Land Risk and Returns Are Not Always Correlated

This month's column is intended for home builder executives who believe land acquisition risk is higher than usual. To me, land acquisition appears very risky in some markets, while it appears much less risky in others.

Despite conducting more due diligence than ever, many executives believe that land acquisition gets riskier every year. The additional risks may be attributed to the following:

1. Competition - More competitors are trying to grow their businesses, placing negotiating power in the hands of sellers of entitled land.

2. Appreciation - Recent appreciation trends have provided support for competitors and capital providers to assume home price appreciation in their pro forma financial projections.

3. Diversity - The geographically diversified large builders are less worried about local market conditions than the smaller builders who have all their investments in a few markets.

4. Price - Builders are paying more for land.

Theoretically, when land acquisition becomes riskier, executives should be requiring above average returns on their investments, and vice versa. Unfortunately, it appears that exactly the opposite is true. In today's environment, many executives tell me that the risks seem higher than usual and the pro forma profit margins seem lower than usual.

What should you do if you believe your market is in a High Risk / Below Average Expected Return land acquisition environment?

Here are four options:

1. Sell Your Company - Most of those who preferred this route sold out several years ago. Although some cashed out, others achieved geographic diversity and reduced risk instantaneously.

2. Hoard Cash - Take the money now and save it for the rainy day when land will be a buyer's market. Buy just enough land to keep your pipeline full.

3. Build Capital Sources - Use as many debt and equity sources as you can so you can be assured of continuous access to capital.

4. Diversify Geographically - By diversifying into more markets, you can reduce the risk of a market collapse damaging your company. Diversification is not easy, however, as it presents a whole new set of management challenges.

5. Build Closer to Job Centers - While the areas furthest from the job centers often have the highest demand because homes are more affordable, these areas are generally where the competition is other builders. If you are concerned about your market, you would rather be competing with resale homes than new homes in the event of a downturn.

The home building business is cyclical. Nobody can predict the length of local housing cycles, as one can see when the fundamentals of demand, supply and affordability appear out of whack. The data on this page is meant to provide you with a quick overview of the statistics. This should not be the answer to your investment decisions, but it should be at least one of the many factors you consider in your business decisions.