LAWS OF THE LAND APPLY
A Wall Street Journal article by staffer Justin Lahart makes a supposition as to why builders are optimistic.
There are fewer of them than there used to be, and therefore, with less competition, they can charge more for each home and share a bigger slice of the buyer pie. Lahart writes:
“Even though there are fewer homes being built than there used to be, the market is getting split among far fewer builders. Throw in the hefty prices new homes are fetching—the median was $316,200 last year versus $240,900 in 2005—and it is easy to see why the people who remain in business feel upbeat.”
To support his theory, Lahart uses data. The number of construction firms the Commerce Department clocked in in 2014 plummeted by 30% from a prior peak in 2005; likewise, the Labor Department reported a 23% decline in residential construction workers during the same period.
Economics laws say, don’t they, that more competition is good for the consumer; it results in more value at lower prices since the desired item is available from several sources.
Good theory. Except, of course, when you start to think about what happens to the cost of a parcel when there are more competitors bidding for it. The lot cost goes up. So, too, does the cost of the home.
Moreover, more builders mean more builders with higher borrowing costs chasing the same opportunities–price, location, pace, etc.–as builders with lower borrowing costs. Don’t those higher finance expenses result in higher prices to potential buyers?
We don’t know how many people who know anything about the business of residential development, home building, or housing economics would agree with the Wall Street Journal‘s “take” that builders’ outlook is brighter for the fact that there are fewer construction workers around to build the homes.
What we know is that home builders’ tactics and strategies in each of their operating arenas is a living, breathing, dynamically evolving process of asset acquisition, inventory turns, and reloads, each requiring constant tweaking, resource reallocation, and vigilance.
One builder we talked to recently focused on a dimension of the labor pain point we might otherwise wouldn’t think about. His thought problem is this: if a project supervisor has five WIPs (work in progress homes) in three different communities in an area like Dallas-Fort Worth, he gets to spend seven minutes per day in each home as it’s under construction.
“You can’t expect any level of quality assurance under those conditions,” our builder executive tells us. “It’s not enough time anywhere.”
To mitigate that, builders have wised up as to how to leverage local scale, clustering job sites to reduce “windshield time,” amping up on technologies to reduce variances and mistakes closer to the instant they occur, and eliminating waste of time, resources, and money.
Ivy Zelman and her team at Zelman & Associates call attention to the fact that rising prices–one of the bedrock assumptions Lahart uses in his circular argument about builder optimism–may be in a “tipping point” inflection moment. Entry level, an afterthought for many of the publics in the first several years of recovery through 2015, is a top priority segment for most of them now. The latest installment of The Z Report–a twice-monthly report compiling exclusive, up-to-the-moment research analysis on home building and residential development and investment trends–focuses on calendar year 2017 first-quarter performance of a Baker’s Dozen of public builders, which account for about nine out of 10 closings, and $4 out of $5 revenue dollars of Zelman’s coverage group.
The key take-away from Zelman’s Q1 analysis–which reports that public builders are “outperforming” expectations–is this. Core home building operating margins, the report notes, are a solid 10%–compared with a median 8% Q1 margin over the prior 25 years. That’s not the highest it’s been recently, but there’s an explanation for that. [You can access a free trial of The Z Report by clicking on this link.]
“We attribute the year-over-year gross margin compression to rising land costs and, to a lesser extent, the aforementioned price point mix given that entry-level homes typically have a lower profit margin but compensate with above-average inventory turnover. Meanwhile, SG&A expenses as a percentage of revenue were near record low levels as builders tightly manage personnel and overhead.”
A question pressing now–having nothing to do with optimism or pessimism about the next six to 12 months–is the reload. Can builders dig their heels in with land sellers and continue to pay 2016-17 prices for lots? Or not? If they can, they can model in some margin compression via labor and materials cost increases, offset that with even stronger disciplines on the local operations and execution front and make a good go of it. If not, it’s back to the drawing board on whether their offerings will fall within the elastic tolerance levels of buyers or not.
Laws of the land inevitably prevail. Local land-buying clout will matter hugely as builders try to program their land portfolios for 2019 and 2020 and beyond. If you’re not big, you’d better know some folks who’ll give you a tip on an off-market parcel in the local path of growth.