Without question, the home building business is working through a serious downturn. National home builders are in retrenchment mode in almost all markets. Most regional builders are similarly afflicted, with a few exceptions for those in areas where business continues to be strong. Many leaders are bracing for worsening conditions. While there's no real consensus for how long it will be before we see the bottom, estimates range from six to 24 months before things start to turn around—and that's assuming there's not a more widespread economic downturn. On the other hand, despite the storm clouds looming overhead, some see silver linings: opportunities to exploit falling land prices, streamline operations, and build teams.

There is clear agreement on a single point: national or regional, public or private, the builders that survive this cycle will be those that are well-managed and maintain their access to capital.

DOES SIZE MATTER ANYMORE? During the last downturn in the early 1990s, regional builders lost market share to big builders simply because the bigger builders were better capitalized. This time around, it's not entirely clear that history will repeat itself. While the big public builders typically enjoy benefits of scale—including geographical diversification and, in some cases, access to lower cost capital–they also face a host of other challenges that regional home builders do not. One of the most notable is the pressure from Wall Street to adapt a business model that delivers earnings in line with expectations. “The big builders are reducing their margins with the hope of moving inventory,” says Eric Belsky, executive director of the Joint Center for Housing Studies at Harvard University. “The regional builders may not feel the same earnings pressure as the big public home builders. They can do what they think is right from a financial perspective. On other hand, because the private regionals are less diversified geographically, they may be under at least as great financial pressure to sell into a down market.”

One CEO of a regional builder has particular concerns about the effect that big builders are having on the industry as a whole. “Some of these builders are simply reacting and trying to maintain their velocity selling homes, discounting deeply as well as turning land positions into cash,” he says. “They're anything but disciplined. And in attempting to maintain their torrid pace, they're hurting all home builders. It's better to build less and try to hold prices and maintain margins.” While he doesn't feel that regional builders are generally at a greater disadvantage than national builders, he says that one key exception will be when regional builders are competing with a national builder that's seriously undercutting prices to move inventory. “If they are, they have to do this through predatory pricing, thereby reducing their margins and that could be the kiss of death” for smaller builders that aren't as well-capitalized.

CAPITAL REWARDS Many executives question whether size is an advantage in today's environment. “I don't think you can take the same brush across the entire canvas and say that the regional players are more or less competitive,” remarks one CEO. From his perspective, a lot depends on how a regional builder is capitalized. “If capital remains robust, then being public will not be a huge advantage,” he says. “However, if a company's capital structure is not strong, and it's largely illiquid, it's tough to compete. Too much leverage is a problem.”

The robust availability of capital is one factor that has evened the playing field between the nationals and regionals. Regional builders can still get bank financing, even if it's offered on a project basis. If that dries up, regional builders could be at a real disadvantage. Clearly, access to the public capital markets is a double-edged sword—while private home builders don't have to worry about meeting Wall Street analysts' expectations, they could find themselves in trouble if the private debt markets tighten.

Executives across the industry seem to be almost universally worried about things far beyond their control. When asked “What keeps you awake at night?” the overwhelming response is concern about the overall economy, specifically that the recession in home building could spur a national recession, which would hurt the industry even more. Some mention higher oil prices, wars in the Middle East, and fears of terrorism. One CEO explains, “This is the first recession that we've experienced that's not interest-rate driven. My biggest concern is that this will trigger a larger consumer confidence issue, which could drive the country into a deeper recession. Then all bets are off, because no one knows how deep or long something like that lasts.”

While some are more pessimistic than others, everyone is feeling the pain right now. Their comments range from “We're down 16 percent relative to new contracts” and “My guess is we'll be down at least 15 percent to 25 percent before this is all over” to “We'll probably downsize by 30 percent by the first quarter of 2007 if things don't improve” and “Our cancellation rates are ballooning from 20 percent to 60 percent” and “The analysts are overly optimistic; my guess is that earnings will be off 60 percent to 70 percent next year.” And while nobody is painting a rosy picture of the near term, nobody's panicking either. Talking with executives, you get a clear sense that there's a shift towards stabilizing their businesses.

THE BEST OPPORTUNITIES While leaders of the home building industry have serious concerns about the health of the business and the overall economy, it is not all gloom and doom. Certainly, there are select opportunities that the best-run companies can capitalize on in the current slowdown—you just have to know where to look and be cautious about how you execute. When asked what they consider to be their best opportunity in the current environment, many say that it's hard to know precisely where these opportunities are. As one succinctly puts it, “Today, everyone has to be a long-term thinker because there's just nothing we can do about earnings in the near term. It's like trying to push a noodle up a wall.”

Many feel that right now, there are no great growth opportunities. However, there seem to be select opportunities to buy land at better prices, as both public and private builders are forced to sell their land inventory at discounts or walk away from their deposits. Despite falling prices, builders need to be smart and selective to avoid ending up with unwanted land inventory on their balance sheets, cautions Eric Price, president and COO of John Wieland Homes. “You have to be patient and focus on the land parcels that provide economic opportunity.” Price believes that the slowdown will give home builders a chance to focus inward and examine what's been working well—and what needs fixing. “The next 12 to 18 months should provide a chance for builders to take a breath and re-evaluate,” he says. “They'll tighten up their systems and procedures and improve efficiencies.”