Home builders enter 2011 with great uncertainty, the result of conflicting data. Some data suggests improvement in 2011, while other forecasts suggest the next 12 months may be even tougher than 2010. Builders who bet on improvement—wrongly—will suffer; builders who bet wrong on conditions worsening will miss an opportunity.
Tolerance for risk is the critical decision variable in strategy development.
As we look to 2011, there's reason for encouragement. The Great Recession has ended. While growth hasn't been robust, GDP turned positive, we now have job growth, and interest rates remain near all-time lows. Word is that, between household growth and loss of housing stock due to obsolescence, demand for new housing stock will approach 13 million units over the next 10 years—1.3 million units annually. Many analysts forecast an increase of 20 percent or more in 2011 over 2010. Things seem to be looking up. Or not.
New-home sales in October fell to 283,000 units annually, continuing a downward spiral. Builders report big reductions in traffic. Potential home buyers are opting more and more to rent. Underwriting standards continue to toughen. Fear of soaring deficits, political turmoil, and recent talk of elimination of the mortgage interest tax deduction converge to scare potential home buyers.
Still, dwindling finished lot supplies have pushed lot prices higher in an environment where home builders have little pricing power with end consumers. Incentives are rising, along with continued high Realtor commission structures, all of which puts pressure on gross margins and profitability. Few public or private builders are making money. This erodes cash flows, the lifeblood of any business. Finally, lenders continue their restrictive lending practices, impacting private builders disproportionately.
So how does a builder, public or private, large or small, plan strategy for 2011? The sound method, given the uncertainty, would draw from each organization's tolerance for risk. Builders can only risk what they can afford to lose. Each builder has a company-unique risk profile. This profile is dependent on their existing markets, balance sheet, ability to access cash, existing backlog, and overall cost structure. Risk is not linear, it is asymmetric and disproportional.
Public builders are best positioned to take greater risks entering 2011. For the most part, they have significant cash positions with access to lower-cost public debt financing. They're better positioned to take risks in developing land, entering new communities, and building spec inventory. If the market improves in 2011, they will have positioned themselves to take advantage of the opportunity. If it remains anemic, they have the capital resources to weather the storm.
Private builders cannot take much risk in 2011. They lack cash and access to financing; and when they can access financing, it is at a higher cost, with more restrictive covenants, and requires a greater infusion of their limited cash. They need to earn a profit and be cash flow positive to access financing. Consequently, they'll have to cede the upside if 2011 proves to be better than 2010 in order to survive in case 2011 proves to be no better or even worse.
So, private builders should build a strategy and financial plans to ensure profitability in a market similar to or slightly worse than 2010. Public builders are in a position to take risk; if 2011 is better than 2010, they will gain market share and enjoy greater earnings, rewarding their shareholders.
The playing field will level in the future, but until it does, the sound approach for builders in developing strategy is to do so consistent with their tolerance for risk. Doing otherwise would be foolish.