Big Builder senior editor Les Shaver kicked off "The New 'A' Locations" on Wednesday, Nov. 28 with a joke about overhearing a builder refer to "'land' as a four-letter word." However, the subjects tackled during this timely session were anything but a laughing matter.

"How did we wind up where we are, and where do we think we'll end up in the future?" asked Jeffrey M. Gault, CEO of LandCap Partners, a firm that provides capital for land transactions.

Peter Tremulis, principal of Sunesta Resort Communities, attributed housing's currently dire straights to the behavior of builders: "They didn't sell their homes–they built their plan. ... Production has run amok. If the production model is at fault ... [then] it's the bricks and sticks that have become worthless–not the lots."

Gault likened the current housing downturn to New England's 1989 "perfect storm," where two sets of storms coming from different directions off the Grand Bank collided, resulting in 100- to 150-foot waves and the deaths of a number of people. "No one saw it coming," Gault said. "My own view is that we're in the perfect storm now."

Some key figures identified by Gault:

  • Standing new-home inventory is up from 3.9 months in 2002 to 8.2 months in 2007.
  • Cancellations rates were up from 17% in 1Q2004 to 40% in 4Q2006.
  • Builder land supply has increased from 3 years in 2002 to 8 years in 2007. Of the top 10 builders, Pulte and Toll have hit a high of an 11-year supply, while KB Home sits at a 3-year supply, according to Gault.
  • Land impairments among the top 14 builders currently total $16 billion. Most of the analysts originally thought that this would be a one-time charge, Gault said. "No one is sure now if there's going to be a recharge," he added.
  • Gault attributed housing's "perfect storm" to the fact that no one anticipated a credit market meltdown and the resulting subprime woes. "The builder performance peaked in a pretty precipitous way," he said, adding that they did not become more productive or efficient.

"To some extent, the perfect storm was also created by the builders themselves [for increasing new-home sales prices and driving values up so high]," Gault said. But this was at a time when loan requirements only stipulated that borrowers could fog a mirror.
"The perfect storm will end when inflation gets more inline with the price of the house so the burden on the homeowner isn't so disproportionate," he said.

According to Gault, 60% to 70% of home sales price reduction falls straight to residual land value. He posited two choices for the builders in the room: either take impairments, defer tax losses, complete the project, and sell to the public at today's prices with no profit or potential losses (what he referred to semi-facetiously as "building for practice"), or else sell to a third party at current market prices and take advantage of new liquidity to partner with a new ownership structure and generate profits.

"What would make a new 'A' location work in the year 2007 or 2008?" Gault asked. His answer: strong economic trends (jobs & growth); good location (access & lifestyle); mature and healthy community structure (existing schools & services); home price that matches homebuyer income (conventional mortgages & underwriting); pricing comparable to existing resales with no premium for new construction; no post-closing long-term infrastructure costs; no affordability issues; no community bond payments by the homeowner; and no project dependence on speculative price increases in the future.

"I would argue that the 'A' locations are going to require a lot of stability from a structural standpoint," Gault said, adding that large landholdings may not fit into that picture right now.

Mike Straneva, director of transaction real estate for Ernst & Young, said that while he doesn't see a lot of pressure on large builders with respect to liquidity, what happens on the banking front in the coming months will determine if the pressure will be on for smaller, regional builders.

"You have to decide whether you're a builder or you're a developer, and if you're a builder, are you going to do the same things that you've done before, or are you going to try to change your model?" said The Atlantic Cos. CEO Ralph Grebow, who stated that, in the end, it doesn't matter if you decide to change the model, because the model will change, regardless: "You are going to be in the finished-lot business if you are a builder."

Noting the efficiency of the real estate market, Grebow added, "If you decided you wanted to build 100 houses, you're going to build them by buying them from a developer. Whether you're a public or a private, you're going to pay for the ability to do that. The developers are going to be a lot more concerned about whether or not you're going to walk. ... I think, many times, the developer's going to ask for a piece of the sales price; generally, I think it's going to be a different world."

Grebow also pointed to the necessity of builders reevaluating their relationships with banks. "It is a cyclical business; it will not change." As soon as the market turns a little, the banks distance themselves from the builders. Builders are going to have to come to grips also, in terms of pricing, with the understanding that the days of going to the bank and putting equity from one job into the next are over.

"You're going to have to partner up with–if you can–institutional capital. ... In the final analysis, you're going to overpay for money, put you're going to try and partner with someone who will stick with you longer than until the next downturn. You're going to be in it with some larger players to get more equity to lever down on the banks, so your loan-to-value is low enough that it's not the end of the world all the time. You make less money, there's consolidation, fewer builders, but they are in it for the long term."

"I think everybody is going to have to mark down their lots," Grebow said. "From our standpoint, we also have a fairly large fund, maybe it's a vulture fund, but we do believe that if we make an offer on a property and they don't want it, they'll be back. It's the hard, cold facts of today: Nobody's going to hold this stuff; everybody's going to move it. ... Cash is king, even if it's just a little."

However, said Gault, "All bets are off if we go into recession."