Everybody knows the real estate market is cyclical. The caution is printed on every public home builder’s annual report to investors. What nobody knew is that the circle could be so big that you couldn’t see the curve ahead and, no matter what direction you headed, it looked like it would go on forever.
In the end, it took six years for the new-home construction market to plunge from that sweet moment in mid-2005 when it defied gravity, pausing for a millisecond between rocketing upward and hurtling, screaming, to the ground in 2011.
Last year—finally—the market started to climb back. It was a relief for BUILDER to put our red ink pen into semi-retirement. For six out of the past eight years that we’ve analyzed the annual results of publicly held new-home builders, our grading charts have been overwhelmingly red as the group bled billions in losses, and the ranks shrunk from 21 to 13.
In 2012, only three of the 13 builders on our list lost money, and there were more A’s and fewer D’s. While the rising tide of an improving market does, indeed, lift all boats, those that are leaky still founder without repairs. Such is the case for Hovnanian Enterprises, which hasn’t made a profit since 2005, and for Beazer Homes USA and KB Home, which have been in the red since 2007. KB Home earned our lowest score this year, sliding from a B- in 2006 to a D in 2012.
There were companies that did more than survive the downturn; they thrived by doing more with less and creating product people want in places where they want to live. The Ryland Group climbed from No. 8 to No. 2 on our list, and Standard Pacific Homes moved up from No. 6 to No. 3. Ryland moved into better markets, which cost it losses in previous years but provided gains in 2012. And Standard Pacific aggressively bought well-positioned land at rock-bottom prices during the recession and then created new-home plans that are selling well.
A Word on Grading
While grading the public builders’ performance involves reviewing all their metrics, BUILDER filters the numbers because the 13 companies vary in size, operate in different markets, and employ diverse business plans.
When grading the financial results we looked at last year’s performance on key metrics and made judgments on how well the builders should have performed given the rising market, as well as how they are positioned to profit from the market’s recent upswing. Some other grading criteria:
—Since most home builders made a profit last year, those that didn’t lost points based on how far off they were from breaking even.
—We expected gross margin improvement and increased revenue per community because the group should have sold more homes with essentially the same infrastructure as the year before.
—We compared percentage improvements in closings to rank the builders in that category.
—We favored those that increased community count even as they sold more homes.
—We looked for healthy backlogs of home sales and compared and ranked builders based on their percentage increases.
—We expected higher debt levels because most builders needed to invest in their businesses to prepare for the recovery, including tying up land.
A Superior Model
In 2005, the big national builder model, financed with other people’s money—namely publicly traded stock and bond debt—was proclaimed superior. The thought was that the Wall Street–traded firms had greater access to cheaper capital for growth and, because they were giants, they had the potential for the Wal-Mart effect; that is, being big enough to buy goods and services for less than their smaller competitors.
The long housing depression put the public builder model through a crucible that proved being big is good, but being a builder funded by publicly held stock and bond debt is even better. Some that fell off the original list of 21 through bankruptcy have reconstituted as private builders, some with plans to go public again.
In the depths of the recession the publicly held builders wrote off billions in losses on land they bought at the peak that was worth nearly nothing in the trough, but they benefited from large tax benefits because of the losses. Despite suffering big losses during those years, many of these builders kept their doors open. On the other hand, private builders in similar circumstances lost their businesses to creditors.
And even as their ranks shrunk, the public builder share of the new-home market grew from 23 percent of deliveries in 2005 to 28 percent in 2012, according to Metrostudy. In total, the largest 100 builders were responsible for 50 percent of all new-home closings in 2011.
Prescience to a Point
When we began assembling the 2006 record-breaking statistics for public builders, the writing was on the wall.
“I’ve said for the last five years that I didn’t think the next year was going to be as good,” D.R. Horton’s CEO Don Tomnitz said at the time. “I was wrong for five years. Unfortunately, this year I’m going to be right.”
But even Tomnitz most likely had no idea that the plunge would last six years. He was predicting that D.R. Horton would build 100,000 homes in 2010, but it closed just 18,983 homes that year.
There was no soft landing as everyone hoped, and the number of homes delivered by the 13 public builders fell by an average of 60 percent from 2005 to 2012.
Despite their advantages, the housing depression proved that the 21 publicly held builders had two weaknesses that could kill or cripple them: excessive debt and too much land in a declining market. It was too much debt that took the publics off our list.
Dominion Homes, with a 110 percent debt-to-equity ratio, died fast. Levitt and Sons did, too. Technical Olympic USA went through a costly bankruptcy that drained the company of so much cash that it ended up folding, its assets auctioned off to the highest bidders.
Meanwhile, WCI Communities filed for a structured bankruptcy reorganization; its debt was bought and the company reconstituted by private equity.
William Lyon Homes, with a debt-to-equity ratio of 124 percent in 2005, held on for years, receiving cash infusions from private equity firms. It then entered a pre-structured bankruptcy from which it emerged with private equity firms holding some of the reins.
Two companies held on despite enormous adversity. Beazer Homes endured tornadic activity when a federal investigation found it guilty of illegal accounting processes, and Hovnanian remains in business even though it had a debt-to-capital ratio of 144.5 percent in 2012.
For the most part, the large public builders haven’t mustered the major national materials buying power they had hoped, and few have developed strong brand recognition. Real estate is a local business, and a national builder must divine local desires and needs to be successful.
Land Poor, Land Rich
Large home builders have love-hate relationships with land. They need it in volume to build homes in volume. Also, because materials, labor, and other component costs are essentially the same for all builders in any market, land purchased at a low price can create an outsized profit when the home is built and sold.
Bagley calls land holdings the differentiator between home builders. “Nobody really has a different technique on how to build a lower-cost home,” he says. “You don’t have better people, you think you do, but you don’t. And your house plans are easily replicable. There really is no differentiation other than the land.”
But land is an illiquid investment. If a builder stocks up and the market tanks, it’s stuck with property that is worth less than the purchase price—and with holding costs and maybe debt costs. The builder might not make a profit from it in years, if at all.
During the decline many public builders wrote land values down, sold it at a loss, or gave it back to the sellers—whatever they needed to do to get it off their books. For big builders that meant a line item on their financial reports. For the smaller companies it often meant losing their shirts.
Sticking to a “land light” strategy of buying land when needed (or not much before that) helped NVR be the only builder on our report card make a profit every year during the downturn. Now, with land prices rising, NVR’s just-in-time buying strategy is likely to stifle its profits, while builders that bought land at rock-bottom prices will be rewarded with greater profit margins when homes are built and closed.
The downside of land speculation kept David Weekley Homes out of the long-term land market. Weekley, which tidily survived the recession, also buys land when it needs it, not before. The retail price Weekley pays suppresses profits, but also risk.
With the market climbing, demand is boosting prices for well-located land, raising the question whether home builders are paying too much in some markets and increasing the possibility that profits will shrink.
“There are clearly builders that will do better than us, who took land risks in the downturn,” says CEO David Weekley. “We are more steady Eddie. We won’t get richer fast, but we won’t get poorer fast, either.”