Underwriting Risk | John Burns Real Estate Consulting

Underwriting Risk


There are many new executives to the industry today who are trying to determine how to underwrite the risk of owning land. These executives range from lenders, who presumed they would never consider owning an asset, to opportunity funds who have no industry experience. In January 2006, we published the following list, and now seems like a good time to revisit it. If we missed anything, please let us know.

The purpose of this e-mail is to help building industry investors understand that builders take varied levels of risk. Therefore, when evaluating a builder’s current or future performance, it is important to consider both of the following:

  1. gross margins, returns on capital, or other financial criteria, and
  2. the level of risk that builder has taken or continues to take.

There are many decisions that builders make each day that involve risk. Those who prefer to take higher risk are likely to make more money when they bet correctly, but they also increase their odds of bankruptcy if they bet incorrectly. Those who take less risk are more likely to survive tough times, but will make less money during good times.

All of our clients have different appetites for risk. Here is a summary of some of the many risk decisions they make every day.

 

HOME BUILDER RISK DECISION MATRIX
LOW RISK /
LOWER MARGIN
RISK CATEGORY
HIGH RISK /
HIGHER MARGIN
Low Risk
DIVERSITY
High Risk
80 metro areas
Geographic
1 metro
Many cities
Submarket
1 city
All price ranges
Price Range
High prices only
Many buyer profiles / home sizes
Product Type
One buyer profile / one floor plan (although specializing has lower risks too)
Low Risk
LOCATION
High Risk
No new home communities nearby
Competitor Exposure
30 builders within 5 miles
High projected population and job growth
Market Choices
Low projected population and job growth
Supply constrained
Barriers to Entry
Few barriers to entry
Communities are close to headquarters
Market Knowledge
Communities are in areas that are not well understood by management
Little Investor Activity
Speculator Presence
Several consecutive years of rising investor activity
Great affordability, both nationally and in comparison to market history
Affordability
Poor affordability, both nationally and in comparison to market history
Predictable weather
Weather
Unpredictable weather
Low Risk
LAND
High Risk
Finished lots only
Entitlement Risk
Many government approvals needed
Disciplined negotiators with significant local market contacts
Acquisition Skills
Inexperienced negotiators with aggressive growth goals
Steady, planned growth
Growth
Aggressive growth mandated from Corporate
Buy on option or with terms
Terms
All cash buyers
Low Risk
FINANCE
High Risk
Can’t decide where to invest all the cash
Cash
Raising money based on “paper equity”
Positive free cash flow
Free Cash Flow
Negative cash flow
Pre-sell everything
Inventory
Build speculative homes
Vertically integrated; Long-term contracts with early delivery
Purchasing
Short-term contracts in high volume or hurricane-prone markets, with just in time delivery
Subcontractors paid promptly
Payables
Subcontractors often threaten to stop work
Low leverage
Debt
Highly leveraged
Staggered debt maturities
Debt Maturities
Short-term debt OR 1-maturity debt only
Multiple sources from multiple industries
Capital Sources
A few debt/equity sources
High inventory turnover
Return on Assets
Low inventory turnover
Publicly traded
Liquidity
Privately held
Maximum coverage
Insurance
Minimum coverage
Low Risk
PROCESSES
High Risk
Loyal, experienced trades
Construction Quality
Hire cheapest trades
Low warranty claims
Construction Quality
High # of oustanding warranties
Low litigation levels
Construction Quality
Ongoing litigation
High referral rates
Customer Service
Low referral rates
Great customer satisfaction scores
Warranty
Weak customer satisfaction scores
Proactively gathering & analyzing as much qualitative and quantitative info as possible
Monitoring Market
No process for monitoring market other than weekly sales reports
Proven, effective
Architecture
Cutting edge
Even flow
Construction Process
Wild volume swings
Low Risk
MANAGEMENT
High Risk
Do 1 thing very well
Focus
Dabble in many things
Conservative
Style
Aggressive
Engaged and passionate
Attitudes
Disengaged, with low golf handicap and little downside risk
Management well-known and respected locally
Market Experience
New to the market
Plans in place for downturn
Preparation
No plans for downturn

 


If you have any questions, please contact us at (949) 870-1200 or fill out this form.