WHAT DO MY THREE YEAR OLD GRANDSON AND MOST HOMEBUILDERS HAVE IN COMMON?

Yesterday was my grandson’s third birthday party and we video chatted that night as he opened his presents. In the middle of our visit I noticed that he had his pants and shirt on backwards and, when I questioned his father as to why, was told that he had come home from his party and changed his clothes, dressing himself.

While this error was unimportant as he was in his own home, most homebuilders are making a similar error and their mistake has serious repercussions.

Over the past few years I have been given numerous assignments by builders to evaluate existing communities and develop programs to accelerate absorption and increase profit. While that type of assignment has always constituted a portion of my consulting practice, I have always preferred, when possible, to be brought into a development during the conceptualization and planning stages and, even better, to be consulted prior to the acquisition of the ground. It is always easier to create success when there are fewer restrictions in place as once the development has begun, those restrictions may have substantial impact and create limitations on future actions. The same is true once the land has been acquired.

But regardless of the state of the specific development my first step is always to analyze the market to determine underlying demand. And that demand should be quantifiable by amount, by product type and use, by location and by price. As I have said in several of my previous blogs, housing demand cannot be created; all we can do is manage and, hopefully, satisfy the existing demand. And, unless we wish to recreate the sub-prime debacle, we cannot sell homes that are priced higher than what the market can afford and then artificially stimulate those sales.

Backwards Tom Green
House pricing cannot be determined by cost but rather by the marketplace. Most builders fail to follow this concept, instead taking the cost of the finished product and then adding a profit allowance. The difficulty that will result from this procedure is that while projected profit goals will thereby be maintained (at least on paper), there is no valid rationale that the market is willing to pay or can afford these prices and, in good markets (which will return someday) no concrete evidence that the prices resulting from this process are, in fact, the maximum that the market is willing to pay. And this is the backwards error that most builders make.

The first step in a proper pricing strategy is to determine what the market can afford to pay as this will establish affordability and the price point of the marketplace and thus the target selling price of the homes. The second factor is to examine competitive buying patterns which will show what the market is willing to accept for that price and the market preference factors that should apply to your houses. Finally, a review of the specific site is required to determine what impact the location, community and neighborhood features will have on perceived value thereby impacting price.

Under the typical builder operation, a parcel of land is purchased and the builder determines what should be built thereon, often using a land cost multiplier, and then does a cost analysis to determine potential profitability. In this situation, land cost is “fixed”, so that the only numbers that can be adjusted are construction costs, absorption, sales and marketing costs or profit.

Adjusting the “profit” numbers is always dangerous. Far too often we encounter builders who started a development with an insufficient profit potential, only to have market conditions force additional cost or discounts that erode the total remaining profit, if not more.

Adjusting the “construction” numbers is equally dangerous. The builder often ends up downsizing the home design below the minimum standards of the market or removing all of the essential features that the market demands in their homes. The rational used is that because the home is built by “Dan Levitan” it will sell regardless of its competitive strengths. But although I personally know that Dan Levitan is a great guy, his homes will not sell unless they create a meaningful value proposition for the market.

Adjusting the marketing numbers or the absorption rates is probably the most dangerous of all, creating a community that can only succeed under the “best case” scenario, with no allowance for necessary adjustments as the market changes and thereby creating substantial downside risk.

Offered here for your consideration is an alternative and what I believe is the correct way to budget a development. This process requires budgeting profit as the first fixed cost, then adding construction and soft costs, leaving the land as the residual variable. Quite simply, if you cannot purchase the land at the indicated value, the deal has potential problems and, quite probably, should be avoided.

In such a simplified budget exercise that I recently presented to a client, the builder could afford to pay $57,600 for a homesite to sell $300,000 average priced homes. At 19.2% of home sales price, that is a noticeable reduction from the 25% allocation that his local market had accepted for the last several years.

And that homesite price was based on a current interest rate of only 5% which this builder is fortunate to enjoy. One of the Linked In groups which I follow has a posting offering land banking and development financing at an effective 16% interest rate. If this builder had that cost his land residual would fall to $46,768 or 15.6% of the home sales price.

This lower than the historically accepted land price is the result of the current market conditions. In the past, the inherent assumption in residential development was that home pricing could be increased regularly to cover the cost of carry on improved homesites. As home prices escalated rapidly it allowed for the forgiveness of many problems and errors including overpaying for land. But the rate of new home price inflation is unlikely to approach the interest carry cost for the foreseeable future and therefore a decreased present value of the land results which often can be significant.

Perhaps that can best be illustrated with a recent assignment that I had for a builder looking to acquire a failed development which was now REO at one of the major money center banks. My analysis showed that the property had real profit potential albeit at a substantially lower price for the housing than had originally been offered and then only after a two year initial holding period when most of the excess inventory on the market would be absorbed. When I ran the numbers and accounted for the holding period plus the carrying costs on the existing homeowners association, the present value of the land was zero ($0)! Needless to say, the bank was less than receptive to an offer even though it was well above the imputed value. However, our value could not have been too far off the mark as the property remains REO in that bank.

I am certain that you have all followed the news over the past 18 months where many of the national builders took hundreds of millions of dollars in write-downs (they called it “impairments”) on their land but many of the local and regional builders have yet to follow suit. And that is why it is often far more difficult to “fix” existing developments than to start new ones; many of the existing developments today are carrying a land cost that is simply too high, all based on the builders’ backwards budgeting process.

Allowances can certainly be made for a three year old child; in fact, I was impressed that he has learned to dress himself even with some remaining challenges. But can we not expect more from homebuilders?

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