Home Builders Knees Shaking on Land Purchases

The home builders are apparently wavering in the confidence that allowed them to go on a land buying spree over the past 15 months.  A client sent me this article that appeared in the WSJ yesterday:

The weakening of the housing sector is having repercussions in the land-speculation market, which enjoyed a miniboom earlier this year when it appeared that the worst of the housing crisis was over.

With sales volume falling and home buyers retreating, home builders are re-examining land contracts, asking land sellers for lower prices or abandoning deals entirely. Land brokers said several of the nation’s builders, including D.R. Horton Inc. and M.D.C. Holdings Inc., have walked away from deals. In some cases, they forfeited the deposit: KB Home walked away from the option to purchase 90 lots, and a $500,000 deposit, in Roseville, Calif.

D.R. Horton and M.D.C. didn’t respond to requests for comment.

So let’s break down the implications of the home builders being out of the land game.

The builders and their access to cheap capital tend to have a pretty big impact on land prices.  Let’s take an example of a group of hypothetical finished residential lots in Southern California.  Let’s say there are 100 lots and the market price is $30,000/lot.  If builders are in the market, the price is no problem as coming up with $3 million to close a land transaction is not an issue for a public company.  However, if the builders are not in the market, you have to find someone with $3 million in cash who is interested in buying and holding a speculative land investment.  Just from the standpoint that you have significantly less buyers, the price is going to soften up, regardless of the theoretical value of the deal.

Should investors, or vulture buyers, be unhappy about the exit of the public builders from the land market?  This is the really interesting question in my mind.  First, I think there are a lot of investors who think of themselves as contrarians who have essentially mirrored the buying habits of the builders over the past 24 months.  Which is to say that they stayed out of the market until June of last year, then they got in and bought, and now will get out again.  I guess the interesting question is really whether these people who self-identify as contrarians are anything of the sort.

If you’re a land investor, your ideal buying opportunity is as follows:

1. Widespread access to discounted deals
2. Little competition from other buyers
3. Future demand for the product you are buying – i.e. home builders that can purchase from you in 3 years.

Over the past 15 months, only one of the three requirements I list above could really be satisfied.  If you were in the market, you were getting a lot of competition from builders, and because they were buying, it meant they were filling development pipeline, which meant that it was less likely that they would be buyers in the future.  So all you were really getting was a flow of bank owned residential lots to bid on.

Banks are perhaps the biggest losers if builders are out of the market to buy.  The homebuyer tax credit was essentially another subsidy for the banks.  It meant that the banks had homebuyers for their distressed inventory of REO homes, and it meant that builders were enthused by their sales numbers and as a result they went and bought land inventory from the banks. 

The residential lot portion of the outstanding non-performing assets held by banks is small compared to inventory of actual REO homes.  When builders entered the market to buy, banks actually took advantage and have been efficiently disposing of lot deals for the past 15 months.  Most bank asset managers will tell you that their lot inventory is thinning out.

Banks need homebuilders in the market to absorb REO lot deals simply because as I mentioned above, the transaction amounts get large enough that individual investors tend to become a little more conservative.  So for the banks, they are lucky that their inventory is thinning out at the same time that the builders are leaving the market.

You can think of any market as being similar to a boat.  The boat takes on water on a regular basis.  The water is new inventory.  If you get too much water coming into the boat, the boat begins to sink.  Buyers in the market are like a bilge pump.  They are responsible for getting the water out of the boat.  When the homebuilders are in the residential lot market, it’s like having a very strong bilge pump that immediately rids the boat of any water it is carrying.  When the homebuilders are out of the market, it’s like having an old bilge pump that works sometimes, and doesn’t work other times.  The boat might not ever sink, but there are times when a lot of water is taken on and it takes awhile to get rid of it all.