Builders Face Many Decisions on Risk

By John Burns

February 8, 2006 (All day)

John Burns

The purpose of this article 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:

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.

Builders 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	One metro
Many cities	Submarket	One 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 number 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