Risk vs. Reward

Today's building industry executive is generally nothing like his or her predecessor. A college-educated executive who understands the importance of research, efficient processes and effective leadership has replaced the entrepreneurial framer/deal-maker who built a large company based on good instincts.

In the 1970s and '80s, home builders made decisions based on gut feel and experience, and their capital providers made loans based on trust. Today, those who relied on instincts alone are gone, and trust is just one of four factors that capital providers consider before making a deal.

Today's successful building industry executives rely on people, processes and research to minimize the risk of making a mistake. I have defined a five-step process I call the Building Market Intelligence™ process, but the exact process varies from builder to builder. What they all have in common, however, is an increasingly thorough, methodical approach to all major decisions. The process helps executives make decisions with more confidence, minimizing the ratio of risk to potential reward. The process is as follows:

The Thirst for Knowledge
At the International Builders' Show in January, the thirst for knowledge was everywhere. More than 100,000 attendees jammed the educational seminars and show floors to learn more about how to run a more profitable business. The educational seminars were packed with builders taking notes and asking great questions. Exhibitors focused more on educating potential customers than on building a relationship over drinks. The building industry has finally joined the "Knowledge Economy" we read so much about in the 1990s.

Superior Knowledge
Today's executives, who are generally baby boomers, are more competitive than any group before them. Because of the size of their generation, they have faced more competition during their lives than any prior generation. They know how to compete and how to win.

Most executives have learned that superior knowledge translates to better decisions and less volatility. Builders and capital sources have taken it upon themselves to gather the knowledge they need to make decisions with more confidence. While old-school managers can't believe the prices builders are paying for land or the cash that builders are devoting to process improvement, new-school managers know they are more prepared than ever before to make money, regardless of future market conditions.

Process Improvement
From land acquisition due diligence to home design to the warranty period, executives spend much of their time eliminating waste in the system and building a company culture that proactively plans for changing market conditions. The tremendous war chest of cash, which was used during the past several years to finance acquisitions, is being turned internally to focus on building better companies. Builders plan to stay one step ahead of customer expectations.

Reducing Volatility
We all know that high risk should be rewarded with high returns, but we sometimes forget that low risk produces lower earnings volatility. In today's environment, with record home sales and home price appreciation, builders are planning for a downturn. They don't expect a downturn, but they are planning for one. They have high cash balances to take advantage of opportunities. They have diversified market segments and geographies, with experts in each managing local operations. They are conducting research so their communities will be based on what will sell in the future rather than what has sold in the past.

Capital Providers
While builders used to rely on free tickets to ballgames or connections with a board of directors member to raise capital, these relationships are no longer sufficient. Capital providers are providing debt and equity at historically low interest rates, so they know they cannot afford to make mistakes. To raise capital today, it takes:

1. Trust - The relationship is still important, but it is not the only factor.
2. Cash - "Equity value" in the land is not enough, as capital providers expect co-investment.
3. Research - "Gut feels" need to be supported with solid research. In defense of past executives, much of the data we can analyze today was not available 15 years ago.
4. Processes - Capital providers want to partner with builders who have all of the processes in place to react to unexpected changes.

Conclusions
Determine your company's appetite for risk versus reward. Ask the following:

• Will spending $10,000 to $30,000 extra on research result in less risk and probably more revenue?
• Will an investment in technology or process redesign pay off during the next three years? Perhaps more important, will you need these efficiencies in order to compete in the event of a downturn?
• Are you good at everything, or can outside providers help you make more money by avoiding mistakes? The answer depends on the size of your company locally and the quality of local expertise.

Chances are that your management team will not agree on the answers, but achieving a consensus will be critical to the success of your company. Build a management team with a cohesive view of the company's appetite for risk, and execute your objectives with precision.

John Burns publishes three free Building Market Intelligence e-mails each month: U.S., Local and Strategic. He helps real estate executives develop and execute strategic plans, conduct market research and maximize profitability.