Publicly traded home builders are shifting quickly into a defensive mode to shield their 2007 earnings from the damage of the current calendar year, as slow-motion absorptions and slipping home sale prices gnaw away at returns on the enormous land investments they've made in the past few years.

Home builders, as a whole, have grown fat and happy on land. Massive run ups in land values, and, therefore, profits, have fueled builders' craving for it, creating rapacious beasts from disciplined businesses. But the recent downturn has more than a few builders realizing that their plates have been too full for too long. As sales volume and prices continue to soften for new homes, builders are opting to “scrub,” or make adjustments to, their balance sheets, either in “write downs” and impairment charges for land they own or write offs of deposits on land optioned, to reflect the lower values of land they control.

Already most of the public builders have announced land-related charges to their balance sheets. At the close of the second quarter of 2006, 13 of the top public builders took an average of $21.8 million in charges, according to data from UBS Securities. The uptick in the value of the charges incurred was a reflection of builders coming to terms with the fact that their land was overvalued, their inventories too deep, and the bulk of their inventory concentrated in least profitable land.

And an even greater flurry of land-related balance sheet charges is likely to be around the corner, if Centex Corp.'s preliminary results for F2Q07 are any indication. The Dallas-based builder warned of a possible $125 million to $135 million in land-related charges, including both option abandonment fees and joint-venture-related land impairments. Taking the charges on the land before the year comes to a close will help builders both protect themselves against potential debt covenant violations and free up financial leverage as they move into 2007.

Underwritten and Overvalued

During the high-flying past few years, builders determined the amount they were willing to pay for a piece of land by adding up expected sales price, material and labor costs, absorption rates, and a desired rate of return. However, many builders were overly optimistic in their outlook and based their assumptions on short-term sales rates, which were at historical highs. As sales have slumped and for-sale inventories swelled, the profitability assumptions that many builders used to substantiate their land investments no longer hold water. Consequently, builders are recognizing many of their land purchases were overvalued.

Back up a few thousand feet for the bigger picture, and the implications are enormous. Just as builders' faith in the sustainability of the robust new-home market pushed them to overpay for land, it also persuaded them to stretch their land supplies past the standard three to five years. Credit Suisse research shows that in 2005, builders' land supplies neared seven years, on average. And as the downturn protracts, slower absorptions will deepen inventories.

Although builders have attempted to mitigate the risks associated with owning a lot of land on their balance sheets through the use of options and joint ventures, the age of the land under their control reveals an additional vulnerability. The bulk of the land that builders currently control was secured since 2003, which marks the beginning of a most substantial escalation in land values.

“Younger” land, which was more recently negotiated, has less embedded profitability and therefore is more susceptible to write downs. Credit Suisse estimates that for the 13 public builders it covers, 74 percent of the lots owned were negotiated between 2003 and 2005 while 88 percent of the lots optioned were negotiated between 2004 and 2005. The sheer concentration of land secured within the past three years, no doubt at inflated prices, makes additional charges to their balance sheets appear imminent.