Risk Revolution: Lessons from The Past, Challenges Of The Future

Scott Cox -

Learning from history is a prerequisite to wisdom and perspective. However, when it comes to applying lessons learned in homebuilding, it is critical to study not just what is the same as in the past but also what is different.

When discussing risk with companies, I frequently hear how the principal’s experience in the Global Financial Crisis has informed their risk management strategy today. There is a saying:

Wounds heal, scars last.” 

We all wear some scars from that period.

There are all kinds of risk in our business, and one could argue the fundamental types have not really changed:

  • Entitlements
  • Land Development
  • Construction/Operations
  • Markets
  • Financial
  • People

However, the relative weights and combinations of risks that are most threatening can and do change over time. This is where considering the differences from “then to now” matters for assessing risk.

So, it is worth noting things that are different from that time:

  • The period before the GFC was, in hindsight, the end of the era we could over build. We can still overbuild for a given price point, but we are effectively prevented by the government from classic overbuilding through lack of infrastructure and failed land use policies. Sadly, I do not see this materially changing.
  • Public builders have grown in scale, expertise, and capitalization.
  • Home buyers are up against it with affordability, but they are not as a whole overleveraged. There is no avalanche of distressed inventory coming to the market.
  • Timelines for entitling and developing property have extended to where many projects are easily five years from conception to first close, or worse.
  • The scale it takes to compete in each market has risen substantially.

These changes have seriously altered the business's risk profile. If you consider risks largely based on the GFC experience, you may not weigh them correctly.

I have heard a similar story quite a few times recently in discussions with builders. They developed lots for sale to builders prior to the GFC. During the crisis, builders walked away from options, and they had to form a home builder to “build their way out of it.” This was followed by the comment,

Never again.”

As I have previously argued, while public builders may temporarily choose not to buy land, this pause likely will end once they have some underwriting visibility. When I was in private equity, we needed land prices to fall so that there were great returns. 

Public builders do not need great returns; they just need reasonable, predictable returns. The model has changed to value throughput and consistency over holding for margins. 

This implies that while land can and probably will fall in value at times, it will not fall as far as in the past, and the period where the public builders are not buying will be relatively short. We saw this when rates rose – they were out of the market for a very brief time. So, land is probably less risky than before. That's not the same as no risk.

What about the risks of homebuilding? During the time since the GFC the public builders have upped their game across the board – lower leverage, better operations and systems, and more discipline. They are harder to compete with.  When your competition is better, the risk has gone up.

In addition, the increased time to bring projects to market has impacted every corner of the business. Not the least of which is it takes longer to grow a business, and retained earnings usually will not capitalize it sufficiently. No matter what type of capital you are using (other than perhaps your own), the financial risk has gone up.

If your homebuilding business is not at the scale it needs to be to compete, it will take longer to get there than in the past. As an example, if you are selling 200 units annually and find it hard to have evenflow at that level, retain the best employees, invest in systems, etc., it could easily take five years to get to 500 units. During this time, your leverage and land exposure will probably go up. And then it takes a couple of years after hitting a stable point to de-lever. So, growing exposes you to an extended period of higher financial and operational risk.

More risk than simply delivering lots for sale if you went that direction rather than growing the building operation? Not an easy question, but one worth pondering since land development has less economies of scale and is more tolerant of ups and downs in volume.

I am not implying grow or get out. These are examples on each end of the spectrum. Plenty of options lie in between. However, the risks of competing in the homebuilding space are increasing, and if you are not comfortable with your business's current state, you need to consider them in a strategy discussion.

Are private builders finished? No. 

There are plenty of great ones, big and small.  Many of whom have a true niche or competitive advantage as opposed to modest differentiation, which is not the same. But just like extended timelines for projects being underwritten today mean we are not just thinking about competition/comps today, we have to focus on what a given market will be like five-plus years from now, so too we must consider what our competition will be like five-plus years from now.

I think it is reasonable to assume the public builders will:

  • Continue to grow market share and local market scale.
  • Invest in people, processes, and procedures. Especially the best people.
  • Invest in AI and off-site homebuilding solutions.
  • Maintain low debt levels with extended maturities, making them relatively immune to severe market pressure.

If all this is directionally correct, we will have more lot supply challenges in five years, with stiffer competition from public builders than we have now. Competing against that carries significant risks that should be acknowledged.

There is no single strategy that makes sense, and this is not meant to suggest that all private builders should become entitlement and land development companies only. However, the weighting of risks in the business has changed, and this needs to be considered in formulating a strategy that combines your expertise, resources, market, and risk tolerance.