FOR BUILDERS EVERYWHERE, a critical priority in today's business environment is land—acquisition, entitlement, and financing. In recent years, large public builders built enormous cash reserves that allow them to invest larger and longer in land. Longer land positions can, however, play a role in higher inventories. Those inventory levels can downwardly depress a public company's return-on-invested capital (ROIC), return-on-assets (ROA), and return-on-equity (ROE). At the same time, builders without overflowing cash war chests are forced to take on big chunks of debt to finance longer land positions; debt financing results in higher leverage ratios, such as liability-to-equity and debt-to-equity.
Carrying a higher leverage ratio limits borrowing capacity (i.e. financial flexibility) and raises the cost of borrowing in both interest rates and loan fees.
A widely used alternative to holding land on the balance sheet is off-balance-sheet financing. The industry term that has gained currency for this type of financing is “land banking.” The use of land banking or structured-lot financing carries a cost to the builder of about 1 percent per month of the total land value. In response to Enron's unscrupulous use of off-balance-sheet financing through special purpose entities (SPEs), the Financial Accounting Standards Board enacted FIN 46 to improve the reporting and disclosure of off-balance-sheet financing. FIN 46 has had a big impact on home builders' use of structured-lot financing.
Tom Bruin, president of Hearthstone Advisors, a provider of this type of financing, asserts that benefits from the tactic differ depending on whether a company is public or private. “Wall Street analysts and owners of stock [have beaten into public builders the message that] they must keep their balance sheet clean as far as land inventory,” he says. Analysts and investors raise a red flag, “if builders carry excess land inventory; probably [anything] more than a three-year supply.” What's more, Bruin notes, as land deals “get bigger, builders realize there is nearly the same amount of brain damage [involved in] processing a smaller tract of land through entitlement as there is in processing a larger tract.”
Contrast those rationales with private builder motivations. Bruin says he believes “private builders have reached their limits with their existing bank lines.” These builders lack the ability to access additional capital for land acquisition because they have run up against their bank covenants. “They lack a source of incremental capital,” he says.
While Hearthstone's clients are mostly public builders, Bruin submits that the answer to the question—will private builders need to access this kind of capital in the future?—will be yes. “This may not take the same form as structured-lot financing,” Bruin says, “but to remain competitive with the publics, private builders will have to get bigger and take on bigger projects.”
For most home builders, traditional lenders such as Bank of America or Bank One like to see liability-to-equity ratios that total no greater than 4-to-1. In other words, every dollar of a company's equity would finance $4 of debt.
(Note: This calculation derives from a company's book equity rather than fair market value equity. GAAP (Generally Accepted Accounting Principles) again rears its ugly head. Book equity, according to GAAP guidelines, refers to assets whose value is the lower figure between cost and fair market value. For example, if you own 50 acres, purchased for $100,000 an acre two years ago, and the land is now properly zoned with a fair market value of $250,000 an acre, the value of this land is still $5 million (lower of cost or market) for accounting purposes. The dollar difference between book value ($5 million) and fair market value ($12.5 million)—the fair market equity value of $7.5 million—bears no valuation relevance in traditional bank covenants. This factor has particular significance for a growing company experiencing rapidly rising land prices and longer processing times: Demand for debt can often outpace the amount of debt the company is capable of financing, based on its book equity.)
“FIN 46 is a new way to look at consolidation,” says Mike Straneva, national head of Real Estate Transactional Advisory Services and a partner at Ernst & Young. “Before FIN 46, the need to consolidate was based on your ownership percentage in an entity. Now we look at both quantitative and qualitative analysis identifying the primary beneficiary … who has the most at risk, as opposed to who owns the most.”
Compliance with FIN 46 started for public builders with their post-Dec. 15, 2003, annual period reports, and for private builders, with their annual period reporting after Dec. 15, 2004. FIN 46 makes holding land off balance sheet through structured-lot financing more difficult, which has crimped demand for the practice.