I have been thinking about the structure of our business, the present spree of M&A, the areas where there is and is not a capital surplus, as well as which aspects are transitory versus those that likely are permanent. The spike in mortgage rates has ultimately benefited the public builders through market share gains. Partly from the ability to manage specs for themselves and not the bank, partly from the ability to offer mortgage buy-downs more efficiently through forwards, and most especially as private builders struggled to reload the pipeline. It has caused me to question what the future holds for private builders and what their options are.

Here are some background observations/beliefs (biases?) about our business environment and its implications.

• No one knows exactly what demand will be as there are too many intersecting factors – natural population increase, immigration, headship rates, etc.  Remember that net housing demand is less than gross when calculated nationwide. People and jobs move, but houses do not.  And most especially, price equilibrates so what is the demand at the price points we can supply?
• The days of overbuilding, in the macro sense, are probably behind us. We will be capacity-constrained in the single-family and townhome business in almost every market. While we will make progress on ADUs, TODs, etc., there is no political groundswell for what used to be the bedrock of affordable housing markets – single-family, townhomes, and manufactured housing.
• Infrastructure limitations will continue to plague us and make the front-end capital on projects a bigger and bigger hurdle – roads, sewer and water infrastructure, fees, underbuilt schools (where we are growing), and water in the west.
• Costs will continue to rise. Unless we have immigration reform, our labor pool will continue to shrink. Material costs will likely rise, as we have moved from a fundamentally deflationary environment to an inflationary one (demographics, energy, de-globalization). Land prices (if approved or likely to be) will rise due to the entitlement challenges.
• Discretionary and non-discretionary (starting to wonder if there is such a thing?) processing time frames continue to elongate. That eats into capital and IRRs and pushes out turning over your capital into the next deal in a reasonable time frame. Growing your business through retained earnings has gotten much tougher.
• There are plenty of positives, some of which are the flip side of our entitlement difficulties, so the macro picture for the business is likely to be generally positive for the foreseeable future.

Implications/Conclusions:

• On balance, I think in our major markets, demand will likely outrun supply over time. This is especially the case for single-family and townhomes.
• Higher (and higher) home prices will mean fewer and fewer truly discretionary buyers, in the sense that buyers can get the house they want on the lot they want where they want it. Compromises will be made for all but a few buyers.  The “winner,” is the builder who delivers the most items on the buyers' list, especially those items at the top. These compromises mean there is less room to get buyers to buy based on brand or design. I am not saying they do not matter, but I would not want to have to survive offering a better-looking house and four "wants" on a buyer’s list of 10 versus the builder with a solid, if unspectacular, design that gets them six of the items they value. If you are betting on high design and a brand, best to stick to the very upper tiers of the market. And accept the throughput limitations. I am differentiating between better aesthetics and better plans that more efficiently provide more items on their list.
• A longer entitlement process means you probably need more land controlled than you used to. Years ago, three years of land was considered prudent. But it also takes twice as long to get approvals on projects now. Simplistically, if it takes twice as long, do you need twice as much? Is it a coincidence the public builders now have six-to-seven years' owned and controlled pipelines? No.
• A smaller unit business over time, but the same or larger dollar business.  Ever-increasing competition for the land.
• Lot prices keep going up, as does the lot-to-house price ratio. This means a greater imperative for velocity to work through a project because more of the total cost gets spent on day one.
• Fewer projects to buy; the ones available are more expensive, so more capital per deal. You could maintain dollar volume but have a lower unit count/project count over time. That will increase the concentration of your capital and risk.
• When you combine the previous point with the long- and unpredictable-time lines for approval unless you have achieved a significant scale, potential home deliveries will be very erratic year to year. If you typically have five to seven projects at a time, having two fall behind schedule could cause a 30-40% drop in deliveries in a given year. This makes it functionally impossible to have an efficient overhead. This is one more place where the law of large numbers is helpful.

Public Builder Competition:

• Public builder market share is now 45%, although this arguably understates the situation, as they do not build in all markets. Their market share in major markets ranges from 40% to 70%. Moreover, every single one of them has growth goals. As the single-family detached/townhome markets are not likely to get markedly bigger, they either fail at this – do not bet on it – or their share will come at the expense of smaller builders. And none of this counts the Japanese subsidiaries with large-and-growing scale and even larger checkbooks.
• An example of what this can look like in the future is Denver. The MSA is a roughly ten thousand-unit-a-year market in the suburbs. Discussing this with thoughtful local developers, we would estimate given the difficulty of approvals and cost of tap and impact fees, this could easily fall to eight thousand units annually five years from now. There are two new builder entrants and two who are substantial players nationwide but have had a small local presence to date and are determined to grow substantially. All expect to be at least 500 units annually in five years. If they need two thousand units and the market shrinks by two thousand units, where do the four thousand units come from (who won’t be building them that is now)? Hard to imagine Lennar or Horton conceding market share willingly.
• While this may be an extreme example, I think the basic idea holds in many markets. Those with market share will fight to keep it, while big players without it will do what it takes to get it. We are in for even more fiercely contested entitled land. And each market correction will likely result in public builder market share gains. They simply are too lowly leveraged to be materially impacted by the ebbs and flows of the market.
• As I have written before, the publics have upped their game over the last decade and concluded (rightly) that velocity creates profits – not holding for gross margin. In 2023, a group of the 10 largest had a 16% EBITDA margin, with a roughly 1:1 ratio of revenues to assets, an SG&A of less than 10%, almost six closings per employee, and leverage of less than 25% of assets. EBITDA per employee is nearing $500K.  Sixty percent of their land is controlled, not owned, allowing them to produce large amounts of cash even as they grow.

Private Builder Impact:  Three Key Cost Disadvantages:

• SG&A – Most privates are 3-4% of revenue more on SG&A than the public builders. It is simply a matter of throughput. Publics average nearly six closings per employee. This is an issue for both the efficiency per employee and the ability to pay for the best talent. If you are doing six projects in a market and Lennar is doing 50, you will have difficulty paying for the best purchasing manager. The shortage we face that's as dire as land is people. A common discussion with my clients and friends is that if they can find someone for an open position, the compensation requirements would blow up their salary structure across the company. I do not think these salaries are going backward. In thinking about your business, if you want “A” players, you have to consider where your overhead will be over time.
• Cost of Capital – This ranges widely, but here is a simple calculation. If the publics have about 25% debt (and revenue roughly equals assets, so the math is easy) at a 6% bond rate, that is 1.5% of revenue. If a private is leveraged at 2:1 (not bad) and has an 8% cost of debt, that’s +5% of revenue – that amounts to a 3.5% delta. This may be a bit deceptive, as the publics are land banking more and more projects, and interest is embedded in those lot costs. But at the same time, they now have 6-7 years of land tied up and are staying within that 1:1 ratio of revenue to assets. As the saying goes, your mileage may vary, but you can do the math on yours. If you need equity or mezz debt, the delta explodes.
• Direct Costs — This is the hardest thing to compare apples to apples, but I do not think many private builders are building within 5% of their public builder brethren on direct costs. If directs are 40% of HP, that is another 2% of revenue.

Taken together, these can add up to an 8-10% margin disadvantage. I am not saying every private company is in this deep a hole. Some actually outperform the PBs. But I think most are working at a big disadvantage. This explains the number of private companies who will opine about the tenor of the most recent land acquisitions by public builders.

They must be doing it for volume, you can’t make money at that land price.” 

I think the correct answer is that they are making money, given their cost structure (and that is what their income statements say).

Capital Availability for Privates

Capital availability for private homebuilders will shrink over time, although this is an opinion, not a fact. Right now, a lot of money is available to land bank public builders and quite a bit from debt funds for land development. Bank capital for privates is a mixed bag. Strong builders are not being shut down, but neither are most banks open to new builders and many have been trying to quietly reduce their exposure to under-performing (re: weak margin) builders. Equity for homebuilding for private builders seems limited, and I do not see new capital sources moving toward this part of the business. That may change, although fundamentally, private equity in home building is a “two-promote” business – that rarely works well without distressed land buys or big entitlement uplifts contributed to a deal. This type of capital will continue to be hyper-IRR sensitive, so accurate underwriting is even more critical.

• Capital is cyclical, and what is in fashion today can be out of fashion tomorrow.  But I think the cost structure disadvantage is a daunting hurdle to overcome, and over time, as banks have become less dependent on the builder business, it is easier for them to be choosey. Also, banks are far more open to construction debt than land acquisition and development debt. Yet deals are getting more front-loaded on the land side. Certainly, the trend has been after each cycle, banks exposure to builders drops to a new lower level.

OK, at this point, some of you might be saying, “Why didn’t you tell me to nail the window shut before I read it?” It is not all negative. Public builders do not have advantages in all areas of the business. Their focus has been on perfecting the manufacturing side of their business – producing houses. Areas where they have much less advantage include:

• Land development is a lower-overhead business with great consultants to help manage various aspects of large projects, and horizontal development has far fewer subcontractors to manage. With all due respect to some of the very large developers in this business, in many markets, I know a small development firm I would pick first to manage a project for me if given the choice. And there is both debt and equity for good-sized land deals.
• Entitlement work will likely continue to be a hyper-local business, where there really are advantages to local relationships. It is not a business publics want to be in anyway. Unless you are buying land in front of entitlements, it is much less capital-intensive. This area has the highest risk and the highest returns, and the least institutional capital. This is a recipe for outsized returns if you have the skills (and stomach).
• There are niches that the publics do not chase and that are emerging – ADUs, mixed-use, ultra-luxury, certain types of infill, etc.

How to think about all this?

• Assess your scale. If you have top-10 local volume and a strong land pipeline, many of the disadvantages noted are likely not there, or much reduced. And if you do a couple of projects a year, or several small ones that are too small to fit the business model of the big guys, that can clearly work. But for many, delivering 150-350 units annually is becoming purgatory. Big enough to need a professional staff, but not large enough to leverage them properly. And needing a fair amount of capital to keep the pipeline up.
• Assess your business vs the publics. How do your un-leveraged metrics compare to theirs? Where do you sit vs the three areas I outlined? If there are areas of significant disadvantage, are they fixable, or simply a fact of your size and scale?
• If your entitlement work creates good HB margins, how much are you subsidizing that part of the business? If it is a little, that is ok. If it is effectively all the profit in the deal, I am not sure that is a sustainable business model.

Options:

• Tertiary markets. I must admit, I have always shied away from these in my career, concerned about the ease with which they can be overbuilt or harmed by the movement of single employer (military markets and base realignments are the classic example). But I must admit, quite a few privates who have grown quickly have done it in these kinds of markets, out of the shadow of PBs. Lower land prices, lower capital needs, less competition. Obviously, the key is to pick a market that will grow, but as affordability problems ripple across our previously affordable major markets, perhaps more spillover to small markets will occur.
• Commit to growing the business if your current scale leaves you at an inherently inefficient size. In most markets where approvals take a long time, this is a long-run solution and requires that you both have a lot of faith in your local market over the next +5 years and a willingness to assume when underwriting deals that you will achieve the economies of scale necessary to make it work. It is circular – you cannot achieve the efficiencies until you have the throughput. But you would not have started your business without a great deal of optimism. The second part to consider beyond the basic business risks is capitalization. Can you attract the capital to achieve the plan, and being realistic about the returns, will it leave you enough to build up the retained earnings necessary to stabilize the business?
• Shrink the business. This is remarkably hard to do as a homebuilder when under duress. But it is more doable as part of a longer-term plan to achieve the maximum size that can be managed with a small staff. You probably once were that size and had a pretty profitable business when you and the key principals did most of the work.
• Focus on small projects and infill, too small to interest the publics and subject to less competition. These projects tend to be inefficient (which is why the publics pass on them), but an organization focused on nothing but this can find ways to streamline the process and product and, hopefully, offset some throughput limitations with stronger margins.
• Off-site building and A.I. It is early days; everyone is experimenting, and frankly, this could help by allowing privates to reimagine their business and create a much lower overhead paradigm. (Or, given the publics' ability to invest in tech, become an even bigger advantage for them?) All innovations eventually flow to the land residual with constrained entitled land supply. The market sets the price for the house. Subtract costs and profit margin, and you get the lot price. If Lennar et al. crack the code on off-site and/or A.I., do you want to bet whether they use it to lower house prices or buy more land and grow?
• Build to Rent. While this asset type is very difficult to pencil now, that is cyclical. It can help get your throughput up and have better scale on the direct cost side.
• Right-size the business to the part you do have competitive advantages at and sell the rest. While it is a tough time to grow a private, it is a good time to be selling a homebuilding company.

There are no easy answers here. To reiterate, this column is not suggesting that private builders will go extinct. Plenty has achieved local scale and operational excellence to compete well and in the long run with public builders. And/or create a defensible product niche. Still, the difficulty of doing that now is substantially higher than it once was. There is no getting around the reality that it's harder to grow than in the days when you could option finished lots and turn over your capital in 6-9 months. A more challenging entitlement world with chronic undersupply likely means being at a margin disadvantage is not a question of merely accepting lower returns. It is the difference between buying and not buying land.

You cannot fix a problem or rise to a challenge until you identify it and know your options. It is better to choose them yourself than have the decisions forced upon you later.