Going For Broke

List Research By Loretta Williams

CLOUDS CROWD THE SKY on this Saturday morning in Northern Virginia, but rain cannot deter these hopeful home buyers. The Preserve at Loudoun Valley Estates opens at 11 a.m., and they are ready to open their checkbooks for these $500,000 Toll Brothers homes; a few have even spent the night in their cars.

As extraordinary as it sounds, such scenes are playing out regularly, from Northern Virginia to Southern California, as builders try to meet the seemingly insatiable demand for homeownership. Last year, U.S. builders beat the odds by far, starting nearly 1.5 million new, single-family homes and selling more than 1 million.

The BUILDER 100, our elite list of the country's 100 largest home builders, did even better. While the overall housing market increased just 8 percent, as measured by total starts, the BUILDER 100 delivered 393,178 U.S. homes, a 14 percent increase over 2002. They break with the wider industry in another way, too: BUILDER 100 companies aren't so quick to give credit for their success to last year's record low interest rates.

“I think interest rates are just a small piece of the puzzle,” says Stuart Miller, CEO of Lennar Corp., which closed 32,180 homes last year, up 17 percent from 2002. He says the real reasons for builders' 2003 success came from the “fundamental changes” in housing drivers—immigration, demographics, household wealth, and more—which have altered the industry's landscape.

Robert Toll, who heads up Toll Brothers, agrees about the relative unimportance of interest rates in last year's performance. “Why were expectations the way they were?” asks the public builder CEO, revealing his lawyerly background with a rhetorical question. “Interest rates [which were expected to rise] and concern with foreign policy. I don't think that really has much to do with the housing fortune the major home building companies are enjoying.”

And fortune is the right word for this group. The BUILDER 100 generated $108 billion in revenue last year, a collective figure that's only expected to increase as the industry steadily consolidates. As much as these companies have grown, many experts say there's a chance for them to take home even larger winnings. Compared with other industries, Smith Barney analyst Stephen S. Kim says, “home building is still a fragmented business.” The BUILDER 100's strategy for beating the house? A hand that includes new products, new geographic markets, and new business strategies.

Share Seekers On Wall Street, market share conveys presence, influence, and power. But public builders aren't the only ones trying to add to their pile of chips on the table. After managing land supply, both the private-heavy BUILDER 100 and Next 100 say they plan to focus on increasing their share of existing markets this year.

And many are. A number of private companies (Reynen & Bardis Development, MJC Cos., and First Texas Homes, just to name a few) leapfrogged onto the BUILDER 100 for the first time this year, landing in the high-production territory of 700 homes and higher.

But those private builders will have to fight to keep those spots. Locally and nationally, public builders have assertively grown their companies through operations and acquisitions, with the top 10 builders now capturing a sizeable portion of the new-home market each year. Last fall, research by Gopal Ahluwalia, NAHB vice president of economics, showed how the top 10 builders have increased their market share during the past five years while the share owned by other segments of the BUILDER 100 (builders ranked 41 to 50, or 91 to 100, for example) stayed essentially flat. Closings for the top 10 also climbed steeply between 1989 and 2002 while remaining level for builders ranked between 11 and 60 on the list. Given such patterns, Ahluwalia suggested that the top 10 builders could deliver as much as 40 percent of the for-sale market in the next 10 years.

Such trends don't surprise public builders, who believe consolidation has not only benefited the biggest builders, but also supported the performance of the broader housing market in recent years. “I think a lot of people underestimate the impact and benefit of the consolidation going on,” says Ara Hovnanian, CEO of Red Bank, N.J.–based Hovnanian Enterprises, which closed 11,531 homes in 2003, a 21 percent increase. “If you look at the overall market, single-family starts have been rising 4 percent or 5 percent a year, which is basically a flat market. The public builders have been rising 20 percent a year due to consolidation, the acquisition of smaller builders, and organic growth.”

But not even stock analysts believe public builders can advance their individual and collective market shares forever. “The real question is how long can they continue to do that, because at some point, they're going to have to take share from another,” says Kim, who predicts “the publics can grow without cannibalizing one another's market share for at least the rest of this decade.”

As for the private builders who appear to be the likely targets for market share theft, they say they plan to stay in the game. At Transeastern Properties (see “Free Thinkers,” page 154), one of the fastest-growing companies on the BUILDER 100 for two years running in terms of closings, CEO Art Falcone says there's no ceiling in sight for his company. “Setting limits doesn't excite us,” he says. “Setting goals excites us.” Its goal for 2004? To close 3,198 homes, a 73 percent increase from 2003.

Product Plays In this quest for market share, the BUILDER 100 companies are playing with product, often venturing beyond their traditional strengths into new buyer segments and housing types such as urban infill, resort or second-home, condominiums, and on-your-lot product. “You will see market share achieved by diversities,” predicts Jeff Meyers, principal of the Meyers Group, a real estate research and consulting firm based in Costa Mesa, Calif. “Today's public builders are not afraid to build high-rise. They are much more diversified.”

So are their competitors. Private builders doing only a few hundred homes a year, such as McLean, Va.–based Miller and Smith, are venturing into resort and second-home product (see “Staying in the Game,” page 188), an appealing area to the biggest builders. Dallas-based Centex targets the resort and second-home buyer through Centex Destination Properties, which builds in Hawaii and elsewhere. The St. Joe Co., the diversified land developer and home builder, has gotten a great response to its Northwest Florida offerings, such as RiverCamps, a secluded, large-lot product for buyers seeking a private retreat. Luxury builder Toll likes this space too. “I think there is a demand for 300,000 to 400,000 second homes a year,” says Toll, whose company currently gets 12 percent of its closings from vacation/second-home product.

Another promising segment in today's land-constrained market: on-your-lot, which Centex, Hovnanian, and private builder David Weekley Homes now count among their product line.

“It's a very different business” from traditional home building, Hovnanian admits, but he believes on-your-lot brings multiple bonuses to his company. “What's interesting about it is that it obviously captures a part of the market we're not reaching,” says the CEO, who hopes to one day expand the approach nationally. “It allows us to penetrate smaller [metropolitan statistical areas] where much of this activity takes place. It allows us to hone our skills as pure home builders because you don't get any land appreciation. And it's a good return on investment.”

Taking A Chance The land factor is also behind infill, a hot area for many public builders. “Infill is small, but growing, and it's important because the land shortage is a real phenomenon,” agrees Miller, of Lennar, which is building high-rises in San Francisco, San Diego, Chicago, and South Florida. “I think all the big builders are looking to participate in this area this year.”

Just within the past seven months, Toll Brothers, for example, has firmly established itself in this market, purchasing one New Jersey infill builder (The Manhattan Building Co.) and joint venturing with another (Pinnacle Communities) on the prominent Maxwell House coffee factory redevelopment project across from New York City.

Other publics are simply expanding their commitment. Hovnanian, which has done infill for 15 years in the Northeast and Southern California, is introducing mid-rises in the suburban Washington market and high-rise product in the West. The builder, like many of its colleagues, anticipates infill accounting for 10 percent to 12 percent of its business.

So far, Wall Street approves, despite the higher risks and slower inventory turns associated with high-rises and mid-rises. “The investment community has not expressed a strong distaste for going vertical,” Kim says, noting that Toll's stock has remained trading at high multiples. “So the stomach [for infill] is pretty good,” Kim says, “but it hasn't been tested.”

Of course, some BUILDER 100 members have focused on infill all along. “We don't try to define a lifestyle. We capture what's already there,” says Stephen Olson, chairman of The Olson Co. in Seal Beach, Calif., which produced $306 million and 701 closings in 2003 through lofts, live/work, mixed-use, and other infill product.

Ironically, such demand for infill is an unintended result of housing's sustained success. “The home building world has been strong for 10 to 12 years,” Miller observes. “Historically, we have operated in waves, which have allowed local governments to catch up and build the infrastructure needed for growth. But we haven't had that wave,” leaving roads and other infrastructure taxed to capacity and buyers seeking relief through closer-in homes.

That's good news for The Olson Co., which has amassed years of experience in this complicated arena and a $2.6 billion land pipeline. As a result, Olson's not too worried about big builder competition. “I think the publics have come into this space and left and come back,” he says. “There's always been some public presence.”

As for the publics themselves, those new to infill are starting small. “We're inclined to walk before we run,” Miller says.

Spreading Their Bets Part of this pressure for a diverse product line comes from builders' own success entering so many of the large, thriving markets, such as Phoenix, Las Vegas, and Washington. “It's hard to grow in a saturated market,” say Credit Suisse First Boston analyst Ivy Zelman.

Given such challenging dynamics, builders are turning to new cities to extend their growth spurt, often purchasing smaller builders. Last year, Jacksonville, Fla., the 21st largest market in 2002 in terms of single-family permits, emerged as an unexpectedly red-hot market for acquisitions as public and private builders alike absorbed local firm after local firm.

Other builders are relying on organic growth, turning to secondary markets to achieve it. D.R. Horton, which closed more homes last year in the United States than any other builder, now plans to enter cities like Savannah, Ga., which pulled just 1,742 single-family building permits in 2003.

Such moves represent quite a shift from the idea that public builders generally want a market producing at least 10,000 permits annually—and some analysts express caution. “It's almost like they have to keep the machine going. Home building is the only factory in the world that has to restart each year,” says Zelman, who wonders about the impact on margins for builders who expand beyond the largest, most competitive, and most high-priced markets into places like Jacksonville, Fla., or West Virginia, where growth happens, but with less contribution to the bottom line. “I have to hope demand stays robust,” she says.

Others disagree. “I think there are a number of markets smaller than 10,000 permits that offer a steady opportunity to deliver homes,” says Miller, who contends that an efficient big builder can operate profitably in a market while delivering as few as 300 homes a year.

The rest of the BUILDER 100 is also venturing into new cities and suburbs. Florida-based Holiday Builders has entered Texas and is considering other Southeastern states. California company Fieldstone Communities now operates in San Antonio after purchasing a small Texas builder. Illinois-based Neumann Homes has its eye on Texas, Arizona, and Florida.

Others have targeted their home states for intensive growth. “We work with 61 cities in California. California has 450 cities in the state,” says the ambitious Olson. On the East Coast, Transeastern has added market after market, with its investments paying off fast. Fort Myers, Fla., which the company added just last year, now stands as the builder's largest source of closings, with 535 deliveries in 2003.

ADVANCING THEIR GAME Wherever and however such growth takes place, though, it all comes back to land, the essential and most challenging aspect of this high-stakes game. Effectively managing one's lot supply today seems to require the treasury of Croesus, the patience of Job, and the creativity of Apple.

Like many builders, G.L. Homes of Florida is going higher-density, bucking conventional home building wisdom by returning to townhouses after a 15-year break. “Usually you do townhouses when interest rates are high and single-family when interest rates are low [because of rates' impact on affordability],” CEO Itchko Ezratti says. “Now, interest rates are low, so you could do single-family, but there's not enough land.”

“The biggest issue for most builders is access to land,” agrees Steven Friedman, who leads the home building group at accounting firm Ernst & Young. “With the constraint on supply, the prices of land have gone up. What that's doing is [compelling] larger builders to push up the development chain, because there's such a dearth of unentitled land.”

But even hungry builders have limits. The publics are generally not buying raw ground, despite their desperate need for dirt. “Public builders don't have the stomach for it. And neither do investors,” Kim says. “The public builders are involved [in the land development and approval process] way before they have been in the past, but they're not taking the risk.”

It leaves an opening for confident and well-connected private BUILDER 100 companies with a big enough bankroll. “The land market is so inefficient that despite the public home builders and their wherewithal to succeed,” Meyers says, “the private companies often end up with better land positions,” despite their relative capital disadvantages.

Public and private companies alike say they are doing whatever they can to maintain their pipeline. They're sweetening the pot with higher offers, anteing up cash early, purchasing parcels both larger and smaller than before, enlarging their land development staff, and considering pieces with special needs (brown-fields, infill, litigation) that would have been deal-killers in the past.

They're also teaming up across the table, forming joint ventures to limit the risk (and the cost of a potential bidding war) on promising parcels. Lennar, the JV master, has used this strategy for everything from community development to acquisitions, where it worked with former affiliate LNR Property Co. to pull off the $1 billion acquisition of Newhall Land and Farming Co. last year. “We'll work with large builders, we'll work with small builders,” Miller says. “Nothing defines where we'll do a joint venture. It's just a question of who's got the appetite for the deal.”

Calling The Shots As the BUILDER 100 has grown in volume and influence, these high-rollers have started asking for special treatment, deals that could dramatically impact the future of the home building industry. It began with national purchasing contracts, which public companies—and, quickly, regional builders—used to drive down hard costs. It expanded into larger alliances, where builders like Pulte and Beazer partnered with manufacturers like Masco to create national supplier arrangements in which Masco provides products and installation services. Who will the builders invite next to their floating poker game? Try distributors, whose middleman role represents big chances for builders to extract costs and time from the home building process.

It's not the greatest hand for building products companies, who are facing foreign manufacturing competition, price pressures from The Home Depot and Lowe's, and an unwieldy supply chain for their products. But they need the business. “Home building companies have more power over building products companies than building products companies have over home builders,” says analyst Kim, who covers both industries. “Building products companies talk about distribution to home centers and distribution to home builders. They treat home building as a separate entity, worthy of being treated separately—it is a business they absolutely want to win,” he says, even if it results in lower margins on their products. “Do they like it? No. Do they have a choice? No.”

Such power reflects the BUILDER 100's unique situation in business today, where builders are enjoying an environment that other industries, especially those in manufacturing, can only imagine. “Home builders have positive pricing every year. They have no foreign competition. They don't have distribution behemoths stealing their lunch,” Kim says. “The home building industry has natural defenses from things that other industries see as major threats.”

No wonder builders keep rolling the dice.

2003 Market Share: 34% The BUILDER 100 companies revealed their winning cards again in 2003, as they captured a slightly larger share of the country's housing activity.

Last year, this elite group delivered 393,178 U.S. homes, 34 percent of the U.S. housing market as measured by new-home sales (1.085 million at press time) and completed attached for-sale homes (i.e., condos, of which there were 56,000 at press time).

Including international activity, the BUILDER 100 closed 408,431 homes in the United States, Canada, Europe, Mexico, and South America.

Playing The Game The top 10 home builders continue to control a majority of the BUILDER 100's total U.S. closings.

Free Thinkers It seems ironic to draw a box around the story of Transeastern Properties even on a magazine page, because this is one home building company that has grown dramatically by doing just the opposite. “We think out of the box,” says CEO Art Falcone. “We think about what's best for our business and our customer.”

While public builders rely on optioning, Transeastern owns 100 percent of its land. While other builders do small, regular releases of new homes, Transeastern will sell thousands of houses in a single weekend. And, while other private builders struggle to manage their growth, Transeastern has created franchiselike procedures that support the company's progression. The very profitable company also follows a five- to eight-year business plan that guides management on everything from staffing requirements to land supply.

As a result, the Coral Springs, Fla.–based builder has expanded tremendously. As recently as 2001, it closed fewer than 600 homes. Last year, it did 1,847, a threefold increase. This year looks even bigger, with 3,198 deliveries projected in 2004. “We stuck with our plan,” Falcone says, “so we won't have the choppiness” that other growing builders often encounter.

Transeastern's unconventional approach to home building stems from its management's background in the restaurant and hospitality industries. “We create almost ‘a wonder' to come see,” says Neil Eisner, president and COO. Buyers who visit discover elaborate entrances, substantial model complexes—typically with 12 model homes—and themed communities with a Mediterranean, Victorian, or other visually and emotionally compelling feel. As a result, Transeastern says it gets faster absorption on its communities than its competitors. Says Falcone: “We create an experience.”