5 lessons from the homebuilders' survival

Imagine the ultimate MBA course in corporate survival, under the rubric "Navigating the Storm: Lessons from the late 2000s." Believe it or not, the ideal industry for tomorrow's managers to study would be America's beleaguered homebuilders. In the past five years, the housing market has shrunk, both in prices and units, on a scale that's almost inconceivable in any other sector.

In 2005, America's top ten homebuilders, a group that includes Lennar (LEN), D.R. Horton (DHI), Toll Brothers (TOL), and Pulte (PHM), posted total sales of $99 billion. (We're including past figures from Centex, acquired by Pulte in 2009.) By last year, their revenues had dwindled to $23 billion, a drop of 77%. In 2009, the top ten suffered over $5 billion in losses. That's a $15 billion drop from the $10 billion in profits they mined from the boom just five years earlier.

Any major player that weathers a collapse that devastating and emerges ready to rumble when markets rebound is a model for "best practices." Amazingly, not one or two, but every one of the top ten homebuilders survived the lengthy crisis, and most boast the financial strength to grow strongly as the pace of recovery quickens. In fact, the prudence that saved the homebuilders stands in stark contrast with the recklessness that sank great names on Wall Street.

So let's examine five lessons America's managers can glean from this remarkably resilient industry--call it the "Homebuilders' Survival Guide." To get specifics, Fortune spoke to Marty Connor, CFO of luxury homebuilder Toll Brothers. Connor provided detail on how Toll, and the industry in general, managed the most successful downsizing in recent history.

1. Keep leverage low, keep maturities long.

While Wall Street firms built gigantic leverage and borrowed short-term in the flush times, the homebuilders did just the opposite. The idea is to build a fortress balance sheet in strong markets to ensure survival in the inevitable downturns. In 2006, for example, Toll's debt-to-equity ratio was just 56%, meaning that it had almost twice as much in net worth as in loans. "We also used relatively long-term, 10-year financing," says Connor. Many of those loans lasted through the crisis. And, adds Connor, Toll had no problem renewing the debt that matured even in the toughest times--we'll get to why in a minute.

Even today, Toll still has more equity than debt, $2.5 billion versus $2.1 billion, and that's after three years of losses.

2. Limit risk on the investment that can really hurt: Land.

Toll and other homebuilders prefer to "option" land rather than to buy parcels outright. An option gives the developer the right to acquire the property at a fixed price at a future date in exchange for a down payment; but if the market declines, a developer like Toll can walk away and simply lose the option price, always a fraction of a full purchase price.

In 2006, Toll controlled 90,000 lots, with two-thirds under option and one-third through direct purchases. Today, it still owns 30,000 lots, and has just 6,000 under option. So Toll has lowered its land inventory in the crunch not by selling land at a loss, but by cancelling options contracts--at far lower cost. Its rivals follow the same formula. D.R. Horton took just $11 million in options losses in 2009, one-tenth of its write-downs on land that it owns. Those write-downs would have been far higher for all homebuilders if they preferred ownership over lower-risk options in the flush markets.

3. When the market turns, harvest cash.

When houses are selling briskly, homebuilders need to keep buying land--the raw material for construction--to meet the strong demand. But when buyers disappear, they harvest cash by selling the houses that are already under contract without building many new ones or buying more land.

Here's the secret: The extra cash wouldn't exist if these companies went wild with leverage. That prudence also explains why, as Connor stated, Toll was able to renew its loans even during the downturn, albeit at higher interests rates.

Connor explains how Toll budgeted for building houses. He adds that these are hypothetical numbers that reflect the general trends. In good times, Toll might spend $150,000 for land and improvements such as roads and utilities. What's crucial for the future is that Toll generally doesn't use debt to buy the land. Instead, it deploys retained earnings, or its own cash. It does borrow to build the house, which in our example costs $300,000. At the height of the market, that house that cost $450,000 might sell for $600,000.

But during the boom the builders, including Toll, paid too much for land. That $150,000 lot fetched $200,000. Toll still paid $300,000 to build the house. But as prices dropped, the house that cost $500,000 brought less than that. Even so, Toll could sell for enough to repay the $300,000 loan and take out plenty of cash. The reason: It purchased the land not with loans, but with the earnings reaped in the good times--and that highly conservative practice provided plenty of cushion. Says Connor: "Since we don't have to buy much land in the difficult markets, we get to keep most of that cash." Once again, it's that cash harvesting that kept the markets lending to homebuilders.

4. Manage costs like a family business.

Many of the homebuilders started as small family businesses, including Toll. Chairman and co-founder Bob Toll started in the 1960's with a single subdivision near Philadelphia -- he'd pick up spare nails and admonish the forklift drivers to get their vehicles out of first gear.

Hence, they're typically adept at paring costs deeply and quickly. Toll has lowered its workforce since 2006 from 7,000 to fewer than 3,000. The top ten builders have shrunk their headcount from 63,000 to 21,000. "At the peak, a team of five to ten people would handle a single community," says Connor. "Now, that team might cover as many as three communities." Toll also values loyalty, once again, in that family business tradition. "We like to hire back people we laid off," says Connor. "I get calls from headhunters recommending new hires and I say, 'I have 4,000 people I'd prefer to hire first.'"

5. Keep forecasts extremely conservative.

When picking a project, Toll projects that home prices won't rise at all from today's levels, even if the houses won't come onto the market for several years. The "zero inflation" formula means that Toll makes money even if prices stay flat--a scenario that didn't play out in the past few years, but still worked to minimize losses.

Toll also builds a house exclusively after the buyer signs a contract. As a result, the only unsold inventory is the model house used for marketing and the homes left when buyers cancel contracts, something that's happened frequently in the last few years. Today, cancellation rates have returned to the historic average of around 6% for Toll. Even in the worst of times, the "contract in hand" approach kept the count of unsold homes far below the levels that sunk many regional "spec" builders.

In fact, sales are starting to rise again for the big builders, though still at a slow rate. Nishu Sood, an analyst for Deutsche Bank, says that the number of projects or subdivisions owned by the major homebuilders rose 6% over the past twelve months. And those big players, survivors all, are doing what they always do in a recovery: Gaining share from regional builders that typically borrowed too much, too short-term and frequently didn't survive as a result.

Indeed, the longevity of America's homebuilders is practically miraculous. And the rewards for that longevity could be rich.

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National Mortgage Rates & Payment Calculator

National Mortgage Rates & Payment Calculator

provided by Informa Research Services, Inc. | updated Monday, November 8, 2010 (what's this?)

Mortgage Type	Today	Last Week	Change	Graph
15 Year Fixed	3.710%	3.816%	-0.106%	graph
30 Year Fixed	4.311%	4.340%	-0.029%	graph
1 Year ARM	3.059%	3.065%	-0.006%	graph
3/1 Year ARM	3.119%	3.127%	-0.008%	graph
5/1 Year ARM	3.123%	3.134%	-0.011%	graph

National Real Estate Market Snapshot

National Real Estate Market Snapshot

updated Monday, November 8, 2010

Listing Type	Median Price	Price Change from Oct
Homes for Sale	$179,900	-0.1%
New Homes	$283,000	-0.4%
Foreclosures	$154,000	0.0%

1 Year Market Value Change

• 1 yr
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See more city graphs & data at Zillow.com

3 ways low mortgage rates can work for you

By Sarah Max, contributing writerNovember 2, 2010: 5:56 AM ET

(MONEY Magazine) -- Just when it looked as if mortgage rates couldn't fall any further, they did.

Rates on 30-year fixed-rate mortgages (excluding jumbos) hit an average of 4.3% in September, the lowest level since 1953, according to Freddie Mac, and are still hovering below 4.5%.

Fifteen-year rates are even more mouthwatering: 3.8%. Mind you, those are averages. The most creditworthy borrowers can do even better, snagging rates perhaps a quarter of a percentage point lower.

So what's in this for you? A lot, potentially. If you have a credit score of 720 or higher and at least 20% equity in your home, you might use these crazy-low rates to shorten your mortgage term, free up cash, or even add to your real estate holdings, for example.

Whatever you decide, don't wait too long.

Home prices expected to slide another 8%

"The consensus is that rates will gradually move up in the new year," says Frank Nothaft, chief economist for Freddie Mac. Freddie projects that the average 30-year fixed will hit 5% by the end of 2011.

Get mortgage-free relief sooner

It's easy to see why more than a quarter of borrowers today are choosing a 15-year mortgage, according to analytics firm Core-Logic, up from about 9% in 2007. A 15-year lets you save in two ways: You get a rate that's about half a percentage point lower than that of a standard 30-year, plus you can save tens of thousands by retiring the loan in half the time.

Let's say you took out a $270,000, 30-year mortgage at 5.9% when you bought your house in 2005. You're paying $1,596 a month in principal and interest and now have a $250,000 balance.

Let's further assume that you roll $5,000 in refinancing costs into a new 15-year mortgage at 3.8% (so the loan is for $255,000). Your new monthly payment will be a heftier $1,860, but you'll save more than $147,000 in interest over the life of the loan.

What if you can't manage the bigger monthly bite? Refi to another 30-year and simply pay more in months when you're able to, assuming you're disciplined enough to actually follow through with that plan.

Given that few new mortgages carry prepayment penalties anymore, kicking in extra money shouldn't be a problem, says Keith Gumbinger, vice president of mortgage data tracker HSH Associates.

Caveat: If you have only a few years left on your current mortgage, or you plan to move soon, a refi may not pay off. Calculate how long it will take to break even on your closing costs, up to three years is typical.

Improve cash flow

Freeing up cash may be your biggest priority right now. Maybe you're trying to replenish your emergency fund after being out of work, or you have lots of high-interest credit card debt to pay off.

Maybe your twins got into Harvard, and you need to cover some of the tuition out of current income. Or maybe you see enough investment opportunities around that you want to lower your monthly payment and invest the difference.

In those cases, choose a 30-year loan. Using the previous example, if you refinance to a $255,000 30-year at 4.4%, you'll lower your monthly payment from $1,596 to $1,277.

True, you won't save nearly as much in interest as you would with a 15-year. But that's not so bad, says Matthew Keeling, a certified financial planner in Mashpee, Mass., as long as you do something smart with the extra $319 a month you'll save.

Double down on real estate

Do your retirement plans call for moving to a house near the beach or a cabin in the mountains? If you can afford another mortgage payment, you may want to start your search now, while rates are in your favor and prices are depressed. Ditto if you've been wanting to buy a second home or an investment property, says Jonathan Bergman, vice president of Palisades Hudson Financial Group in Scarsdale, N.Y.

Assuming you're buying the place as a true second home, lenders generally charge the same rate they would for a primary residence. But if you intend to rent the place out, even if just for a few years until you retire and you need rental income to qualify for the mortgage, it's considered an investment property.

And mortgage rates on investment properties are running about a half to a full percentage point higher. Still, the numbers are "pretty compelling," says Justin Krane, a certified financial planner in Los Angeles.  

New Listing / 525 W Washington Ave Unit 15, Lake Bluff

                      

    

The Right Time to Buy or Sell

The Right Time to Buy or Sell

With winter approaching, many homebuyers and sellers assume now is the time to put real estate matters on hold. That logic may have held true in years past, but in the current market the idea of hibernating for the winter may not be the best decision. Following are a few reasons why right now is the right time for both buyers and sellers to be in the market.

Good Time to Buy
1. Price - The #1 reason qualified individuals are reluctant to buy today is a fear that prices will fall. And they may. But according to arecent story on MSN.com, "it doesn't really matter in the long haul." Housing affordability is near an all-time high, and according to the S&P/Case Shiller Home Price Index, local prices have increased for six consecutive months through August.
2. Interest Rates - Mortgage interest rates are 30% lower than they were four years ago. When you layer today's rates on top of prices that are 30% lower, you get monthly principal and interest that is only slightly more than half of what it was four years ago. That's a big deal.
3. Less Expensive Than Renting - According to the latest Trulia.com Rent vs. Buy Index, it is less expensive to own a home in Chicago than it is to rent. The 50-city index is calculated using the average list price compared with the average rent on two-bedroom apartments, condos, townhomes and co-ops listed on Trulia.com.

Good Time to Sell
1. Buyers Are Serious - It may be fun to drive around and look at open houses on a beautiful summer day, but when the weather starts to turn and people get busy with holiday schedules, kicking the tires on a new home is usually the last thing on someone's mind...unless, of course, they actually need to buy. Sure, there are fewer buyers in the fall and winter, but the ones who are out there are serious.
2. You're Moving Up - The thought of losing equity on a sale doesn't appeal to anyone, but in this market, sellers who trade up have more to gain than to lose. That's because, dollar for dollar, the more expensive home they're buying almost certainly has come down in price more than the home they're selling, which means move-up buyers will actually come out ahead provided they have the finances to complete a transaction.
3. Less Competition - While inventories remain high relative to past markets, the number of homes for sale in the fall and winter is generally about 25% less than in the spring. In addition, the recent moratorium on foreclosures has kept thousands of homes off the market. Those homes will eventually be put up for sale. So if you can capture the last few weeks of fall, you will face less competition than if you wait until next spring.

If you're considering buying or selling, there are many more reasons why it makes sense to do so now. To talk about your specific real estate needs, call or e-mail me today. And please remember that I always appreciate your referrals.