The recent downturn in the housing market is putting to the test builders' adeptness at calculating the long-term impact on their bottom lines from warranty claims. A recent analysis conducted by the newsletter Warranty Week, which looks at the warranty expenses of 30 public builders (including some that build manufactured housing) in 2006, shows that some builders play the odds a bit more aggressively than others.

The newsletter examines documents filed with the U.S. Securities and Exchange Commission and finds these companies reported a 14 percent increase in warranty claims last year to $946 million. During this time, their aggregate sales increased only 4.7 percent to $111.2 billion. Even though the dollar amount of claims had been rising for these companies over the past several years, 2006 was the first time in three years that the percentage growth of claims outpaced their sales percentage increases.

Among the industry's 10 largest builders, Pulte Homes' warranty claims rate—i.e., claims paid divided by sales made—was the highest, at 1.2 percent of sales, followed by Lennar (at 1.1 percent) and Beazer Homes (at 1 percent). On the other hand, M.D.C. Holdings saw its claims rate decline by more than 10 percent, the only company among those analyzed with a double-digit falloff.

Some builders, this survey finds, are more conservative than others about squirreling away funds to cover future anticipated claims. Pulte, for example, ended last year with a reserve fund of roughly $120 million, or about eight months' capacity; whereas Hovnanian Enterprises ended 2006 with a reserve fund of $93.5 million at a time when it was paying out claims at a rate of $6 million per month, meaning that its reserve capacity was 15.5 months.

ACTUARIAL ANOMALY: For the first time in three years, warranty claims in 2006 rose  at a faster rate than that of new-home sales, most likely due to the  market downturn.
ACTUARIAL ANOMALY: For the first time in three years, warranty claims in 2006 rose at a faster rate than that of new-home sales, most likely due to the market downturn.

“It's not so much science as it is art,” says Eric Arnum, Warranty Week's editor, who tells Builder that the newsletter's survey shows how seasonal fluctuations in builders' sales make calculating accrual rates extremely difficult. “If you put too much money into your warranty reserve, you're reducing your earnings and that becomes unproductive money. But if you're under-reserved and something goes wrong, that can be a magnificent hit to your earnings, and a serious embarrassment because you have to report it, Bloomberg finds out, and the conclusion your customers draw is that your product is breaking down faster than you can account for it.”

Jerry Belfiglio, vice president of risk management for Toll Brothers (whose warranty claims were 0.6 percent of sales last year), points out that Toll, like other builders, offers 10-year structural warranties on its homes. So its longer-term risks get more challenging to gauge when the number of homes it is selling year to year becomes less predictable, as is now the case. Clark Stewart, a vice president with Eastwood Homes in North Carolina, says his company has seen a “big spike” in warranty calls from customers because “we're more focused on it.” The company has been soliciting such calls from owners as part of its customer service efforts.

In a down market, some buyers don't need much prompting to complain about flaws in the homes they've purchased, observes Sandra Stewart, a partner with Los Angeles–based real estate law firm Cox, Castle, and Nicholson. The firm has been getting more calls from builders about “post-closing complaints,” which she says seem to translate to “a lot of second guessing about the product.” As the market recedes, buyers get nervous about anything that might decrease their property values—a nervousness which quickly manifests itself through calls to builders if anything goes wrong. Stewart also notes that, during down periods, builders tend to reduce the size of their customer service departments, which can heighten some owners' anxieties.

Learn more about markets featured in this article: Los Angeles, CA.