The Land Dilemma: Is it Time to Buy or Sell?
With all of the difficulties facing the industry in this business climate, one of the most vexing is what to do about land holdings
With all of the difficulties facing the industry in this business climate, one of the most vexing is what to do about land holdings. In today's environment, land can be more of a liability than an asset for home builders. Tracts of home sites will lie dormant until the housing market revives, which could take several years or more in many locations. Meanwhile, these properties incur finance charges and taxes on builders' balance sheets.
To build, builders obviously need land, but extensive holdings of undesirable properties threaten some companies' very existence. Yet, for those who can raise the cash and afford to hold land assets for a few years, depressed prices may present a terrific opportunity to pick up property at bargain prices.
What is certain is that the residential construction slowdown has changed home builders' business strategy regarding land. “What had been a two-year supply of property in recent years may now be a five- or six-year supply,” says Derek Thomas, vice chairman and chief investment officer for Newland Communities, a privately owned residential and urban mixed-use community developer. Some of those lots, Thomas says, may be worth less than the debt owed upon them.
Given this challenge, the most logical strategy for most builders is to sell off lots that are unlikely to be developed in the foreseeable future. But with so many builders in the same situation, that leaves a lot of land for sale with relatively few potential buyers. Those who do find interested buyers may have to sell at a considerable discount. Some large builders have done just that this year.
In March, for example, Centex sold 8,500 lots in 11 states to a joint venture led by Dallas-based RSF partners for $161 million. The book value, according to Centex, was $528 million at the time of the sale, but analysts said that was already after significant write downs, and that the land was worth $900 million originally. Based on a $900 million valuation, the properties sold for just 18 cents on the dollar, analysts said.
Why would Centex unload these lots for so little? A big incentive to do so is for a tax refund, which the company said is “an anticipated $294 million.” The IRS allows businesses to offset taxes paid over the previous two years if they have a loss in the current year. This is a strong motivator for some to sell now at a considerable loss. “The tax lookback could be the difference between bankruptcy and non-bankruptcy for a lot of builders,” says John Burns, an HG columnist and president of John Burns Real Estate Consulting, based in Irvine, Calif.
Centex's move reflects a major strategic recalibration that other builders may look to emulate. “This transaction is consistent with our near-term goals of reducing our land supply and generating cash,” said Centex CEO Timothy Eller in a prepared statement. “This land sale accelerates our move to a more asset-light operating model.” Eller said in conference call with financial analysts on May 1 that Centex has reduced its lot holdings by 70 percent from its peak supply two years ago, and that the company is reducing the number of homes built on spec and will transition to building only pre-sold homes.
Although most builders likely want to reduce their land holdings, the task is complicated by a very tight capital market with few willing to lend at favorable rates. The Centex deal was capitalized without debt, the company said.
In the capital markets, the huge volume of foreclosures and falling property values has overwhelmed many lenders. “Banks are reacting pretty slowly to this,” Burns says. “Information flow to the banks about how difficult this market is has been pretty slow. Appraisals have been far more than the asset was really worth. Builders have been slow to take impairments, particularly the private builders.” Some banks have decided to get out of the business of lending to builders altogether, Burns notes.
But public builders have an advantage in raising capital, Thomas points out. “Public builders still have access to capital,” he says. “Investors are still willing to put in cash.” Any loans required to raise capital, however, come with high interest compared to recent times, and lenders are demanding that builders put in a lot more cash upfront.
Some cash-rich private and institutional investors who can afford to hold property for several years
are looking to acquire home lots under the right conditions, says Bob Eck, principal with Land Asset Strategies, based in Arvada, Colo. “If they can buy at a low enough basis so there is still room at the margin to hold and sell back to a builder in the future at a good return, then it makes sense,” Eck says. These types of investors include high net worth individuals and institutions such as large pension funds, he says. Home builders typically find such entities through networking and sometimes by sending out RFPs. These sales tend to be cash deals today, Eck adds. When buying makes sense
Builders shouldn't expect investors to line up at the door to take their unwanted properties, though. Prices may still have to fall for properties in some areas to become desirable. Builders that are able to convert excess land holdings into cash within the next couple of years and shore up their financial positions through cost cutting, could end up in advantageous positions. Some may be there already.
“Plenty of builders are in a position to buy and hold; the problem is they are not finding what they want to buy at the right price,” Burns notes. Values on the best properties may still have room to fall. When they do, those who are financially sound will be ready to snap up bargains.
An attractive alternative to buying property is to take out development options, says David Clinger, president of Denver-based consulting firm Land Planners. “Builders should only option a piece of ground, not buy it,” he says. Options allow builders to reserve the right to build on a property for a set period for a fee, and if they decide not to go ahead with a project, they can walk away without the obligations of ownership. Option fees that have already been paid, however, are forfeited.
In any economic environment, the location of buildable lots is essential to successful development. Never has this been more critical, as the next housing recovery will likely be uneven with certain areas expected to bounce back much faster than others. Regions that have a fast-growing population and rising average incomes are poised for the quickest recovery. Within most regions, certain types of properties will take longer than others to rebound in value.
“The biggest areas for defaults are the inner city and outer suburbs,” says John McIlwaine, senior fellow with the Urban Land Institute. Outlying suburban areas that have spawned tracts of so-called McMansions this decade have a few negatives to overcome, McIlwaine points out. The high cost of gasoline and growing pressure to reduce greenhouse gas emissions add up to a less favorable public view of the automobile culture, he says. Many people are fed up with driving long distances through heavy traffic. Unless outlying suburban properties are within easy access to commuter rail or other public transportation, they may miss out entirely on a home building recovery.
Although vacant sites that had been earmarked for large-lot homes in the outer suburbs may not be desirable for single-family construction for many years, if ever, they may be repurposed for
more easily saleable development. Though many builders have been concentrating on traditional single-family construction, they may have to refocus on alternative residential construction. Planned communities that are compact and walkable, mixed used development, 55-and-older housing, and affordable, high-density housing may all be sound alternatives for builders and investors in the near term, Clinger says. These types of properties, however, must usually be rezoned and re-permitted first.
On a recent trip to Austin, Texas, Clinger took note of a dramatic difference in the activity of two nearby developments.One, the site of a traditional suburban development of a large builder had infrastructure in place, but little construction activity. “Just a half-mile closer to the city in a lifestyle project, sales were ahead of construction,” he says. This could very well portend a shift in the residential construction industry.
Clinger also noted a successful development under construction that puts 11 units of housing on each acre. Such high-density developments that yield affordable housing might just be the kind of projects that keep home builders alive in the next decade, Clinger says. Smaller homes on in-fill lots are another development that could help relieve a slowdown in large-lot suburban construction.
If anything is clear in these uncertain times, it's that the success formula for home builders of the past 15-plus years needs to be adjusted. With so much change in the air, many builders are going to have to reexamine their outlook on land assets. The goal is to unload the least desirable lots and hold or acquire lots that are most likely to yield sales most quickly. It's easier said than done, but those who succeed may well thrive when the housing market recovers, while those who fail get their land positions in order may have to close up shop.
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