There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says 'Morning, boys. How’s the water?' And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes 'What the hell is water?'" - David Foster Wallace, This Is Water

We often are so busy navigating our day-to-day challenges, we can fail to comprehend the gradual changes in our environment, or the water we swim in. Our housing markets across the country have been rapidly changing and if we don’t change with it, we risk being the proverbial frog in boiling water. This article lays out some of the major features of the water we swim in today, what it might mean for us, and what we might do to thrive in it.

Demand

• Fannie Mae (among others), declared not long ago, we are 5 million units short
• Ivy Zelman declared we are headed towards new residential units oversupply

Who is right, why do they disagree?

How do you calculate demand?

• Change in vacancy – generally at record lows, supports undersupply argument (FM assumes vacancy will revert to mean, which requires more supply).
• Headship rates – generally very positive for household formation for the next decade.
• Population growth – abysmal, implies very low demand.
• Immigration – was way down, has recovered a bit, necessary when looking at our demographics – and a highly toxic topic. And what kind of immigration? It matters for whom we sell/rent to.

What is flawed in all the approaches?

• Demand is impacted by price. Price does equilibrate. Move up the price curve, move down the demand curve. We need to stop saying “they have to live somewhere.” When they can’t afford it, somewhere is not what we produce.
• All the calculations above are net, not gross. If someone in Cleveland has a job and a house and moves to Austin for a new job and buys a house, we need another house. You cannot move the one in Cleveland to Austin. But when you calculate these figures at the national level it all nets out. Real demand adds up market by market. 25 states in America are shrinking in population. We do not have a national housing market; we have growing, stagnant, and shrinking areas (and variations within submarkets).

Supply

Entitlements

Every major city in the US has a longer and more difficult timeline for entitlements than 10 years ago. In most cases, a great deal harder. The trend line is clear and seems inexorable. Time and certainty of outcome have deteriorated. In the west, fire and water are increasingly weaponized, and where can you go that traffic, school crowding, greenhouse gas emissions are not the reasons given by NIMBYs why we should not approve a project?

But what about the greatly intensified focus on housing in this country?

• It is getting way more focus than ever before
• There are some green shoots – Oregon and Portland’s reforms, Minneapolis, ADUs in California, etc. Will state law effectively trump local control? Even if technically possible, will it fail in practice as local jurisdictions find ways to slow/stop growth?
• What do nearly all of the efforts have in common? The arguments have not been around a mathematical practical analysis of what it would take to “solve” the problem. And our industry is not a meaningful participant in the discussions. What has resonated are social arguments around justice and equity.
• But I’ve yet to hear a reasoned analysis in a community of how to actually create enough supply to meet demand. The accepted narrative is: There is good housing – Transit Oriented Development and ADUs (gentle density) – and bad housing – SROs, manufactured housing (unless it already exists, then it's precious), boarding houses, suburban car-oriented development. There is no mathematical way to get to a balanced housing market using only some of our options. I’ve seen no ground swell for the medium density suburban housing that must be part of a real solution.
• For those who see the solution in expanding non-profit developed projects, you have to ask the question: Since homebuilder margins are typically 7-10% on a long-term basis, and even non-profits get substantial fees, would reducing the price of units by a net 5% change anything?
• And someone has to build an increase in units. We don’t have enough labor as it is, there is no evidence young people have been convinced to start going into construction trades in large numbers, and there seems to be no appetite to greatly expand immigration.

Capital Markets

• A very wise man, Doug Neff, told me years ago the more capital our business attracted, the more volatile it would get, as so much of the money comes from sources that can come and go quickly. He likened it to a bath tub, where it does not take much tilting of the tub back and forth to slosh the water out. I think he was, and is, right.
• Banks now have so little concentration to homebuilding and land development that they can actually leave the industry without crippling their business. Private Equity, Hedge Funds, Mezzanine funds, etc. can simply move to another asset class.
• There are only two stable sources of capital. Your own equity, and long term low- or no-covenant unsecured bonds.

So, what does that all mean?

• There is no national housing market. There is a national mortgage market, which ties the markets together for periods of time.
• Simply my opinion, but I tend toward the lower demand estimates, but even lower supply over time, resulting in a lowered rate of home ownership. A permanent housing shortage in high growth markets. Think California.
• And an aspect as critical as undersupply are the extended timelines in the business. Not just “discretionary” entitlements, but simply processing of plats, engineering, systems, development time frames, home building cycle times, etc.
• More market share for public builders. That trend will continue.

Implications for home building and private builders?

More volatile housing markets, subject to price corrections.

When demand rises, it takes a long time for the supply response to kick in. The time lag is years, during which, prices rise beyond incomes as housing becomes a scarce good. And the very fact that house prices are going up encourages buyers to buy now. So higher prices create more demand – at least until they don’t.

An extended period of price increases will create more supply than anticipated:

• Higher prices and higher absorption make bigger deals pencil than did before
• Land sellers holding out for a price, finally sell
• The price differential from closer in to further out gets high enough to make further out work
• Projects that were infeasible due to conditions of approval now become feasible
• More people try to get projects approved (with bigger bottlenecks at the city/county)

Price increases really are the cure for high prices – in the long run. At which point we often deliver the new supply at the moment we don’t need it (at least at that price point).

No one has found a reliable metric for how high prices can go before the buyer strike sets in. When this process is under way, there is no way to know when it will end, and the end is often fast.

As land value goes up, the value of maximizing product/density decisions can eclipse cost control of a house (not that it does not matter). If you are building in California and a lot is 50% of revenue and direct costs are 25%, the penalty stroke for being 10% wrong on house cost is 2.5% of revenue. Bad, but your proforma will live. When a lot is 20% of house price and directs are 55%, a 10% house cost bust is 5.5% of revenue. You are done. And the higher the land is as a percent of revenue, inflation is more your friend, and the value/imperative of velocity goes up.

And within this process lies some very bad math for your batting average:

• When the cycle starts, prices and absorption are lower, so deals are smaller.
• As the cycle plays out, prices and absorption rates increase. Deals get bigger (sometimes exponentially bigger) over time.
• Your early victories are smaller in size than your mistakes at the end.
• 8 victories early offset by 2 losses at the end is not a true 4:1 ratio of success (dollar-weighted).

That all adds up to a lot of volatility – Yikes!

• Longer time frames to bring projects to fruition means you simply cannot meaningfully grow on retained earnings anymore.
• Erratic and long time frames to achieve project approvals and shovel ready projects mean maintaining anything like a predictable flow of units through a small or medium sized builder is nearly impossible. So, periodically, overhead will eat into profits.
• Starting and growing a company requires leverage and you simply can’t de-lever while you’re growing.
• More volatility means it takes lower leverage levels and higher liquidity to survive in the long run. Builders used to think 4:1 leverage was ok. The reality is it takes 2:1 to survive most downturns and it's 1:1 to survive serious ones. That is incompatible with growth, absent raising very long-term money. It takes a more and more conservative balance sheet to survive in this business.
• Public builders, as a group, have improved operations and de-levered to the point they can survive nearly anything and are in fact cash machines when they stop buying dirt. Those borrowing on a secured basis are anything but a cash machine when times are difficult. This means the publics can always keep building if they chose to, and will be buyers early in a recovery. So, it is possible land, at least land ready for building, will not be as volatile in downturns as it was, which is both good for those delivering land and bad for private builders looking for distressed buys at awesome values. And the public builders will be less likely to dump much land – they won’t have to.

What’s a builder to do?

Before it sounds too discouraging, all of this has applied to California for years, and people make money there. Society sets the rules of the game and we just play. And volatility does produce profits (part of the time).

• Capitalization, as always, is key. Capital has to match your risk and time frames. Easier said than done, but I constantly see people taking the cheapest capital, not the best capital.
• Flexible overhead. One of the chief problems in our business is how much we do in-house. We’re our own GC’s and marketing companies. And we all know you need great people in our various disciplines, regardless of whether you have 5, 50, or 500 projects to leverage them over. Scale, particularly local scale, helps to pay the best people. It also helps even out some projects being behind schedule.
• In commercial real estate, you can outsource construction to Turner to build your building, CBRE to lease it, etc. The ratio of overhead to projects is much less, and more flexible. Which makes it easier to manage erratic volume. A great deal of the overhead in our business comes from being our own general contractors. Not just our construction personnel, but fractured and less sophisticated subs (often, not always) than in other parts of RE, more purchasing people, more accounting people for the multiplicity of subs, etc. It ripples through the whole company.
• Off-site building could ultimately be more helpful for the overhead problem than the way it is viewed to bring down costs. Ultimately, all cost-saving measures, as long as we’re short of entitled dirt, simply flow to the land residuals. Only the farmers and ranchers benefit. It is true of MUDs; it is true of every cost-saving innovation.  Over time, land just becomes a higher percentage of revenue.
• Ultimately even if off-site building improves dramatically, it will be more the cost of admission for builders, than fundamentally changing the price side of the equation (which the market decides). However, it could be hugely important for reducing the size of our overhead (less contracts, less purchasing, accounting people, etc.), allowing us to much better match our overhead to our volume. Which would also allow us to be more disciplined in our land buying.
• Our commercial RE brethren choose to pre-lease/pre-sell their projects part of the time. We have the option, depending on product and location, of pre-selling to BTR companies. I’m of the opinion this is not going to work as often as is commonly assumed – the for-rent pricing curve is flatter than the for-sale pricing curve – but it certainly can work in many cases.

If this is our industry's 'climate change,' how do we adapt?

• Local deep scale matters. More than deep scale nationally. That mostly matters for capital cost – not a small thing. But local scale is where cost savings come from and the ability to hire the best local talent. Whether you have 5 projects or 15, you need a great purchasing department. But it’s a lot easier to pay for the best when you have 15.
• With it becoming more and more difficult to get projects approved, processed, plats recorded, land developed, etc., efficiency of effort comes more and more into play. Small projects often can take as much time and effort to get to model opening as big ones. If you are managing your overhead, less projects with more velocity are better. To get the velocity you have to have a really good value proposition – not an OK one - vs your peers.
• That value proposition could be truly unique product, or very cost-effective product. What it is not is being a “bit better” than what you perceive your peers are doing, in vague ways we often tell ourselves, “It’s a better house” (specifically how?), “We have a brand” (that makes people buy homes they would not otherwise?), etc.
• I’m an architect, and love creative product. But do we get paid sufficiently for it? Is it truly unique? The answer is 'sometimes,' but often it ends in our being in a higher price point with slow absorption and questionable returns on capital.
• Velocity is a virtuous circle. The faster you can sell and close, the bigger project you can do, and the more efficient you will become. It is not the only way to profitability, but it works.
• A high level of operational efficiency also allows you to manage risk at different points in the cycle. If you are very efficient, you can move back and forth between higher risk/higher return, when it feels appropriate, and buying finished lots on rolling takedowns or land banking when you think there is more risk. But the second option will not work if you are not efficient and have to use your entitlement or land risk profits to subsidize your home building profits.
• Creative people solutions. We’re not just short of people in the field, we’re having a hard time finding people for our offices. Creative solutions began with flex time/WFH, but that is rapidly the cost of admission. Perhaps as our industry ages, we’ll have three experienced people working part-time to fill what once was a full-time role? More people to manage, but more flexibility and there is a lot of talent in our business at or near the end of their desired full-time/full tilt career, but still interested in contributing – just not full time (hat tip to Rodney Hall for pointing this out to me several years ago).

Being in the middle has never been the path to above-average returns, but it may increasingly not even produce mediocre returns. If you feel you make money on entitlements – something public builders are less skillful at, or even land planning/land development, you might ask, ‘then am I making more money than the publicly-traded builders?’ Because you are taking more risk and doing more value add. If not, then these activities are just subsidizing your homebuilding.

Which begs the question, "how are you making money and why are you doing things where you do not?"

There are, of course, very successful private builders. Those that I know have had one thing in common. They do not try to be all things to all people. They really know how they make money. Just as important, they also know how they do not make money, and are willing to walk away from deals that someone else might make money from but they know does not fit their discipline.

Discipline is the key word.

Does everyone in the company understand what we do to make strong profits, which ultimately allows us to pay them well?"