Steve Hilton, CEO of Meritage Homes, believed that a decentralized business model for producing semi-custom luxury homes would shield his company from any major downturn in buyer demand. But a persistent housing recession wrapped inside an unraveling economy—which precipitated the nearly $600 million in losses that Scottsdale, Ariz.–based Meritage reported over the past two years—shook those tenets to the point where Hilton has made “strategic shifts” toward centralized management and entry-level construction.
These major tactical changes helped Meritage survive a home building recession that has taken down at least 75 companies and led countless other builders to slash their workforces, close divisions, exit markets, write down billions of dollars in assets, and suspend construction activities. Many of the other survivors on this year’s Builder 100 list made similar structural changes to their operations that position them to take market share in coming years. But when asked how long he’ll keep those changes in place, Hilton responds, “for a long time, but probably not forever.”
Therein lies a paradox that trails the collapse in the housing market: Are builders experiencing what Jim Loewenberg, co-CEO of Chicago’s Magellan Development Corp. sees as “The Great Epiphany,” which is spurring a reinvention of their businesses in a world transformed? Or are they moving “from a volume focus to a cost focus,” in the words of Dick Norwalk, COO of G.L. Homes in Sunrise, Fla., and doing whatever is necessary to survive a downturn of epic proportions only to resume business as usual once economic conditions improve?
Well, the recession certainly has turned conventional wisdom about land, debt, product diversity, and expansion on its head. It will be hard for builders to shake the memories of a year during which new-home sales were off from a weak 2007 by 37.5 percent, housing starts fell by 33.1 percent (and by 40.5 percent for single-family units), and building permits tumbled by 35.1 percent, according to Census Bureau estimates. New-home prices, competing against mountains of unsold existing houses and foreclosures, shrank by nearly 7 percent to an average of $230,600 and continued to fall through the first quarter of 2009.
“It’s a stupid business to be in right now,” says a frustrated Michael Lerner, president and founder of MCZ Development in Chicago, whose revenue fell by 80 percent last year. Bill Clark, owner of Bill Clark Homes of Greenville, N.C., which in 2008 closed about half the number of homes it closed in 2006, thinks that anyone making money “is a genius. We’ve tightened every nut. But right now, nothing’s working.”
BUYERS WERE SCARCE: Total closings of single-family and condominium dwellings declined last year by nearly one-third to an estimated 586,000 units. And for the second consecutive year the BUILDER 100 saw their closings, as a portion of that total, get smaller, as many companies reported double-digit cancellation rates throughout the year.
Some builders recognize the need to break from their pasts to prepare for the future. “Builders should be asking themselves ‘am I a merchant builder or a land developer?’” says Doug Bauer, the former COO of William Lyon Homes of Newport Beach, Calif. (See “Rules of Engagement”) But other builders see their survival so far as validation of their flexible business models, regardless of how much money they’ve lost. “I don’t think there’s anything we would change,” says Jeff Mezger, CEO of KB Home. “Our model has worked well for us during the down period, and we think it will be a real differentiator when things turn around.”
Mandatory Multitasking
While most builders contacted are content with their companies’ business models, they are also spending a lot of time fixing potholes that the recession has deepened.
“We had too much fat, and we wasted a lot of money on advertising,” says Clark, whose company has discontinued all newspaper ads. Craig Perry, owner of Centerline Homes of Coral Gables, Fla., is scrutinizing every aspect of his business today because “margins are thinner and mistakes are more relevant.” Centerline reduced its workforce to 63 people from 150 at its peak and is asking its remaining employees to “pick up the slack.” Indeed, as builders get leaner they must rely on fewer people doing more.
Park Square Homes reengineered its newer homes to lower their prices, says CEO Suresh Gupta.
Orlando, Fla.–based Park Square Homes was paying its six area managers $200,000 to $300,000 each. But when the recession hit, they suddenly became expendable, says CEO and co-owner Suresh Gupta. Senior-level management got more involved in day-to-day operations, “and we uncovered tremendous talent among our rank and file, which we hadn’t seen before,” he says. Rausch Coleman Homes of Fort Smith, Ark., has its managers handling multiple areas, and some employees are even cleaning its offices at night, says president and CEO John Rausch. Meritage’s divisional presidents are in the trenches, too, after the builder eliminated “a lot of vice presidents,” says Hilton.
Still, some builders are wary about cutting too deeply into bone: G.L. Homes has resisted laying off its “core” people, says Norwalk, because “we don’t want to be a shell of who we were when the recovery comes.” Desert View Homes in El Paso, Texas, has been hiring and has had luck attracting laid off workers from other companies who wouldn’t have considered relocating there during the housing boom.
Low-Price Limbo
Desert View’s CEO Randy O’Leary says his company has been “shoring its foundation” by replacing outmoded process software, some of which was a decade old. But one area this builder is still working on is its pricing. The recession has left builders scratching their heads about what price/size/quality equation will get buyers off the fence when, observes Mezger, “the price points of today are the market going forward.” Even though Desert View is an entry-level builder in its markets—El Paso, Las Cruces, N.M., and Colorado where product changes helped lower prices by $26,000—“we have to figure out how to cut our costs by a minimum of 10 percent,” O’Leary asserts.
THE CHOSEN FEW: Only six of the BUILDER 100 increased their closings in 2008, led by Omaha’s HearthStone Homes, which may have benefi ted from that metro’s low unemployment rate. The collapse of Chicago’s housing market, on the other hand, did in MCZ Development last year.
The notion that builders selling affordable homes would fare better in a recession imploded when companies such as Choice Homes and C.P. Morgan Communities, which featured low-priced houses, couldn’t make it. But affordability will be a marketing imperative for builders as long as their areas are inundated with foreclosures, which are what KB is combatting with its low-cost Open Series homes. Park Square has reengineered its newer houses so that their average price is $250,000, from $400,000 at peak when, says Gupta, “we ignored affordability, we ignored people’s incomes, and just kept building.” Some of Park Square’s new homes start at $150,000.
Before it opened a resort community in Kissimmee, Fla., Park Square spoke with local brokers about what they thought would motivate buyers. “We were told that buyers want the least amount of monthly payments,” says Gupta, “So we decided not to build a clubhouse and went back to the cable company to unwind a contract that made it compulsory [for homes to accept] cable.” By doing that, Park Square helped bring down monthly HOA fees to $125 from what they would have been—$300—with those amenities.
Builders have also been able to lower their construction costs because their relationships with subcontractors have strengthened during the recession. “To get your prices in line, you’ve got to bring your trades into the picture,” says O’Leary. MCZ’s newest homes are 20 percent smaller and 25 percent less expensive after it hired contractors and engineers with experience in building affordably.
Show Me the Money
Building anything, though, is difficult when banks won’t finance projects.
HIGH-RISE HOPE: Magellan’s Jim Loewenberg (right), with co-CEO Joel Carlins.
Lerner says banks are funding only those projects “they are comfortable with,” such as a second-home community MCZ is building in St. Joseph, Mich. But Steve Roberts, CEO of McCar Homes in Alpharetta, Ga., also notices an attitude adjustment among banks away from blaming builders for their financial problems and toward “trying to find ways to keep preferred builders operating.”
That being said, a growing number of builders have concluded that they must recapitalize, but they wonder how. In February, Atlanta-based Ashton Woods Homes restructured $125 million in debt by turning over 20 percent of its ownership to bondholders. Around the same time McCar, whose financing comes in part from a 10-bank syndicate, was attempting what Roberts calls a “full-scale restructuring and recapitalization.” Roberts doesn’t think many private builders can survive unless they recapitalize. “There’s no equity left in their companies, and they will continue to feel downward pressure on prices.”
But where will that money come from? Magellan, which owns enough lakefront property to put up 10 more condo buildings, was looking overseas to formalize an arrangement with a South Korea–based company that helped finance three previous projects, says Loewenberg. Clark, though, says private equity is too expensive. “My company has $50 million in net worth, and a partner would want to come in, put up $12.5 million, and expect to get half of the company.” Mark McMillin, CEO of The Corky McMillin Cos. of San Diego (which recently negotiated three bank-financed construction loans for projects in California’s Central Valley), says investors will put up as much as 80 percent of a project’s equity in exchange for half of the profit. But some want to be in and out of deals within three years. “We tell them that’s not possible, at least in the first round of financing.”
McMillin, like other builders, is generating cash by building out subdivisions for banks with distressed assets. His company is under contract with one bank to complete 58 projects in California and Arizona, each of which includes between 70 and 100 homes. In one project for which McMillin is completing, Bank of America has nearly 1,000 lots. Another 97-lot project, which a previous builder abandoned, had streets and sidewalks installed “and tumbleweeds 4 feet high,” McMillin says.
MIDSIZE MISFIRES: While big builders got all the press last year about their business losses, those ranked 51 through 100 actually took a much bigger percentage hit in their number of closings from the prior year.
When its lender told Desert View that its ratios were out of whack, the builder recapped its New Mexico and Colorado divisions out of its cash flow, says O’Leary. A number of other builders are trying to figure out how they can self-finance, too. “We need to make do with what we’ve got,” says Hilton about Meritage, which has $200 million in cash and a $112 million rebate coming from the government.
Growing In One’s Backyard
The recession is also forcing builders to rethink where they will build. Centerline has been exiting second-tier markets such as Fort Myers, Fla., where, says Perry, “the only job growth was from the construction industry.”
SALES DRAIN: A spiraling high-rise condo market didn’t faze Novare Group, which specializes in that product and led a handful of BUILDER 100 companies that showed revenue gains last year. Several of the builders that reported jaw-dropping revenue declines have signifi cant exposure in foreclosure-heavy areas such as California, Arizona, and Florida.
While a few builders, such as G.L. Homes, are looking for development opportunities, most have lost their appetites for purchasing and developing raw land, especially when the recession is likely to leave a ton of low-priced finished lots available.
Roberts fears that companies such as his will be at the mercy of big public companies that have the financial clout to scoop up those bargains. “We’ll come in and pick up lots for $60,000 that the big publics purchased for $30,000,” he says. But large builders are having second thoughts about their land and growth strategies.
Between 2002 and 2005, KB expanded to 39 markets from 17. Now, in its current 29 markets, where it built 29,000 homes per year at peak, KB thinks it could eventually build 50,000 units. “We need to maximize those opportunities instead of looking to open seven new markets all the time.”
Park Square’s Gupta admits he “got caught up” in trying to keep pace with national builders in Florida. Now, with 1,300 finished lots, Park Square isn’t clamoring for land deals. What the company has learned from this recession, says Gupta, is that “we can grow at our own pace and be successful.”
Rules of Engagement
How one former home building executive would restructure his company to align with market realities.
After more than 21 years with William Lyon Homes, Doug Bauer resigned as that builder’s president and COO in March to spend more time with his family and pursue personal interests. Before he left, the 48-year-old Bauer shared his thoughts with Builder about what “core disciplines” he’d follow if he were reinventing a home building company, in light of current economic conditions:
1) Maintain no more than a 50 percent debt-to-capitalization ratio.
2) Purchase land with low leverage through options and from land banks.
3) Maintain a true two-year inventory. “And it’s okay to be short,” he says.
4) Structure liabilities with short- and long-term debt instruments. “What’s keeping a lot of builders alive today are bonds. It’s the same thing as the auto industry.” The challenge for a builder is generating enough cash to get out from under its bond obligations, especially when the bonds builders floated were based on volume expectations that “are nowhere near today’s.”
5) Be opportunistic about growth. Stick to transportation corridors but don’t get locked into one or two customer bases. “And don’t just go for market share.”
6) Whenever the market turns, “move quickly to monetize assets.”
7) Place greater emphasis on ancillary activities-such as doing general contractor work or having supervisors or warranty specialists do inspections for resale brokers—“so that your employees have something to do when the housing market goes bad.”
8) “Try not to be so naive.”
In From The Cold
Will the Pulte-Centex deal thaw a frozen industry?
When news leaked out late last year that TOUSA was in talks with Standard Pacific about a possible asset sale, some industry watchers must have thought that, finally, an industry with too many builders to begin with, and so many that have failed or are bankrupt, would start to consolidate big time.
But while a few opportunistic companies had seized upon distressed assets, the recession had generated scant merger and acquisition activity on the housing front. That trend seemed to be confirmed when TOUSA and StanPac stopped talking in February.
2009 might tell a different story, especially after Pulte and Centex merged in April, creating what is by far the largest home builder in the country. Those builders’ aggregate $11.6 billion in revenue and 39,000-plus closings last year are double the volume and nearly 40 percent more in closings than what D.R. Horton posted for 2008 and will likely knock it from its top perch in next year’s Builder 100 ranking.
Richard Dugas, Pulte’s chairman and CEO, characterizes this merger as a marriage of remarkably similar builders that, as one, would be able to reduce debt, cut costs, and return to profitability quicker. And while Dugas insists that supersizing Pulte wasn’t what motivated this $3.1 billion deal, the combined company has $3.4 billion in cash to play with and now operates in 59 markets in 29 states and the District of Columbia.
The new Pulte’s home building business also has an estimated $6.2 billion in debt. Its debt and land positions could prevent other besieged builders from finding merger partners. And some analysts still suspect that Pulte-Centex could turn out to be a one-off deal, especially when the market caps of several public builders remain stubbornly below their cash holdings.