“Our house is a very, very, very fine house … ” — “Our House,” as recorded by Crosby, Stills and Nash
While in high school I worked at my parents’ lunch restaurant in Lake Zurich, Illinois, then a sleepy little town that has since become a booming suburb of Chicago. Even though restaurants are oftentimes bad investments, my parents opened one anyway. My mom said, and I remember it well, “People have to eat.” Mom built a solid business that she later sold when she and my dad traded frigid Illinois winters for sunny Florida.
I was thinking about my mom’s “people have to eat” rationale recently while researching the large, publicly traded homebuilders. The shares of these companies have fallen since the start of the year, presumably because interest rates have risen slightly and because the pace of sales has slowed a bit. I believe that the country’s largest homebuilders have a multi-year growth runway ahead of them, so naturally the falling share prices further piqued my interest. Rising rates or not, people have to live somewhere, as well as eat.
In the past, homebuilding was a relatively low margin, capital intensive, boom-and-bust industry dominated by thousands of local builders. Small homebuilders still put up the majority of new houses in America, but that’s changing quickly. The ten largest homebuilders have been growing their market share and now construct almost a third of all new homes. Industry consolidation is often a sign that the remaining players will become more profitable since they face less aggressive competition.
Less competition isn’t their only advantage, though. Homebuilding costs are rising, which should also benefit the larger players because they can borrow money cheaper than smaller builders; buy materials in bulk and save money; and spread their design and labor costs over more projects. All this means more profit per home than subscale competitors.
Additionally, the largest homebuilders are moving to an “asset light” business model, which has substantially improved their returns on capital. Instead of having their money tied up in land that may or may not be developed in the near future, some homebuilders are increasingly using purchase options to reserve land they may buy rather than buying the land outright.
This sometimes means they end up paying a few percent more for a parcel of land. But by securing construction sites this way, companies can build more homes where the demand (and prices) are currently highest and forego projects that may not be as profitable. In the old days when a project got scrapped, the homebuilders had to find a buyer for their land, which isn’t always an easy task. Now, when a project doesn’t work out, they walk away from the land and forfeit the small option payment.
Margaret R. McDowell, ChFC, AIF, author of the syndicated economic column "Arbor Outlook," is the founder of Arbor Wealth Management, LLC, (850-608-6121 — www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin.