The pace of mergers and acquisitions (M&A) in the home builder sector is accelerating, with many multi-billion transactions from large companies chasing scale. The Berkshire Hathaway-Taylor Morrison, Dream Finders Homes-Beazer Homes, and Sumitomo Forestry-Tri Pointe Homes mergers are among the recent transactions reshaping the housing landscape.
High interest rates, the cost of incentives, regulatory costs, and margin pressure is causing many builders to think harder about scale. In many cases, M&A buys additional time that is not afforded by organic growth. The years to assemble local relationships, land positions, and a strong operating team can be bypassed when expanding into the same market via acquisition.
Builders Capital
Builders Capital CEO Robert Trent
For Builders Capital CEO Robert Trent, while capital capacity is a driving force in the current M&A landscape, it is not an inevitable outcome for strong regional builders. As former home builders, Trent and the founding team of Builders Capital understood firsthand the challenges of financing residential construction at scale and the importance of a trusted partner in helping build the future of housing.
In a conversation with BUILDER, Trent discussed the dynamics behind the current M&A landscape, the role of capital in M&A and growth, and the factors impacting builders and the capital markets in the current market.
What do you think is driving the recent surge of interest and activity in the M&A space?
The market is very margin-constrained right now. Interest rates are high, there are a lot of rate buydowns, and regulatory costs are increasing. Builders are trying to figure out how to squeeze more margin and become more efficient. That happens a couple of different ways, but scale helps with that. Access to broader capital markets help with that. I think with the need to create scale, M&A seems the most logical first step [to create scale].
Look at the recent Dream Finders-Beazer merger. The synergies they have alone just in their overhead, cost allocation, and buying power will deliver just about $100 in cost savings. Is M&A going to continue? Absolutely. But, I don’t think it has to in all cases. There are still going to be some very strong local and regional home builders.
What does it look like when a builder reaches their financial capacity?
A lot of builders reach their financing ceiling before they reach their operational capacity. We see builders that could build and sell a lot more houses, but they’re constrained by the financing capability of their current capital partners. Geographic diversity, community diversity, and balance sheet strength help with that.
If a lender is financing a builder that has a giant community, for example, there’s a lot of risk concentrated in one place. What we like about the smaller- to mid-size home builders is they spread their land out a lot more with smaller communities with smaller lot volumes. We like that risk a lot better than giant communities where slow absorption or other issues may affect a lot of the lending and put you at risk.
Does access to capital increasingly favor the largest builders?
It depends on where they’re getting their financing. If you are a larger public builder and are accessing public bond markets or getting bank financing, you have access to more capital but the frictional cost of that capital is more expensive. A big builder may have three to five different lenders providing access to capital at land acquisition, land development, and vertical construction phases and that becomes operational friction.
Where smaller builders can have an advantage is finding private lenders that would finance the entire work stream of capital needs. It makes it a lot more efficient and you are not having to go out and access those different relationships and have that operational burden on your system.
How can a builder tell whether it is ready to expand or whether it is growing faster than the organization can absorb?
Geographic diversity and expanding into new markets, reducing the concentration of the lender, is beneficial in a lot of ways. It makes your current lenders have a different risk appetite. They are willing to do a deeper concentration with you as a builder. You are also increasing your balance sheet strength.
If you are going out and looking to get capital, the right “yes” matters a lot more than the fastest “yes.” That right “yes” is understanding your business model, understanding your business needs, and making sure you are not outgrowing your capabilities.
What we tend to do is look back at one to three years of historical performance, look what growth trends have been, how the P&L and balance sheet have reacted to that, and how a company can handle stressful times, downturns, or slower markets to make sure the future expansion is not outpacing historical expansion. If you are in M&A, that helps that growth trend and growth trajectory occur much faster.
What makes a regional builder an attractive acquisition target right now?
You’re not going to take over and duplicate your corporate structure or your executive team. But what you are going to do is take that team on the ground and put them to work. They’ve got relationships in the market. You’re looking at land bases and how that is going to help growth the business and help position the company in the market much faster than if it were to expand organically.
Is M&A necessarily the best outcome for a regional builder that receives an offer?
But, if you have a decent land supply and believe there is a good housing economy ahead of us, I don’t think it makes sense to sell and get rid of that land supply. I think there’s much more upside if you are looking at the long term benefits of ownership than the short term sell side.
If you look at the top 200 to 300 builders, the number of homes the recent M&A companies are doing versus where the rest of the market sits, these are outliers. These are top ten builders. As you start to go down to the builders building less than 1,000 homes annually, I think those M&As are going to get much harder to do if the builder that has a decent land supply really evaluates the value of their business as it is versus what they would get paid in the short term to sell those lots to a larger builder.
In a market where large builders can offer aggressive incentives and rate buydowns, how can smaller builders compete?
Today’s builder is increasingly selling a payment, not just a house. The public builders have been very effective at using their mortgage companies to engineer that payment. A smaller builder may not have a mortgage company, but they can partner with a lender that may have a forward-flow program.
You look at the concessions that are happening right now on new home sales and you’ve got to compete with the concessions that the large public and regional builders can do. If you don’t have the capability of doing that, I think you have to find a capital partner that gives you that capability so you can continue to compete and maintain margin.
The answer isn’t always lower the home price and be more competitive on pricing. It is really creating a creative financing structure and engineering the payment for the buyer where they can afford to buy a more expensive home.
What are you watching in the market over the next 6 to 18 months?
One thing I’m watching is the Census data. There’s 9.3 months of new-home supply out there and the median existing home is about $434,000. The median new-home is $398,000. I think that tells you how aggressively builders are engineering affordability. I think that’s really important to watch.
The other thing I am paying close attention to is regulatory costs. Regulatory costs are fixed, the builder can’t do anything about them. It’s a fixed cost representing 26% of building a home, and that’s gone up 40% over the past five years. If look at affordability and focus on that, we have to have some help with these regulatory costs to help bring down the cost balance between regulatory costs and the cost of land. In most markets, about 30% of your home value is land value. That means roughly 56% of your house cost is baked in with just regulatory fees and land. How do we become more affordable and sell more houses? We’ve got to help with regulatory costs and get some of the costs spread out.
I’m also watching interest rates. I would have bet money last year that interest rates would be coming down by now. It looks like rates instead are going to stay higher for much longer than I had thought. That makes the competitive nature of who you are financing with and what are their abilities with some these mortgage takeouts more important. As a builder, how does that help with your margin and your ability to compete with larger builders.
The long-term macro trends on housing are still very positive. We are very bullish long-term. The war in Iran is still kind of top of mind right now with everybody. How that is affecting fuel prices, people’s purchasing power, and those kind of short-term headwinds.
Once we get through those headwinds, hopefully interest rates start to tail off a little bit. The economy is still surging, and I think you start to have even more of a supply and demand issue because I think a lot of today’s inventory is going to get snatched up pretty quick. I don’t think builders are building enough inventory today that is going to relieve when inventory starts to get absorbed. I think we are going to have another shortage, similar to the post-COVID period when housing all of a sudden got snatched up quickly.
