6 Lessons For Builders From the Housing Bust

The economy shrank by 6.1% in the first quarter of 2009, so the recession is far from being over. But as consumer confidence slowly returns, and as the deterioration in home sales finally abates, it might be a good time for builders to look back on their industry’s performance over the past three years, learn from past mistakes (or rare successes), and adjust their own strategies to avoid—or at least minimize—the damage from future cyclical downturns.

Builders can’t control some negative factors—such as the 5 million American jobs lost since the end of 2007. But in many ways builders predetermined their own recessionary destinies during the last housing boom, when they let slide so many elements of their operations—sales training, customer service marketing, trade-partner relations, and supply-chain management—and instead pursued frenzied growth by accumulating land and building homes whose escalating values were never supposed to recede, much less crash, to where they are today.

Many builders would argue that recessions come and go, and this one, too, will pass, so why make dramatic changes? But many of these same builders have called this recession the absolute nastiest they’ve experienced, and no one wants to go through this again. So, to help readers who want to avoid such scenarios in the future, BUILDER has assembled six “lessons learned” from the housing bust, based on our reporting since last fall, when the economy took a severe turn for the worse.

Some of these strategies would require simple changes. Others are more complicated to achieve. All of them, though, do ask builders to muster the guts and the vision to look beyond the status quo, and be flexible and open to new ideas for operating a home building business for the long term, through the booms and the busts.

Small Blessings. Neal Communities in Florida is among the builders that are attracting customers with smaller, less-expensive cottages.

1. Build Smarter

When K. Hovnanian unveiled its high-performance Building America Concept Home earlier this month, it took a bolder step onto a path towards energy-efficient construction that more builders are also now walking.

Building efficient homes makes business sense in what’s shaping up to be a tougher regulatory climate. As such, it's not surprising to see more builders promote their “greenness.” Lennar and Concordia Homes are among the builders that have made solar panels standard for certain of their communities. Artistic Homes in New Mexico has spent the last decade moving towards its ultimate goal of building net-zero-energy homes exclusively. And then there's Centex and Pulte, whose merger brings together two companies whose homes have garnered recognition for their energy-saving features.

Environmental concern is also manifesting itself in builders’ and buyers’ increasing interest in transit-oriented development. The one drawback so far has been that land around transit centers is usually so expensive that homes built near them get priced beyond the reach of low- and middle-income buyers who need public transportation the most.

Building smarter means more than just incorporating energy efficiency; it can also mean building smaller to keep pricing competitive. Many builders have downsized and reengineered their products to lower their sticker prices, with positive results. Neal Communities in Florida, for one, has been featuring cottages that start at 947 square feet and $109,000, and enjoyed its best first-quarter sales in three years.

But builders who add affordable choices to a development's offerings need to be prepared for pushback from existing owners, as KB Home has encountered from residents in two San Antonio communities who complained about KB’s plan to build smaller, lower-priced homes there.

Takedown Tactic. Having impaired billions in real estate holdings, more builders now favor a “land-lite” position.

2. Limit Your Land Holdings

“I never expected to write off all of my options.” That’s Steve Hilton, CEO of Meritage Homes, singing the blues in chorus with countless other builders whose outsized land positions became untenable as the housing market spiraled downward.

There’s been a lot of envious chatter lately about how NVR’s land-lite business model allows it to remain profitable during tough times. And it’s hard to dispute that, over the past decade, too many builders bought too much land, paid too much for it, and suffered the consequences when home buyer demand evaporated. Devalued land assets contributed to the bankruptcies of numerous companies, including Kimball Hill Homes and Legend Homes.

The problem is that no one knows for certain what amount of land is right, or at what price. There’s no measure that can be applied universally, because the level of acceptable risk varies from builder to builder. Even today, big builders and developers continue to purchase land “opportunistically” and haven’t been dumping pricier assets at discounted prices to the extent some investors had predicted. In fact, it’s inconceivable that some builders would ever wean themselves entirely of their land addictions, especially those that made a ton of dough from their land assets during past booms.

But it is equally unlikely—at least in the near term—that many builders will be eager anytime soon to “gorge at the buffet table,” which is how Jeff Gault of LandCap Partners describes builders that, intoxicated by the scent of escalating land values, bought everything that wasn’t nailed down when business was robust.

Now the recession is forcing builders to take a considerably more conservative approach to their land holdings. Some already have erected walls that separate land acquisition and development activities from construction, to get a truer perspective about the value of that land, what their companies will need to build on, and what and when they should sell to other builders.

For the moment at least, quite a few builders say they are traveling the merchant builder route and are looking for economical finished lots they can take down as demand dictates. That’s music to the ears of land investors and developers that are already acquiring real estate in markets such as Dallas and Phoenix with the intention of reselling finished lots to builders once the economy improves.

Fleeting Financing. With banks on the ropes and reluctant to lend, builders are grasping for capital where they can find it.

3. Find New Cash Streams

“Money doesn’t talk, it swears,” wrote Bob Dylan. And more than a few builders over the past few years have muttered obscenities about lenders whose fealty disappeared once the value of real estate that backed these builders’ debt withered.

Despite the massive federal bailout of a crippled banking industry, builders and contractors still find themselves scrounging for credit, and lenders’ rigid stance has driven numerous companies into bankruptcy. “A substantial recovery in housing of the kind that’s required to help get the national economy back on its feet will not happen until the logjam in AD&C [acquisition, development, and construction] lending has been broken,” wrote NAHB’s chief economist David Crowe this month.

As more builders conclude that they must recapitalize to emerge competitively from the downturn, they are also realizing that they will need to find capital from someplace other than banks, especially if sales don’t eventually return to previous levels.

Some of the traditional equity sources are out there, hovering. Bondholders recently took a 20% ownership stake in Atlanta-based Ashton Woods Homes in exchange for $125 million in debt. Magellan Development has been working out a financing deal with South Korean investors. But going overseas doesn’t guarantee salvation, as John Laing Homes discovered when its parent, United Arab Emirate-based Emaar Properties, pulled the plug on its financing.

The recession is compelling builders to explore new ways to generate cash flow. One solution that’s gaining popularity—a sign of the times, but perhaps viable even after the economy rebounds—is to build out communities for lenders that recovered those assets in foreclosure proceedings from other builders. For example, this month Warmington Residential agreed to build and sell more than 500 homes for a private equity firm stuck with that real estate and to provide due diligence and asset management services for three national banks.

Quick Action. Bowen Family Homes is among the numerous builders that responded swiftly to rising unemployment by offering buyers job-loss mortgage protection.

4. Respond Quicker to Market Conditions

How many builders have claimed that they were totally caught off guard by the freefall in housing demand? And how many builders have stated confidently that they will return to what they were doing before that collapse once the recession subsides?

Some companies, like Stanley Martin Homes in Virginia, started downsizing their businesses at the first signs of trouble in early 2007. But if the latest economic chaos has taught builders anything, it’s that too many are still practicing home building as if it were religion: sacred, immutable, and driven by an unshakable belief that things will eventually normalize because they always have. That faith has led too many builders to use the industry’s cyclicality as an excuse for their own inaction and inertia.

But faith alone isn't cutting it these days, at least not in the housing business. (Just ask the bankrupt or out-of-business builders who now admit their companies waited too long to seek professional crisis management help.) And builders’ optimism has, for too long, gotten in the way of their formulating contingency plans.

The irony is that when builders are pushed up against the wall, they can be nimble. Look, for example, at the builders that suddenly rolled out mortgage protection programs to give customers worried about losing their jobs the comfort to buy. Just this week, Taylor Morrison launched its “Rest Assured” program, which gives new buyers with FHA or VA loans a six-month grace period if they get laid off.

Change, for many builders, starts with renewing their acquaintance with customers. Raleigh, N.C.-based Savvy Homes expects to sell 150 homes this year, from 98 in 2008, after shifting to a marketing-driven platform, which it launched in January, that dictates Savvy’s production and allows buyers to get more involved in the design of their house. Lennar is among the builders that stay in constant contact with their buyers and communities through social networks such as Facebook. And at least two builders—Trend Homes and Dominion Homes—have held out to their customers the stick of sweat equity during the building of their houses for the carrot of shaving their downpayment requirement by at least two percentage points.

All hands on deck. Fewer employees doing more jobs need encouragement and better training.

5. Value Your Workers and Trades

In the aftermath of what have been devastating workforce reductions for many home building firms, employees who remain and constitute their companies’ “core” are being asked to wear more hats. The recession is teaching builders the value of cross-training their associates for cost savings, efficiency, and maintaining esprit d’corps during trying times.

The downturn is also giving builders a deeper appreciation for their contractors and building product suppliers. That wasn’t always the case: when the housing market started tanking, big builders in particular bragged about the concessions they were exacting from their trades. But when subcontractors started going out of business in droves, builders had to rethink those high-pressure tactics.

In the process, they realized how contractors and suppliers can contribute to helping them value-engineer their products and keep their homes competitive in the marketplace. “To get your prices down, you’ve got to bring your trades into the picture,” says Dennis O’Leary, CEO of Desert View Homes.

Pulte, Corky McMillin, and Ryland are among the builders that have brought their subs into the process and have enjoyed positive results in their construction costs and cash flow. Jagoe Homes in Kentucky is living in the best of both worlds, by having its associates and trades form “lean teams” to find and eliminate operational waste.

Life Rafts. Mixed-use and commercial construction has buoyed some builders during the recession.

6. Diversify Beyond New-Home Construction

Earlier this year, Centrum Properties started its first industrial-to-industrial project, a $23 million renovation of a distribution center in South San Francisco. “This was an opportunity to take an existing building and add value,” said Centrum’s vice president of development Michael McLean.

It is also an opportunity for Centrum to keep busy during a recession that has paralyzed other builders that are seeing, once again, how confining their business model to building single-family houses within suburban subdivisions can be a severely limiting proposition when housing demand craters.

Few builders, though, ever diversify. Public companies resist because analysts and investors prefer “pure” plays with uncluttered balance sheets. Other builders don’t want to commit the time and expense necessary to develop the expertise needed to compete outside of their comfort zones. Multifamily construction or property management—to name two potential areas of long-term diversification—have cash-flow, profit margin, client service, and warranty parameters that are unfamiliar to many single-family firms.

Still, there are several builders and developers—Toll Brothers and The Bozzuto Group come to mind—that do more than just build single-family houses. And it makes sense for companies in a cyclical industry to be ambidextrous. Take Sares-Regis Group, a mid-rise builder that had the construction disciplines in place last year to switch gears to for-rent projects that its officers hope can carry it until demand for for-sale homes perks up again.

Diversity can be accomplished in stages, such as a builder that follows green construction standards as the first step towards integrating smart-growth commercial elements into a community—retail shops, groceries, offices—to reduce auto traffic and air pollution. “Mixed use is the real green,” said Robert Cogan with the New Jersey-based architectural firm BartonPartners.

But most builders still consider diversity as a temporary supplement to their new-home construction that isn’t too far afield from it in terms of complexity. Fulton Homes, T.W. Lewis, and Encanta Construction (which rose from the ashes of Hacienda Builders) are among the many builders that now accept remodeling jobs as a cash-flow maneuver.

As it waited to get its $3 billion, 7,000-home Sanctuary master-planned community in Stockton, Calif., off the ground, The Grupe Co. focused on mini-storage construction and rental, a reliable, profitable and relatively simple ancillary business that a smattering of other builders now embrace.

John Caulfield is senior editor at BUILDER magazine.