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:
- gross margins, returns on capital, or other financial criteria, and
- 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.
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HOME BUILDER RISK DECISION MATRIX
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LOW RISK /
LOWER MARGIN
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RISK CATEGORY
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HIGH RISK /
HIGHER MARGIN
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Low Risk
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DIVERSITY
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High Risk
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80 metro areas
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Geographic
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1 metro
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Many cities
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Submarket
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1 city
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All price ranges
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Price Range
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High prices only
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Many buyer profiles / home sizes
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Product Type
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One buyer profile / one floor plan (although specializing has lower risks too)
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Low Risk
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LOCATION
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High Risk
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No new home communities nearby
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Competitor Exposure
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30 builders within 5 miles
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High projected population and job growth
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Market Choices
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Low projected population and job growth
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Supply constrained
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Barriers to Entry
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Few barriers to entry
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Communities are close to headquarters
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Market Knowledge
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Communities are in areas that are not well understood by management
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Little Investor Activity
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Speculator Presence
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Several consecutive years of rising investor activity
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Great affordability, both nationally and in comparison to market history
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Affordability
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Poor affordability, both nationally and in comparison to market history
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Predictable weather
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Weather
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Unpredictable weather
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Low Risk
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LAND
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High Risk
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Finished lots only
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Entitlement Risk
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Many government approvals needed
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Disciplined negotiators with significant local market contacts
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Acquisition Skills
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Inexperienced negotiators with aggressive growth goals
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Steady, planned growth
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Growth
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Aggressive growth mandated from Corporate
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Buy on option or with terms
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Terms
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All cash buyers
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Low Risk
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FINANCE
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High Risk
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Can’t decide where to invest all the cash
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Cash
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Raising money based on “paper equity”
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Positive free cash flow
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Free Cash Flow
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Negative cash flow
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Pre-sell everything
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Inventory
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Build speculative homes
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Vertically integrated; Long-term contracts with early delivery
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Purchasing
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Short-term contracts in high volume or hurricane-prone markets, with just in time delivery
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Subcontractors paid promptly
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Payables
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Subcontractors often threaten to stop work
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Low leverage
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Debt
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Highly leveraged
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Staggered debt maturities
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Debt Maturities
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Short-term debt OR 1-maturity debt only
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Multiple sources from multiple industries
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Capital Sources
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A few debt/equity sources
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High inventory turnover
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Return on Assets
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Low inventory turnover
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Publicly traded
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Liquidity
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Privately held
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Maximum coverage
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Insurance
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Minimum coverage
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Low Risk
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PROCESSES
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High Risk
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Loyal, experienced trades
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Construction Quality
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Hire cheapest trades
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Low warranty claims
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Construction Quality
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High # of oustanding warranties
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Low litigation levels
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Construction Quality
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Ongoing litigation
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High referral rates
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Customer Service
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Low referral rates
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Great customer satisfaction scores
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Warranty
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Weak customer satisfaction scores
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Proactively gathering & analyzing as much qualitative and quantitative info as possible
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Monitoring Market
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No process for monitoring market other than weekly sales reports
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Proven, effective
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Architecture
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Cutting edge
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Even flow
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Construction Process
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Wild volume swings
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Low Risk
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MANAGEMENT
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High Risk
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Do 1 thing very well
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Focus
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Dabble in many things
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Conservative
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Style
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Aggressive
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Engaged and passionate
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Attitudes
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Disengaged, with low golf handicap and little downside risk
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Management well-known and respected locally
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Market Experience
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New to the market
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Plans in place for downturn
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Preparation
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No plans for downturn
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If you have any questions, please contact us at (949) 870-1200 or fill out this form.
