- Penciling Probability [Download PDF]
Gary Dumas, a regional general manager at southwest Florida master planned community developer Bonita Bay Group, recently asked me, "Why did builders become land developers?" Clearly, it was a desire to vertically integrate their supply chain in order to capture larger profits from each new-home sale. Larger profits translate into more earnings per share. That increases stock prices, resulting in greater shareholder value.
Over the last seven years, builders strayed from their low-risk manufacturing model. They flaunted risk and juiced their returns. But risks baked into this hybrid model differ enormously from the manufacturing business of home building. The failure was in properly adjusting for risk. In classic investing, greater risk–i.e. from speculative land development–requires greater returns.
Builders' pro forma analyses typically don't distinguish home building profits from land development profits. Not factoring in returns appropriately adjusted for risk is where the trouble lies. Builders create a pro forma analysis by subtracting the cost to purchase, entitle, and develop lots and the cost to construct and market homes from the revenues of homes sold. Hurdle rates emerge from calculating a gross margin, a pre-tax profit margin, and an internal rate of return. If the analysis indicates the thresholds will be met or exceeded, the investment is approved without accounting for the investment's associated risk.
To account for land risk, builders must realize there is a cost-of-equity tied to risk. Also, they should separate home building from land acquisition and development and price equity based on the weighted risks of each. Public builders added land risk, but then assumed their P/E ratio would remain constant.
The Capital Asset Pricing Model (CAPM), a mainstay of modern finance, accounts for both market (systemic) and firm-specific risk. Yet very few undertake CAPM analysis, as it looks more complex than it really is. If a builder chooses not to use CAPM, at least the cost of equity should be priced into the financial analysis, just like debt. The price of equity should be consistent with the returns investors require for investments that carry similar risk.
To calculate the cost of a firm's equity, start with the inverse of the P/E ratio for mature (not actively growing) firms. If a company's P/E ratio is 7 to 1, investors are willing to pay seven times each dollar of after-tax profit, or they require a 14.3 percent after-tax return. If one's combined federal and state tax rate is 45 percent, the cost of equity pre-tax for your firm is 26.0 percent–1 divided by 7, divided by (1 minus the tax rate).
Privately-held builders don't have P/E ratios, so they need to find comparable public firms whose assets carry similar risk and leverage. For a number of reasons, one of which is a liquidity discount, private firms are typically valued at a 30 percent discount to public companies. The cost of capital for privately-held firms must be adjusted accordingly.
Probability theory, which takes the weighted average of a number of outcomes to arrive at an adjusted equity investment, needs to come into play. Builders should pencil out scenarios, apply a probability, and calculate the equity at risk. Total equity at risk includes the value of cash invested and the value of any guarantees.
Risk will forever link to reward.
–Jamie M. Pirrello is the CEO of Vision Homes USA, a Fort Myers, Fla.-based home building company, and the CFO of Michael Sivage Homes and Communities. He may be reached at firstname.lastname@example.org.