Cash Flow Case Study [Download PDF]

Home building's playing field isn't level. Private builders struggle at a distinct disadvantage, especially in a prolonged slump. Executives at these companies sense that the behavior of their public company brethren–even as they continue to suffer big losses–defies logic.

While their actions may seem illogical, privates have little choice but to understand the strategic and financial logic from a public builder's perspective. Like it or not, it may be the only chance private builders get to predict future public builder tactics and chisel out a way to compete.

In today's environment, both public and private home builders should focus on cash. Even as the publics recorded unprecedented losses for 1Q2008, the vast majority of them reported strong positive cash flow. Private builders are mystified. How can losing so much money generate so much cash?

Jamie M. Pirrello The strategy of public builders is to sell homes, moving them at very low margins and, in some cases, below cost. Privates realize selling homes at below cost for any period of time is a recipe for disaster. Are private builders smarter? Probably, but let's not open a can of worms! Let's just say the capital structure of public builders is different than that of most privates. The difference in capital structure allows public builders to pursue a strategy of improving their cash position even if they run in the red.

This is due in part to the fact that lenders don't require public builders to secure assets with mortgages. Many publics accessed long-term public debt when rates were low at favorable terms. Capital raised through public bonds acts as equity to senior lenders–commercial banks–since these bonds are "subordinate" to the majority of senior bank borrowing. With shareholders' equity and these bonds to protect their interests, senior lenders generally waive requirements that builders secure their inventory with mortgages.

Fair Play?

So most public builders' land and work-in-process inventories are not secured. Every time a public builder sells a home, it generates cash even if it's at or below cost. A public builder can generate cash by selling a home below cost as long as the cash received is greater than the cost to construct a home plus any sales and marketing expenses (see chart).

The key is cash flow. The public builder has no loan in place and, therefore, generates $48,000 of positive cash flow as a result of the net sales price less the construction costs and closing costs. This is a result of having owned and paid for the land and the absence of a bank loan.

While the public builder generates $48,000 by building and selling the house, the private builder loses $10,000 of cash to build and sell the same home. Private builders can't and won't pursue such a strategy. The private builder who has a loan in place has borrowed the full $120,000 for construction costs, has a loan on the finished lot at or near 100 percent as the development loan traditionally requires repayment above par, must pay the $8,000 of financing costs, and must pay closing costs of $12,000.

This is how the capital structure tilts the playing field in favor of public builders. For private builders to level the playing field, they must realize they can't compete head-to-head with public builders. Private builders must find alternative strategies to tilt the playing field back toward their favor. It's how they'll survive.

–Jamie M. Pirrello is CEO of Fort Myers, Fla.-based Vision Homes USA and CFO of Michael Sivage Homes and Communities, which builds in Texas and New Mexico. He may be reached at