In Men Are From Mars, Women Are From Venus, John Gray reminds us of a simple fact that we're apt to forget: Men are different from women. The same is true among home building organizations: Public builders are different from private builders. And the use of inventory impairments and land write-offs is a perfect illustration of the distinction between the two.
Since Hovnanian Enterprises announced on Nov. 7, 2006, that the company would likely incur charges of $300 million for inventory impairment and lot-option deposit write-offs, large public builders have subsequently taken their turn in doing the same–impairment season seems to have arrived with a vengeance.
However, for a clearer perspective on the hundreds of millions of dollar losses public builders are taking in write-offs, remember that all home builders–public and private–must comply with generally accepted accounting principles (GAAP). Still, compliance with GAAP entails a range of outcomes depending on assumptions that come into play when penciling the value and absorption schedule of lots. Because there's an interpretive level to "correctly" doing the math, public builders may have an incentive to write off more rather than less.
Private builders, on the other hand, gain no benefit in writing off land. As a matter of fact, they may subject themselves to significant problems, and therefore have no incentive to aggressively take such charges.
Let's start with public builders. Amid the trough of a housing cycle, builders' valuations derive principally from their book value. Book value serves as a proxy for the current net market value of the assets owned. While investors would welcome disclosure by public builders concerning the net current market value of their assets, GAAP prohibits inclusion of the market appreciation of assets in a financial statement.
Investors, well aware of a big downturn in housing, have already downwardly pressured stock prices based on their convictions about the amount of exposure builders have to inventory impairments. So stock prices of public builders reflect a discount based on expected impairment charges.
Writing off lot-option deposits forfeits real money that can never be recovered. But writing down the value of inventory mostly works out to be a timing issue for publics.
If a builder bought a lot for $100,000, and its current market value is $75,000, GAAP requires the builder to reduce the value of the lot to its current market value now. The charge of $25,000 reduces the value of the lot on the balance sheet to $75,000. If the builder had not taken the impairment charge and sold the lot sometime in the future for the market value of $75,000, the company would have recorded a loss on the sale of $25,000; the amount of the loss is the same, it's only a matter of when one takes the loss.
If after taking the impairment charge, the builder sold the lot for $85,000, the company would actually record a profit on the sale as the lot's value in inventory had been reduced to $75,000. The original impairment charge taken of $25,000 would be offset by the profit of $10,000 resulting in a net loss of $15,000.
Why would public builders be tempted to be more excessive in their use of impairment charges? After all, as we've discussed, the impairment charge is priced into a public builder's stock price. So, taking the charge should have little, if any, impact on stock price.
However, if one does take a more aggressive approach and writes inventory down to the lowest possible level, it's more likely that the actual sales price will exceed the "new" inventory value. Ta da! The public builder then begins to report improving profits.
Margaret Whelan, an equity analyst at UBS covering home builders, calls this throwing in "the kitchen sink." In her 2007 Outlook analysis, dated Jan. 11, Whelanargues, "Although these charges have a negative impact on profitability in the near term, the land cost basis is being reset to current values, which we expect should help to drive margin expansion once demand re-accelerates."
Might this really happen? I've been told that one large national home builder with operations in California asked its local management to review its inventory position there. Local management submitted recommendations for impairment charges. The response from corporate was "that's not enough."
Now let's look at the plight of private builders faced with net price decreases and stalled absorption rates. If they elect to take impairment charges, the effect is reduced book equity, weakening ratios such as total liabilities-to-equity and debt-to-equity. These are typical covenants in borrowing facilities; any deterioration in these metrics can put builders at risk of debt covenant violations and default.
Second, if the collateral value supporting a credit facility is reduced as a result of an impairment, a builder may wind up with loans "out of balance." Builders may need immediately to contribute additional capital to bring the loan back into balance. Again, the consequence of a loan "out of balance" could put the builder into default.
Adding insult to injury is another scenario. Let's say there's a public builder, apt to take an aggressive action on impairment charges, competing head to head in a market area near a private builder that is reluctant to take impairments. By resetting the lot value lower, the public builder could accept a lower sales price and still report a profit at the time of sale. How would you like to be a private builder competing with a public builder who has already written down the value of the property right next to you by 15 percent to 25 percent? There should be a law against this. BB
–Jamie M. Pirrello is president and CEO of Vision Homes USA, a Fort Myers, Fla.–based home building company E-mail: firstname.lastname@example.org.