LOW INTEREST RATES ARE FUELING more than record sales for the home building industry of late. Home builders issued a record dollar amount of unsecured debt in the public capital markets in the last year, according to Jim Fielding, associate director of the Real Estate Companies Group at Standard & Poor's. Fitch Ratings, another credit rating agency, reports that no less than six big builders instituted or expanded credit lines with commercial banks in sizeable amounts in April through June of this year.
The volume of public debt issuance has gradually increased in the past five years, according to Fielding's associate, Lisa Sarajian. Bob Curran, senior director at Fitch Ratings, concurs, noting that the level of activity in the past three years has been “pretty heavy.” Curran says he expects some of the same companies to return to the bond market for more in the next two or three years as they step up their growth.
Rising Reserves Lining up relatively inexpensive capital, of course, makes sense. But with the surge in profits most builders are reporting in recent quarters, builders' cash reserves are piling up fast. The companies are building large cash balances and liquidity both from capital infusions and because, in part, “they are having difficulty reinvesting capital after selling inventory,” Fielding says. Moreover, they have unused credit capacity as they have not fully tapped their upsized bank revolving credit facilities, Sarajian says. In S&P's view, the builders have taken down more credit than they currently need to refinance debt or increase inventory, citing Pulte Homes as one example.
Joe Snider, home building analyst at Moody's Investors Service, another credit rating agency, holds a different view. “Why pay 5 [percent] or 6 percent interest on 10-year notes just to leave the cash sitting around where it can only earn less than 1 percent?,” he asks.
Moreover, Snider says he believes that the “burst of activity” in revolving credit lines stems from larger seasonal spikes in the need for working capital. Untapped credit capacity might be used opportunistically for mergers or land acquisitions, but this is not the same as “stockpiling” capital with ulterior motives, he says.
Curran disagrees, arguing that revolvers are tied to floating rates (LIBOR plus a premium) and are therefore volatile. Builders prefer to lock in attractive long-term rates in the public and private debt markets in advance of their needs so they can plan ahead, he says. He cites as an example Lennar Corp.'s purchase of $400 million worth of land with debt proceeds even though construction will not take place immediately. Lennar made the purchase in order to avoid escalator clauses in the option agreement that would have raised the price of the land 7 percent to 8 percent a year, Curran says. Knowing the cost of capital with certainty enables home builders to decide what price they want to pay for land that will be developed several years out, he says.
Rate Anticipation Several key drivers have been cited for the increased level of debt activity in the home building industry, foremost among them is the desire to refinance debt at lower interest rates and the prospect of rising rates. Less obvious, says S&P's Sarajian, however, is an “under-the-radar concern” that consolidation in the banking industry is reducing the number of commercial lenders willing to underwrite loans for home builders.
“Builders are reluctant to become over-reliant on any one source of capital,” she says. That may be true, but the problem most likely won't affect large volume builders who continue to find plenty of capital providers knocking on their doors.
The analysts also provide contrasting views as to whether having capital at the ready confers a competitive advantage. “A company that has a $1.2 billion revolving credit facility that is largely unused can talk turkey with a land seller,” Moody's Snider says. A firm that can produce cash on the barrelhead has the advantage in merger and land negotiations over smaller outfits that have yet to line up financing, he says. “It's gotten to the point that some small local builders are throwing in the towel” and selling out, he says.
Fielding, however, points out some downsides to having too much financial flexibility. Builders who leave debt proceeds sitting around are “sacrificing near-term returns,” he says. Moreover, companies with too much liquidity can more easily make mistakes and bad investments, he says.
Curran says that stockpiling low-cost capital is a “reasonable strategy” in a rising interest rate environment for companies that will continue to grow. “I don't expect the debt to be on their balance sheets 10 years from now,” he says. “They will find good uses for it much sooner, in the next two to four years,” he says. Moody's Snider says he is similarly unconcerned by the large volume of debt issuance. Long-term debt was 70 percent of capitalization in the industry in the early 1990s but only 50 percent now. Home builder debt has increased, but “balance sheets are still getting stronger because of retained earnings,” he says.
Sarajian says, “I have to give the industry credit for being in this position. Too much liquidity is something new and not too many industries have this luxury.” As builders have gotten bigger and raised their profile, the number of institutional investors willing to hold home builder debt has steadily increased, adds Fielding.
Institutions like the liquidity of the secondary market for home builder bonds, Sarajian says. They also like the fact that hard assets back up the notes, Fielding says. Another sign of a maturing home builder debt market, says Curran, is that issuances are now routinely unsecured, something not formerly the case. “This means that financial entities are looking at home builders as substantial companies with steady cash flow,” he says.