As the downturn unfolds, you might wonder how and why public builders amassed a record-setting seven years' supply of land and over 2 million home lots in various stages of the entitlement and development process. The answer is cash. They plowed about 40 percent of their revenue back into land purchases, doubling their land pipeline in the past three years. Today, we expect land positions to be maintained, but not increased, until demand starts to accelerate. Already, several of the builders are walking away from land positions that do not meet their threshold internal rate of return.

LIMITING LAND SPEND Centex, K. Hovnanian, and Technical Olympic announced they had walked away from option deposits in select markets. Based on current prices and absorption rates, building on these lots would not have met targeted return hurdles. Option deposits average 5 percent of the total value of the underlying dirt and tie up larger land positions. We estimate that Centex forfeited the option to buy down some $400 million in land.

Until now, the reason a builder would reluctantly forfeit on an option deposit was most often that the landowner failed to secure permits. What's more, land sellers got higher prices when they took options rather than cash up front, building the risk of a possible no takedown into the price. As demand softens, sellers and developers are likely to try to re-negotiate price and take-down terms with the builder who has placed the original deposit. It's unlikely that another builder will take the lots given the decline in demand.

CASH IS KING In our view, these decisions underscore the financial discipline and constraint being exercised by the leading builders. Limiting land investment should prevent a significant supply glut from unfolding, once speculative inventory has been absorbed. It should also lead to positive free cash flow generation.

Until 2006, some 87 percent of available cash was being used to fuel land investments annually, with the balance split unevenly among share repurchasing, acquisitions, capital expenditures, and dividends. In 2005, the average free cash flow, as a percentage of market capitalization, stood at -2 percent. Exceptions were NVR, which options 100 percent of its lot position, compared with the 63 percent group average, driving a positive free cash flow yield of 9 percent, and Meritage, which options 90 percent of its land, with a resulting 3 percent free cash flow yield. We expect free cash flow yields for the group to turn positive by the end of 2006.

LONG-TERM BENEFIT Double-digit home price appreciation over the last two years, combined with increasingly lengthy entitlement periods, drove land values to new highs in 2005. Although the pricing power benefited operating margins, the downside of this trend is that asset turns have slowed, and builders incur higher costs because of the longer carrying times.

Given record lot positions, slowing demand, and lengthening entitlement periods, land prices have started to soften as demand has declined. By postponing land purchases until demand has bottomed out, the big builders will gain leverage over land sellers.

In 2006, we estimate that the combined net income of the top builders we cover will be $12 billion. As less capital competes for dirt, the rate of land appreciation has slowed, and sellers are more flexible in negotiating terms, so options are less expensive, with lower deposits and fewer demands for profit sharing. This will lift profit margins and returns, once demand re-accelerates.

Margaret Whelan is an analyst with UBS Investment Bank.