that the companies that now have nearly national footprints will scale back to more regional operations, focusing on markets where their competency evaluation turns up strongest.
Meritage CEO Steven J. Hilton recently touched on this notion as it relates to land strategy during a home building conference held by UBS in New York: "We think some of the best opportunities for us to average our costs down and to create new lots for us going forward are in the deals that we are already doing business in. Some of the options we terminated are going to be the best opportunities for us to go back and buy these lots at a more favorable market price than we were paying previously."
The questions that must be answered as builders set future land strategy extend well beyond location. Not all will arrive at the same–or even similar–strategies.
"Behind the scenes, many of the builders have some very experienced folks and knowledgeable strategists working on those questions," Benson says. "Those are the builders that are likely to do best as we hit the trough and start coming out of this."
Learn more about markets featured in this article: Phoenix, AZ.