In January 2002, Arthur Andersen released a highly publicized paper titled "The Impending Consolidation of the Homebuilding Industry." The paper concluded that, by 2011, the top 20 builders could account for more than three-fourths of new-home sales, and the largest company could deliver as much as one-fifth of the total. These certainly were provocative conclusions about an industry that traditionally had been highly fragmented and that had defied forecasts of consolidation in the past.

The NAHB has been conducting a major study of industry consolidation this year. We're concluding that the Arthur Andersen study goes much too far, and that there most likely will be plenty of room for smaller builders at the end of this decade.

Who's consolidating?

There's no question that mergers and acquisitions (M&A) have been gaining momentum in recent years and that a small number of companies have been gaining significant market share as a result. Indeed, between 1989 and 2002 the market share of the top 10 companies rose from 9 percent to 20 percent, with most of the increase recorded since 1997.

But there's been remarkably little change in the market shares of large companies below the top 10. In fact, the share accounted for by the next 50 increased by less than a percentage point over the 1989 2002 period, and the share of the 11 to 100 group has gone absolutely nowhere! It's clear that the M&A phenomenon so far involved combinations of large and very large companies (within the top 100), with little involvement of medium- and small-volume builders.

Why consolidate?

Companies that seek to merge or acquire other firms naturally are focusing on growth potential and future profitability. Large public companies can gain access to lower-cost financing, they can exercise market power to negotiate preferential pricing for building materials and components, they can take advantage of managerial and technical efficiencies, and they can establish valuable "branding" in the markets. M&A enable companies to put together inventories of the most precious of all inputs to the building process--zoned residential land.

The following conditions generally are considered absolutely necessary for a successful merger or acquisition: substantial land inventory (owned or optioned), availability of additional land in the market area, size of the market (minimum of 5,000 permits per year), and size of the target company (at least 250 units per year). Other important factors include the profitability of the target company, the position of the company in the market, and the quality of management and management systems in place.

The importance of land can readily be seen in the current land holdings of the 10 largest companies, where inventories are sufficient for five or more years of projected housing production. Large land holdings provide large companies with substantial competitive advantages over their smaller counterparts in markets where land-use constraints are tightening.

Whither small builders?

The market-driven incentives for large builders to get bigger and bigger are quite strong, and M&A activity certainly will continue and possibly accelerate; indeed, a mega-builder (producing more than 100,000 units per year) could emerge within a few years if further consolidation continues to be concentrated at the top.

But it seems smaller companies will thrive in hundreds of smaller markets for the foreseeable future, and many small- and medium-sized companies already are focusing on relatively safe market niches--including custom homes on owner's lots, teardowns/rebuilds, infill, and light commercial development.