As land parcels become larger, take longer to negotiate through entitlements, and are continuously more expensive, a common question persists: Is it advantageous to be long on land?
Over the past several years, a majority of the public home builders have accelerated land positions beyond what was typical in the mid-1990s. Prior to the acceleration, builders did not exceed a three- or four-year supply of land controlled (owned and optioned). In 1995, the median duration of land holdings for the builders I cover was roughly 3.5 years (45 percent optioned); today, however, the builders control a median of seven years (60 percent optioned). In short, public builders no longer seem to be concerned with controlling too much land. Among the leading public companies, only MDC Holdings has maintained a disciplined long-term approach on its land positions, controlling a smaller position today (approximately three years) than it did 10 years ago.
Let's consider the reasons for this trend. First, among those who adopt a bullish view, the willingness to invest more heavily in land owes in large part to the assumption that the scarcity of land prevents any risk of declining value. Second, for large builders to successfully continue their double-digit growth rates, they're going to have to steal market share. Controlling the land should ultimately control the market. And third, the ability to secure land via option contracts locks up lots across the country, and at the same time mitigates the capital devoted to the investment. In theory, options allow the “ownership” of land to increase, even as the amount of money required to acquire the land decreases.
For those of us who are more cautionary, two big risks offset these assumptions. First, these convictions argue for a longer-term outlook. In the near-term (one to three years), land values will naturally soften if demand for new homes slows. The problem for home builders is that a decline in land values not only affects the holdings of builders' current investments, but it trails any flattening or decline in home prices. Land prices lag in adjusting downward to reflect a weaker housing environment. When they finally do adjust, it takes several years to ultimately work their way through the income statement.
Second, despite the shift of optioned land to about 60 percent of total land supplies from 45 percent in 1995, a majority of public home builders are still free-cash-flow negative due to the vast run-up of the land that they are buying outright. Return on capital should always validate an investment strategy, but when it comes to land, it seldom does. The primary question should be: Will future returns justify the amount of capital invested today?
What will differentiate builders in a more challenging housing market is the quality of the land purchased during the past three years, as well as a company's ability to alter its investment strategy. As buyers become less abundant and supply begins to outweigh demand, fringe investments are likely to fare far worse.
As with any land purchase, absorption rates (homes sold per period) are a key assumption to research when evaluating a parcel. While builders do not imbed home price appreciation in their pro forma analyses, the level of absorption does serve as a good proxy for the amount of maneuverability a builder has. If velocity declines from one's original assumptions used to purchase the parcel, future sales, margins, and return on capital naturally come under pressure. It won't be until the country experiences a market slowdown that builders will be punished for bad land purchases. Those who buy prudently are more apt to sustain a competitive performance trend.
SOURCE: 2005 ANALYSIS OF 13 PUBLIC BUILDER LAND HOLDINGS BY CREDIT SUISSE FIRST BOSTON