Investopedia defines a futures market as an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. This fairly closely describes what residential investors, developers, and builders do too.
They invest in future scenarios for a present model. If investors, developers, and builders were not subject to reliable human laws that ensure we're bad at predicting the future, then residential real estate and construction would be a very different kind of business. However, prediction, much as we'd want to deny it, is not part of most people's or organizations' tool set. So, pros in the business tend to resort to the next best thing.
They bet.
Now, home building's higher-volume business landscape in the Spring of 2017 is a hive of mergers and acquisitions conversations, diligence, negotiations, and flirtations. At the same time, there are some home building operators who--for the moment, anyway--view their entrepreneurial independence as essential to manifest destiny their way. They want to grow, but they want to do it within a stakeholder set that is finite, chosen, and wholly aligned with the interests of the principals, founders, and key operators.
Atlanta-based, southeast regional entry-level home builder Smith Douglas Homes would be an example.
While capital investment for home building is plentiful on some levels, it's unevenly available. For a few publics and even fewer private companies, access to capital for growth--on land, development, acquisitions, etc.--is no more than a complex process that is a means to an end. For many, many builders, mostly local, multi-market, and regional companies, the pursuit of acquisition, construction, and development capital is daunting, is a time-suck of leadership's band-width away from operations, and can--especially these days when land is expensive and competition among other builders to source those parcels is fierce--lead to overpaying, and exposing the company to financial distress.
Here, in three segments, is the story of Smith Douglas Homes' pursuit of the kind of capital--public debt--that would allow it to compete for land strategically, smooth out market volatility in the near-term future, and--it's No. 1 goal--grow into one of the nation's top private home builders.
Our first segment told of founder Tom Bradbury's re-assembly of his core brain trust of talent from an earlier home building operation, Colony Homes. Bradbury added to his trusted leadership team, Charles Schetter, a former KB Home executive who'd ministered the KB acquisition of Colony in 2003, and became fast-friends with Bradbury from that moment forward. Here, we explore a classic, ever-debated question in any home builder capital structure conversation, which is this: how much of a home building organization's value derives from the people and the business model vs. the sheer asset value of the land on the balance sheet? Our look at Smith Douglas' proprietary approach to creating value on a lot may expose how financial and investment experts are trying to get their minds around relative values in today's single-family housing arena.
The Smith Douglas Model
Usually, builders give buyers at the lower tiers of the price spectrum a choice. Low, low price, or choice. Pick one or the other, but you can’t have both.
But what if you can?
What can be done in a day on a home site in the United States is either one of two quantities that reflect productive capacity: 100% or less than 100%. 100% is what can be completed on a house in a single workday on the site; and, all too often, less than 100% is what is done during that particular duration.
What San Antonio legend and innovator Ray Ellison figured out in the 1950s and made a discipline of, that many other home builders never seem to solve, was how to get 100% of a day's work done--or close to it--on his home sites. Ellison sold his company, Rayco, to Kaufman and Broad Home Corp. (KB Home) in 1996, and the Rayco model was the industry standard at the time for how to give customers both a modicum of choice about what was in their home and a price tag they could manage within their means.
Now, by estimates of veteran southeast regional home building, there are 210 days of a year, give or take, in prime home building markets that you can drive a nail or put up a form. Not surprisingly, maybe 20% or more of what could happen on every one of those days on a home site fails to happen for some reason or other, or maybe no reason at all.
So, for every 210 actual workdays, building superintendents, project managers, and executives are only getting 168 days of work actually done. They're paying at a rate of 100% to get work processes completed, when in reality, just 80% of the work gets done.
Twenty-percent waste is not unusual in home building, and 20% waste is not confined only to home building. Now, how does a home building company executive, a project manager, a superintendent approach that challenge of reducing waste, of getting 100% done in a day, as opposed to 80%, or less?
Smith Douglas, an Atlanta-based, six-market southeastern builder, operates in Atlanta, Birmingham, Charlotte, Nashville, and Raleigh, and last year, delivered 665 home closings (up 26% y-o-y) and $225 million in home building revenue (up 106% y-o-y). Their pedigree dates back to 1975, when Tom Bradbury founded Colony Homes.
One thing Tom Bradbury did early on was to go to school on what Ray Ellison was doing down in San Antonio, and then he worked with pioneer data-operations information technology geeks Mike Goldsberry, Mike Johnson, and Kenny Norton to commit their thinking, visualizations, construction, engineering, product spec, and work-streams to code, so that every task, process, product SKU, and system was mapped into an integrated workflow tool.
At that time, the late 1990s, an endeavor like that was practically insane, but what it allowed Tom Bradbury and his team--including a young, up-and-coming operations superstar named Greg Bennett--to do was to build houses virtually before they built them on site.
Imagine, taking a Rayco-like construction management discipline and then connecting the entire ecosystem of construction--manufacturers, materials suppliers, trades--to a single operations plan, one playbook. This is what evolved into the SMART system Smith Douglas uses today, and it allows teams in their respective communities in their six markets to execute on a true evenflow building model--one start, one completion, one sale per community per day--and average 3-and-a-half to four asset turns per year, a best of breed productivity measure.
"What you usually see at the site is a super[intendant] yelling and screaming at the trade crew, and they’re usually responsive to that kind of thing, and they work for the day, and get about 80% of the job done," Bennett observed. "That last 20%? You couldn't get them back to finish that up, and that’s the kind of thing that holds up the rest of the job."
What Bradbury and Bennett--and the Smith Douglas culture--have gotten down is this. Get 100% of a day's work done in a day. If a trade crew is 100% finished with its task(s) in its scheduled day's work, the next crew can come in and do its part.
This way, Smith Douglas can build an additional house every week of the year, and it can get each house done in 60 days or less, which means three things that are vitally important to a builder whose No. 1 customer is an FHA buyer in its six markets.
Its buyers can have choice in options and personalization, as well as a low price because of the efficiency in the executional model. What's more, they can move into their new home about two months from the time they pick one of Smith Douglas' 40 models, specify their options, and get their financing in order.
Choice and a low price are not mutually exclusive if you can execute. Execution is treated as a data-backed science at Smith Douglas, built around mini-ecosystems of accountable project members called “R Teams,” a project organization formula that Bennett and Bradbury ported over from the Colony days.
Think of “r” words: relationship, repeatable, reliable, real-time, and you can understand how Smith Douglas might structure and manage execution at a high level around this concept. These localized mini-ecosystems are geographically clustered to reduce “windshield time” for trades, superintendents, key
“Our process is schedule-driven, single-data base, real-time information, and it’s designed so that everybody does their 100% every day, and hands their 100% on to the next set of crews the following day, and so on,” says Bradbury. “If there’s an error causing variability to the schedule, anybody in the R Team community can pull the cord, stop production. Everybody’s part of the community, and everybody has reason to want us to get back on our schedule-driven process. It works.”
It’s this type of organizational capital that you wouldn’t find in other private builders that an institutional investor might find to be compelling as Smith Douglas bids to attract hybrid bond takers. Market growth expectations in Smith Douglas’ customer segmentation wheelhouse and operational footprint aren’t too shabby either.
Unmet Need
Whether or not it’s existing homes or new homes buyers look for these days, there seem not to be enough of them, especially when it comes to homes young adult households can afford to buy.
One of the strategic pillars of the company Bradbury and his early team members baked into the DNA of Smith Douglas was its customer segmentation aim, to serve entry-level buyers. Normally, first-time buyers activate early in housing recoveries as they surge into the market to get into homes before prices spiral up to where they’re shut out.
This time, however, entry-level buyers failed to materialize for the first several years of the rebound—they were besieged by college debt, slow to get jobs and raises in the wake of the downturn, and kicking into gear at a slower pace as households than late-20s early 30s-year-olds would have in years past.
“We lost nearly a quarter of a million dollars that first year, and we were losing money in year two, and I went to my wife and wondered out loud about whether we were throwing good money after bad, and maybe ought to think about giving up,” recalls Bradbury. “Nell said to me, then we’ll be losing everything, Tom. Let’s keep working on it.”
It took three-plus years of running in the red before Smith Douglas started to get traction.
Now, the Federal Housing Administration market—those who buy a house below the limits of FHA-backed loan amounts—comprises six of every 10 homes Smith Douglas sells, and the builder counts itself one of the largest customers of its Fidelity mortgage company partners, at more than 600 homes a year.
This market, Charles Schetter will tell you, is the present and future essence of the company’s reason for being. Now, the timing couldn’t seem better. While discretionary luxury and second-time move-up buyers—those with cash to spend and incomes at the higher-end—were first to kick in on recovery, entry-level buyers are finally showing signs that a much-awaited release of pent-up demand may have activated.
Credit box protocols around credit scores, loan-to-value and loan-to-income ratios, credit scores, and now—especially as a new policy environment seems ready to peel back regulations and punitive measures that have been looked at as suppressive to lending—borrowers seem ready to crowd back into the market in large numbers.
Research produced by John Burns Real Estate Consultants lends support to the Smith Douglas geographical footprint in the southeast, showing that between now and 2027, the southeast will account for about one-in-four new households in the United States. Further encouragement emerges when you zero in on the southeast’s most active metro areas and see that they sync up precisely with Smith Douglas’s markets in Atlanta, Birmingham, Charlotte, Nashville, and Raleigh.
Even more data points to the fact that within those geographic areas, it’s the FHA qualified price points that move the fastest these days in any market. No wonder either, both existing and new homes are in far shorter supply in the FHA-limit price tiers than in the move-up, second-time-move-up, and luxury price tiers.
“Atlanta is a ‘tale of two cities,’” says Schetter. “The market’s getting saturated at above half-a-million dollar ranges, but below $300,000, and especially in that FHA range, it’s quite robust.”
Schetter notes that feeding into the future, Atlanta is expected to account for one out of every two of its homes sold as Smith Douglas gets closer to its Grail of 4,000 homes and $1 billion in revenues.
Our Part 3, and final segment of the series, will explore how, given the limitations of its stakeholders' capacity to predict the future, the strategic management of Smith Douglas plans to make good on its promise to quantum leap from its current middle-tier stature among regional home builders to one of private home building's exclusive elite. And, in so doing, how it plans to access the public debt markets as a capital structure tool to catalyze a growth opportunity its owners believe to be unique among home builders right now. Check it out on Friday this week.
