It’s a good time to be a home builder in America. The combination of low mortgage rates, favorable demographic trends, and a heightened desire for single-family homeownership and rentership brought about by the current pandemic has spurred demand to high levels in many markets across the country. Combine those demand factors with a dearth of for-sale inventory, and it's clear to see why many local builders are doing well.
Given the strong housing fundamentals, many builders are faced with a choice: maintain the current run rate of production or take advantage of the favorable trends and grow the business. Those who choose the latter path will likely need to address the question of how to fund the growth?
Most private builders get started with internally generated funds, or equity from local friends and family. This equity is typically supplemented with a credit facility from a bank, which usually requires some form of personal guarantee. At some point, however, these capital sources may become insufficient or too time consuming to suit a builder’s needs.
“There are many financing options available to local builders with a good track record, lot pipeline, growth plan, and reliable financial projections,” says Margaret Whelan, founder and CEO of the boutique investment bank Whelan Advisory, which specializes in capital raising, merger, and acquisition advisory for home builder and construction companies. “At some point, these companies are ready for the next stage, which is to move toward larger and more programmatic capital sources, thereby allowing the builder to primarily focus on operating the business versus continuously sourcing new capital.”
One alternative available to builders looking to take the next step in their growth trajectory is an equity joint venture (JV). The benefits of a JV beyond the infusion of capital are that all parties agree ahead of time on the parameters around land deals to be secured, also known as the "buy box."
“This visibility accelerates the land acquisition process, increasing their ability to execute on deals, and freeing up time for the builder, who benefits from having the committed capital required to facilitate their growth,” says Whelan.
Another advantage with an equity JV is that the builder deposit is often just 5% of the total equity required, with the balance being provided by the investor. Simultaneously, the builder is aligned with the investor and participates in returns being generated through a split of the promoted interest, once the preferred return—typically around 10%—has been delivered.
Land banking can be similar in that the program can be established around the parameters of a buy box. Land bankers, however, typically require a larger deposit of 15%-plus from the builder, though they also offer a total fixed "all-in" cost of capital around 15%.
Whelan notes, however, that the additional capital will likely also mean additional oversight. “At the beginning, the interaction is more frequent as the partners work to refine their communication and the deals are being analyzed, investment committee memos are digested and approved, and funds are deployed. As familiarity grows, and as long as a project is continuing to perform to expectations, the capital partner can be less involved. On the other hand, if something goes wrong, the builder can expect a lot more engagement.”
Another route for a builder who has exhausted their immediate sources of capital is to sell their operations to a larger builder. Given that U.S. housing has emerged as a bright spot in the global economy, Whelan says her firm is seeing interest from financial and real estate companies all over the world in home builders that can reliably deliver both for-sale and for-rent homes. In addition, as demand for new homes has accelerated through the pandemic, many of the national builders have shrinking lot counts and an increasing appetite for M&A.
So, what are these potential acquirers looking for? “The screening process for all types of buyers is the same,” says Whelan. “They’re looking for a well-regarded management team operating in a leading MSA or region, with decent margins and returns, and access to a robust pipeline.” She also stresses that employing a strong controller or CFO is critical to ensuring reliable execution and efficient communication in order to develop trust and minimize the cost of capital.
Regardless of whether the acquiring party has an existing operation in the market factors heavily into a selling builder’s future. “If the geographic market or product type are new to the buyer, the seller often stays on to be part of the team going forward,” Whelan says. “Alternatively, the seller might prefer to move on, having crystallized the value of their company through the transaction.” She notes that when a seller offers flexibility in regard to an exit it is reassuring for buyers, and can translate to a higher valuation or earn out.
Successfully managing growth can be a challenging—but welcome—problem for any builder, and choosing the right financing alternatives to fund that growth is critical. Fortunately, given the many tailwinds benefiting the housing industry, home builders have many options available to them.
