While COVID-19 continues to bring uncertainty to the world, one thing is for certain—it has and will continue to reshuffle the residential real estate market on a large scale. Much of this may be irreversible, since this change is not a function of an event where consumer habits tend to shift back to what is considered normal. Instead, the COVID-19 pandemic has begged the question± “What is the new ‘normal’?”
Changing Market Dynamics
The pandemic is accelerating shifts in residential real estate that are being driven by a few key dynamics, which are expected to continue to impact the residential market for the foreseeable future:
- Millennials, the largest generational group in U.S. history, have begun growing their families and embracing the American dream of homeownership.
- Working from home is affording a large group of consumers the flexibility of working from anywhere, most notably from suburban or rural areas.
- Affordability, a priority for many consumers, is leading more home buyers into suburban neighborhoods and away from higher-cost, close-in locations where appreciation has far outpaced income growth.
- Mortgage interest rates are at a historic low point, making homeownership more achievable and appealing to renters than ever.
Meeting Unanticipated Demand Calls for a New Approach
These fundamental shifts have made their way to developers and builders who hold the key to unlocking the recognition of growing demand and generally believe that the residential market can withstand and is in need of a greater supply of residential lots and housing. To meet the previously unanticipated demand created by the unprecedented times we are living in will likely require some creativity in the utilization of unique financing structures, symbiotic partnerships and/or stepping outside the traditional comfort zone to flatten the supply chain, maintain/grow market share, scale profit, and remain a viable operation.
In a capital intensive, margin-compressed business where developable land is at a premium and so much risk is borne by the operator, the idea of entering into a venture without the lowest possible defined cost of capital and/or sharing significant upside with a partner is incongruous. As such, most operators focus on the lowest cost, most simplistic form of financing. Traditionally this has lent itself to structured finance vehicles (land/lot banking, model home sale lease-back, mezzanine/preferred equity, etc.). While holding firm to the “K.I.S.S.” principle has served many builders well for years, the challenge to continue sourcing scalable new business given the highly competitive, supply constrained, and consolidating housing market has altered the very definition of a viable opportunity to the point where fitting in a conventional solution can be a difficult undertaking.
Builders and developers who are poised to take advantage of market opportunities need to find viable financing strategies. Some of the most appealing options entail unique solutions without dramatically altering the risk/reward profile, including projects that range from too small/too large in unit count; too short/long in duration; limited submarket data due to the suburban “stretch;” unique housing product (attached, 55+, etc.); and a good fit in the partnership between the capital and the developer or builder.
Advancing New Deal Strategies
“When the marketplace evolves, reshaping the approach to financing provides scalable opportunities for all parties involved and offers a benefit to an industry’s burgeoning structure, releasing its confines,” said Greg Vogel, founder and CEO of Land Advisors Organization. “We’re seeing nimble home builders and developers pivot in order to position their organizations to secure the supply necessary to meet demand through various types of deal strategies. These deals help their appeal to capital markets and set the stage for healthy partnerships to flourish well into the future.”
A couple examples of creative deal structures that are being developed in various markets include:
Lot banking “with a twist.” Lot banking was borne and driven by the demand for publicly traded home builders to manage and maintain their lot inventory pipeline, while simultaneously reducing balance sheet liabilities. The demand for this product has grown to include privately held builders that utilize this financing vehicle with an intent to define their cost of capital and maintain operational control of their company. For this builder cohort, it remains a constant challenge to maintain scale while driving bottom line profit (while also competing with public builders), which is open-ended and less defined under a traditional home building joint venture structure. Therefore, an ideal financing strategy alters the traditional lot banking structure with respect to current option payments, accrual, deposit treatment, etc., to account for specific nuances at the project level, while still optimizing the cost of capital and allowing for the home builder to maintain operational control.
Development partnerships. In several U.S. markets, developers and builders have maintained the separation of skill sets required to bring a project to fruition. This model has worked seamlessly for many years in markets like Texas, for example, where land is plentiful, and the entitlement process remains far less painful than in coastal markets. However, with the complexity of entitlements incrementally increasing, continued discipline demonstrated by the home building industry combined with the continued job growth and demand, a shortage in lot supply exists. This effective kink in the supply chain has created a situation where merchant home builders have become overly reliant on developers who are gapping out of lot positions. To address this issue, creating a deal strategy that entails joint venture partnerships between developers and builders prior to raw land closing can create a steadier supply chain. Of course, consummating transactions of this nature are highly dependent on each party understanding that entering into these ventures can create a longer investment horizon (for home builder) and reduction in bottom line profit (for developer).
Given the continued expected growth of residential housing, it is imperative that creative capital solutions be employed. The risk is that the housing market supply chain will become even less efficient and undersupplied, continuing to put pressure on home pricing. Simply put, the creative use of capital is one of the tools available to the industry that can help smooth out the supply chain and tame price growth so that the American dream of homeownership remains attainable.
