Housing Scenario for 2010: Home Building 3.0
Here’s one installment in what will probably be a multi-part series extending into the year ahead, which no one will deny is going to be another rough one for residential construction companies. The theme here might be “how home building companies shift from a role as passive victims of housing’s 100-year storm to seizing control of their own destiny in a challenged GDP economy.”
The thought comes from the assumption that home builders’ early November Capitol Hill coup–the passage of the extension and expansion of home buyer tax credits through April 2010, and the telescoping of the Net Operating Loss tax carry back period to 60 months–is it as far as policy’s helping hand to stimulate demand.
May as well think of it this way. Run like hell to avail of every possible tax refund dollar, and cash generative dollar from home sales that will likely crescendo in February and March of next year. Then brace for dip number two–in sales volumes, prices, and possibly the broader economy.
You may have been through the worst of this, but nobody’s saying that getting better isn’t going to hurt.
At any rate, count out more policy care packages. Even interest rates have got to unglue once the trillion-plus in recently minted dollars start blowing around in the real economy. So that tail wind becomes another stiff blast in the face.
Where does this leave home builders’ odds of controlling their own destiny by the end of 2010?
If Moody’s chief economist Mark Zandi’s math works out correctly, 4.8 million homes are going into foreclosure and will come out as foreclosure sales in the years 2009 through 2011. That works out roughly to 4500 a day for the next 700 days or thereabouts.
So if taking control of your destiny is to be more than a pipe dream, fighting foreclosure sales is a fact of new home builder life that needs to get operationalized strategically, in design, in sales, in identifying the need you fill, in land selection, in quality construction, and in delighting your buyer. KB Home, Meritage, D.R. Horton, M/I Homes, and many others did brilliant things to design and operationalize foreclosure fighting home strategies around monthly payments for the entry level market.
We’re convinced of the notion Tim Sullivan of Sullivan Group Real Estate Advisors speaks of as “relative affordability,” [simply click the link, register, click on "Best Practices," scroll to Sales & Marketing, and select "What's Selling? Who's Buying?"] which suggests that there’ll be a foreclosure fighter [follow same directions above, click on Design and select Foreclosure Fighters] at multiple price points.
As we see it, there are two big inhibitors big builders face in fighting foreclosure sales. One is cost and the other is value. Lets consider cost first.
Fletcher L. Groves III does a marvelous job of mapping the cost flow for an enterprise builder in words in an analysis titled “Three Ways to Measure the Pipeline. ” Imagine a dialogue–consultant and CFO.
“Well, we have never thought about it that way”, the CFO responded. “I suppose the cost would be whatever we spend to have a pipeline in place. The nature of a production pipeline is that of a relatively fixed object, heavy and difficult to move. I would say that the cost of our pipeline is all of the non-variable cost we incur every year, to have the capacity to build homes.”
“Yes”, she [intrepid consultant] replied. “The cost of the pipeline is what RB Builders pays every year, in the form of operating costs and resources, to have the use of it. You pay for the cost of the pipeline, whether you use it or not. That puts the cost of the pipeline squarely in the category of non-variable costs.
“In order to understand productivity and production capacity, you must first understand how costs behave in relation to Revenue, and, more importantly, how you manage those costs on the basis of that behavior.
“On the one hand, you want to control your direct, variable costs — you want to reduce the cost. Really, though, what you want to do is extract maximum value from it. Value is the difference between the price you sell a house for, and what it cost you to deliver it.
“On the other hand, you want to leverage your indirect, non-variable costs. Those are the costs you expect to incur regardless of the Revenue you generate, and you want to produce as much output — as much Revenue, as much Gross Income — as you can from them.
The issue, vis a vis the industry’s fight against foreclosures is this: on a macro basis, there’s too much pipeline. There are too many invariable costs going into too much operational capacity right now. We’re probably paying for SG&A at the expense of actually employing talent that would create long term value.
Variable direct costs, construction time and labor efficiency, first-time quality can be managed for greater improvement, and land costs can and should be managed down to achieve foreclosure-fighting relative affordability at every price point.
But the glaring fact is, too many markets have too much home building operational infrastructure in place at too high an aggregate cost for new home building to gain a secular advantage over foreclosure sales.
The simplistic answer here is that consolidation will correct for the excess pipeline capacity, take out the redundant overheads and the market will find equilibrium.
But that discounts the importance of the other big inhibitor we mention above: value.
And here’s where the real opportunity is for home builders to gain control of their own destiny. Cost and its relation to a buyer’s price is but one part of the solution. The buyer, after all is not only buying on price, he or she is buying on value–present and future–and to fight foreclosures, relative affordability means that value is factored into the equation.
So, here’s the idea. In markets where there are national builders, which have access to capital, and local builders who don’t have access to capital, the opportunity would be to capture overheads and invariable infrastructure costs across multiple companies, and set management, local real estate, and design talent to the task of developing the value side of the equation. A national builder would underwrite the development, design, and process engineering work of a private home building company, which would keep its brand trust mark and its incubator business alive but get rid of fixed costs.
The model works in the pharmaceuticals sector, where mega companies partner with entrepreneurial biotechs skilled at identifying and meeting the evolving need for innovative new medications.
Amid the emergence of NewCo executives from the woodwork and the ever-fainter pulse of private companies who’ve been living on their cash reserves, alliances like these could break up the logjam on distressed land pricing because the cost and value equation would add up.
That’s one way home builders begin to grab control of their destiny irrespective of the cycle’s hesitant move toward recovery.
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