The Update

In early August I wrote that we’d have to wait and see whether we could get the pig (specs we’d started) through the python without significant discounts. Up until the last two weeks, it seemed so far so good. Now, however, reports from the field are pretty bad in real time. And the economic backdrop looks more perilous by the day.  

People who were saying “as long as rates don’t go over 6% ...” are now saying “as long as rates don’t break 7% ...” But it certainly does not look like we’ll have a soft landing. Maybe bumpy is possible, although I’m losing faith in that. But we’re all just guessing. No one knows. I suspect [Fed chairman Jay] Powell isn’t sure either.

Sometimes it helps to separate our thoughts into categories.

What I’m confident of:

• House affordability cratered in the LTM between rates and prices.  No easy or fast fix for this.  Prices will adjust, products will be changed and it all takes time.
• It’s going to be hard to get people to move who have sub 5% mortgages unless rates fall a lot.  Probably can’t fall a lot without a recession.  So, move up housing will have to really offer something different. In the mid-90s after the aerospace collapse crushed southern California, a design revolution in production housing started with really innovative products that gave people a reason to move. We may need something like that again.
• Public builders are in the best financial shape they’ve ever been in.  No one is bulletproof, but most of them are close.  So, while they can’t ignore investors and the market, they will not be dealing with cash flow, debt or other stresses.  And the market has already beat their stock up like this is the end of the world, so in some sense they’ve already taken their pain.
• It’s nearly impossible to underwrite a deal of any size right now.  What will absorption be?  Where will prices end up?  At the same, it’s much too early for land owners to capitulate.  So, I’m not expecting much to happen for a while.

What I believe, with limited confidence:

• I don’t see the public builders allowing a big drop in volume next year in order to maintain price stability. They’d rather maintain volumes at a reduced level, say 10-20%, and have much lower margins, than 40% lower volume and higher margins. So, they are going to start homes to achieve that (see Lennar’s latest comments about start pace) and do what it takes to sell homes. Outside of some protected niches/locations, the rest of us will to a large degree have to follow their lead.
• We’ll see some M&A. While everyone who sells their company will wish it was last year, the reality is, it’s hard to shrink a private builder without overhead eating you alive, secured lenders take a big chunk of the closing cash flow, and your mezz lenders/pref equity, equity partners will take the rest in many cases.  Where does the capital come from for new deals, until (if) there is blood in the water?  A public builder can buy an asset priced fairly, but probably not at the bottom, if they need it.  You can’t raise capital for that.  So, some will decide it’s not worth grinding it out to the other side of this.
• The industry as a whole was fairly prudent this cycle. There are always exceptions, and we all make some mistakes, but lending has been conservative, publics de-levered, etc. I wonder about some of the larger land bank deals with lots of term, and especially some of the new people in this space. That did get a bit aggressive and there is not much room for error in that business. But overall, hard to tell what kind of price/absorption drop would be sufficient, or duration of whatever we go through, that would provide significant great opportunities. But there will be good ones at some point.

What I have no confidence in:

• How far will Fed raise rates? Will they pause if inflation is dented, or drive it all the way down?
• Mortgage spreads are high relative to treasuries, but the Fed is stepping up its MBS asset reductions, leaving more supply for the market. What does that add up to?
• If the Fed does what they are saying they will do, can we avoid a recession?  Will the government step in to money-whip a recession, when part (not all) of the reason for inflation was the previous money-whipping?
• How will geopolitical events affect all this?

So how do you build a business plan with no confidence in the big picture?

Yellow Pad Time, Then Action

I think you start with the basics. Evaluate your strengths and weaknesses, positioning of your projects, stability of capital, etc. Always start with looking at your assets and cash flow with a simple yellow pad calculation. You can learn a lot fast, just by sketching out basic numbers. It’ll keep you centered on core issues.

What is the worst outcome for your business that you could accept (not be happy with, but accept)? Reverse engineer what level of sales and pricing in your markets create that outcome. Does that seem unlikely, or a real risk? That will tell you how you have to treat your own resources and how much room, if any, you have to be optimistic/opportunistic.

Evaluate your assets, capital providers and people with a ruthlessly clear-eyed view. So easy to say and so hard to do. Ask the classic question – what would my successor do? Eliminate the baggage of your own history and emotional connections. What would a new person with lots of experience and no personnel connection think of what they see?  I’m not sure there is any piece of advice more important than this. Find a trusted source to help you with this if need be. Who will tell you stuff you don’t want to hear.

If you’ve got partners always double check if your interests are aligned. And if not, you’re better off reworking a deal in a way that sticks in your craw than to carry on with people who are unmotivated.

I once heard a great investor state that he always changed operators when conditions deteriorated, because the odds were completely against an incumbent operator being able to look at the project with fresh eyes given new conditions. Or being happy with the existing deal. Don’t wait to hear it from them – deal with it and prove you do have clear eyes.

It’s trite, but true. Over-communicate with your capital sources. It almost always helps, rarely hurts, and if nothing else, it's always worth points if the relationship is over and new people are calling your old sources for a reference. Remember the capital providers have their own stresses/problems. Some have young people who have not been through this before. Don’t assume they know how to properly read your financials, project projections or reports and convey the right message. Talk to them.

One of the worst phrases in our industry is “but we have to hit the business plan." A plan is just a projection and a set of goals that were produced in a specific environment with assumptions about the future. None of which is valid anymore.  It’s one thing to make decisions that are not optimal for the long run if cash flow, debt covenants, etc. make it necessary. We all do what we have to, to survive. But making poor long decisions because of a piece of paper produced last year makes no sense.

I’m hearing about opening projects for sale early, before models are finished, landscape/entries done, etc. due to fear of missing a few sales you’ll need. I think that’s wrong. Open when buyers can see how great what you are offering is. We have a payment problem, but we are also developing a confidence problem. Confidence won’t be helped by buyers seeing you not at your best. A few sales are nothing compared to a good opening and momentum.

If you find a problem or area of underperformance in your company or project, sorry for being crude, but never assume there is only one cockroach. Almost every time I’ve stepped into a situation with a real problem, and initially ignored other areas that had not evidenced problems (yet), I’ve regretted it. Don’t take anything for granted. If nothing else you’ll sleep better knowing you truly isolated the issue(s).

You’ll be going up against time to do all this. So, extraneous stuff has to be jettisoned and if you have the money, don’t hesitate to hire experts in areas to help you investigate it. We have a tendency in this business to be penny wise and pound foolish when it comes to getting help/measuring twice and cutting once.
Never rob Peter to pay Paul. There is nothing sadder and more damaging than seeing a basically good person start moving money around between projects in the genuine belief it will save the company and make everyone better off. And then waking up one day when it collapses and asking “how did I end up here?”

For those who’ve been around a while, I’ve said nothing new or novel here. But it never hurts to remind ourselves of the basics and we have a lot of people on our teams who do not have these hard-won lessons. It’s a teaching moment.
Celebrate the little victories and maintain a sense of humor. It’ll be a slog; everyone needs a laugh and sense of accomplishment.

Oh, and I’ve found good whiskey is cheaper than good wine.

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