Homebuilders from the Horse’s Mouth
We look at some of the color offered by builders on cancellations, pricing, incentives, land spend, and impairments.
Below I excerpt management commentary from some of the homebuilders that reported earnings this week. As there are no shortage of moving parts in housing and homebuilding, the “horse’s mouth” is a good source.
The problems run the gamut from the spike in mortgage rates to supplier chain problems to recession fears negatively impacting potential homebuyers. Some of the topics covered in management calls are not much of a mystery, but the drill-down in Q&A with management teams can be revealing on a wider range of the fundamental challenges and how they respond to such very difficult markets.
In this commentary, I do two things. First, I briefly summarize what I see as the main topics identified on the calls. Some are obvious while some are more nuanced but very important in framing the challenges. Second, I take some quotes from the main calls reviewed from this past week’s earnings. Even a quick scan of the quotes gives some flavor to the most important themes and the management game plans. Items such as cancellation rates, discounts, and volume fears get more substance coming out of the mouths of CEOs or management. I found most of the responses very candid and detailed. These companies faced bigger challenges not too long ago. They have a plan and a playbook.
Main Topics…
Mortgage rates and affordability: This topic is the most obvious of the bunch. Monthly payments are soaring for new buyers, and volume will be hurt badly. That bring a chain reaction where more of the focus will be for investors. Earlier this week, I looked at some of the big housing questions to ponder, provided some context for the mortgage rate history and the equity market valuation responses (see Market Menagerie: Housing Questions to Ponder). A key theme on the calls was that the reported numbers coming out of 3Q22 earnings seasons heavily reflect sales deals struck in earlier periods and that the go-forward run rates will change materially.
Cancellations: The rate of cancellations were putting up numbers like 30% in some cases for a range of reasons. The typical explanation was homebuyer recession fears but we also hear about elongated cycle times dragging on and investors worried about financing and rates moving even higher. The fear of buying a house that will be worth less in a year is a natural concern even if the buyer qualifies easily at 7% mortgage rates. That directly hits volumes and is a leading indicator to more potential buyers just hunkering down to “wait and see.” The Fed tightening cycle is still a heated debate on scale and duration, and the recession months could arrive in 2023. The color on the calls highlight that many homebuyer cancellations were sometimes just psychology. But many were due in fact to mortgage qualification problems as rates soared.
Incentives: The management teams discuss incentives from various angles, including discounts to base prices, shifting buyer “options” in the home models pricing, and changing features and add-ons in a build-to-order process. We also hear about mortgage rate buy-downs and closing cost benefits. Some were loath to get too far into the weeds, but some did. Whether an incentive is a price discount or an alternative marketing cost, it all comes down to lower net economics to the builder. This will be a big drilldown item in Q&A sessions and a hot industry topic from here during the housing sector downturn.
Land spend budgets, canceling land options: The prospects of much lower land spend and a reallocation of the budget share to development is a major part of the credit risk story line. With billions of dollars in budget swings ahead, the stated focus on managing financial risk and maximizing cash flow was clear enough on the calls. The costs of cancelling options is booked at a fraction of the land spend required to develop those assets. This is a case of foregone spending and essentially a downsizing of projected outlays. Where there is not an “option” to cancel, the builders also cite ongoing dealings with developers to change terms or delay investment schedules.
Balance sheet priority: Most reiterated their balance sheet focus to remind investors that this is not a replay of the housing sector crisis. Not even close. They did not overdo the topic (which would make listeners nervous), but the land spend commentary was to reassure on financial flexibility. I always focus on the theme of when the analysis “shifts from the income statement to the cash flow statement,” and we will be focusing on both in coming quarters as inventory goes into a slow-and-steady liquidation mode, and the process shrinks both sides of the balance sheet. Asset protection for unsecured noteholders is very strong for most of the major builders with a few exceptions. The same is true in financial flexibility given such a large unencumbered pool of assets.
Impairments: Some builders revisited in general terms the accounting and math around impairments. The basic theme was that it is looked at annually or as needed (like any impairment exercise such as in goodwill). The exercise comes back to framing cash flows of a community vs. the carrying value. They are analyzing the economics of land, lot, and community investments all the time. So this is not a sensitive area – yet – for companies running gross margins as high as 30%. The builders will be looking at costs and dialing up the supplier chain to change the economics of that cash flow analysis. The carrying value of inventory vs total debt is very lopsided in favor of asset coverage at this time, so there is a lot of cushion.
Supply-demand handicapping: The big sentiment shift for investors will get influenced by how the market sees the balance of much lower demand and how that stacks up against supply shifts. The homebuilders can control their end of the supply, but existing home sales dominate the total home sales number. We had looked at some of the moving parts in our question checklist earlier this week. The main theme there is that homebuyers with material positive equity also likely have a 3% to 4% range mortgage and will not want to sell into a weak market where they face high mortgages on the other side (e.g., in move-up trade). In other words, supply will remain tight from the existing sales side. The supplier chain challenges also had prevented too much an inventory build up of spec homes.
Supply chain strains and long cycle times: A recurring theme was how hard the supply chain was to manage even without the mortgage payment spike and recession fears. Materials and suppliers (e.g. glass, appliances) were a challenge. Meanwhile, the clock was ticking on mortgage rates as the backlog was slow to get delivered. Labor shortages and problems finding enough qualified crews was a problem as well. The desire to dig (more like excavate) for a silver lining had some builders indicating that supplier chain issues would improve. Even then, the supplier challenge for builders will be to try to extract concessions on costs. The ability to reduce costs and improve community economics could also reduce impairment risks.
NOTABLE QUOTABLES FROM HOMEBUILDER CALLS
Below we excerpt some notable comments by management teams from the following builders: PHM, TMHC, MTH, MDC, CCS, TPH. The geographic reach and scale of these builders covered below tell a broad national story.
PulteGroup (PHM): Pulte is a distant #3 in the homebuilder rankings based on revenue, well behind #1 DR Horton and #2 Lennar (who are a toss-up for #1). In market cap, PHM sits behind NVR, which has been a very strong equity story going back over decades and presented a very strong financial profile even across the housing bubble and ensuing crisis. NVR does not do quarterly earnings calls.
“If our income statement demonstrates prior demand strength, third quarter order and cancellation rates show the more challenging market dynamics we are operating under today.”
“The impact of consumers dealing with issues of financing or fear also extended to our backlog as cancellation rates increased 24% in the quarter.”
“When demand first began so slow in response to higher rates, incentives in most of our markets were focused on mortgage rate locks and buydowns…as mortgage rates moved even higher, incentives have extended to other areas, including more aggressive discounting of standing inventory and price reductions…”
“…we are re-underwriting our land deals using price, pace, and cost assumptions based on current market conditions with a view towards assessing whether expected returns still achieve or exceed our required hurdle rates.”
“…we have now lowered our spec starts and we’ll manage our production to maintain the balance…with emphasis on build-to-order production…”
“…our preliminary estimate is that land acquisition and development spend in 2023 will drop by $1.5 billion to approximately $3.3 billion.”
Taylor Morrison Home Corp (TMHC): TMHC projected itself into the upper ranks of the US builders with its acquisition of William Lyon (closed Feb 2020). We frame TMHC as #6 among the builders looking at revenues behind DR Horton, Lennar, Pulte, NVR (larger than PHM in market cap), and Toll Brothers. The Lyon deal brought a major western regional player that also increased exposure to the Pacific Northwest as well as NV (Las Vegas) in addition to overlapping West/South regions (CA, CO, AZ, TX). TMHC’s traditional areas at the time of the merger were FL, NC, SC, GA in the Southeast and IL in the Midwest. THMC now brings a national view.
“…due to the significant level of uncertainty in the current housing market, ongoing material and labor supply issues as well as the added complexity and production delays stemming from Hurricane Ian, we are not providing fourth quarter operational guidance.” (Note: it is rare for major homebuilders not to offer guidance and hard numbers.).
“…our entry level communities continued to face the most pressure as we would expect given the greatest affordability constraints among these buyers.”
“…we strongly believe in the value of using finance as a sales tool by offering generous market incentives versus simply reducing price as the benefits to the buyer is often much greater...includes a range of tools…permanent and temporary interest rate buy downs, extended rate locks, and various financing programs.”
“…in the third quarter, our homebuyers using Taylor Morrison home funding…average credit score of 752 and a down payment of 23%.”
“…for the third quarter 80% of our contemplated core business land spend progressing through the investment committee was restructured or terminated when underwriting no longer met our required thresholds…70% year-over-year decline in our third quarter spend…the lowest level since 2016.”
“controlled …80,000 homebuilding lots…of these lots, we controlled 42% via options…all time high percentage…”
“Florida…accounted for nearly 25% of our closings in the first half of the year.”
Meritage Homes (MTH): Meritage Homes weighs in around #8 in the Top 10 based on revenues with a presence across 9 states including CA, AZ, and CO in its West segment, Texas in the Central segment, and in the East segment FL, GA, NC, SC, and TN.
“The rapid and steep increases in mortgage rates and the expectations of further significant rate hikes to come coupled with inflation and uncertainty in economy as well as elevated cycle times all drove meaningful deterioration in customer demand.”
“…favorable homebuyer demographics and an undersupplied overall housing inventory still exist…we expect them to be overshadowed in the short run…”
“…our cancellation rate was 30%...above our historical average in the in the mid-teens…increased from 10% in Q3 2021 and 13% in Q3 2022…”
“… we saw cancellation spikes in our markets where there are other move-in ready alternatives…”
“…these results mostly reflect closings of homes sold in a different sales environment, and that based on current trends will not be indicative of near-term quarterly operations…”
“…we plan to continue to prioritize pace over price…”
“impairment assessment of real estate assets is conducted at least annually on a community-by-community basis or more frequently if needed…we do not anticipate broad-based impairments in the near term, barring further material ASP declines.”
“…charges from terminated land deals represented about 10% of the total exposure related to our capitalized costs as we only have $110 million remaining of deposits and due diligence costs…this $110 million makes up less than 2% of our total assets.”
“…incentives are moving all over the place, price rollbacks are moving all over the place…it’s been kind of a combination…maybe some rate buy-downs, maybe some closing cost support and then maybe an adjustment in net pricing.”
“…I couldn’t really imagine a scenario where mortgage rates have done what they have done over the last 4 months…it’s really created the perfect storm for pricing…to roll back as materially as it has to solve for the lack of consumer confidence…uncertainty in the economy…the rate and the payment that people are comfortable with… am I surprised that when rates double, prices have to roll back meaningfully, no.”
“…the consumer today is pretty shaken…if they’re going to buy a home, they got to be confident that they’re getting in at a price that they don’t feel like they’re going to lose equity over the next year or two. And it’s about the price.”
MDC Holdings (MDC): MDC weighs in at #9 among the homebuilders based on recent quarterly revenue numbers just behind Meritage and ahead of Century Communities. MDC is very strong in Colorado but operates in almost half of the Top 50 metros area (MSAs).
“…we have refocused our efforts on generating cash, fortifying the balance sheet and taking costs out of the business.”
“…we approved virtually no new land deals during the quarter and walked away from over $11 million in option deposits and pre-acquisition costs.”
“…continues to experience long lead times and delays on the back end…working diligently with our trade vendors and suppliers to find solutions…expect to see some improvement over time as the slowdown in order activity translates into better trade availability.”
“…cancellation activity in the second quarter was largely driven by affordability issues due to the sudden increase in mortgage rates. Cancellation activity in the third quarter seemed to be driven more by psychological factors than financial ones.”
“…incentives as a percentage of the dollar value or gross new orders increased by approximately 400 basis points year-over-year and 280 points versus the second quarter of 2020.”
“….net unit orders were negatively impacted by the number of cancellations during the quarter, which more than doubled from the prior year…”
“…43% of cancellations during the third quarter…from buyers who could still afford to move forward…36% of cancellations … were strictly due to the buyer no longer qualifying for a mortgage.”
Century Communities (CCS): CCS has been an acquisitive operation and is now a Top 10 player with a major presence in areas such as Atlanta, Denver and Las Vegas. The “CCS” map shows operations in the Southeast, Mid-Atlantic, Mountain region, Southwest, and Texas with a line running north up to Michigan from the south. In other words, it has a national, multi-regional perspective in its market commentary. CCS had seen its revenue base quadruple from 2016 to 2021. With 80% of their revenues being entry level buyers, CCS will offer a window into the impact of rising mortgages on the lower price buyer.
“Homebuyers are continuing to look for homes that are closer to completion in order to lock in their interest rates, and our sales continue to be impacted by the fact that we simply did not have a significant number of homes available for a near-term move-in…”
“…our plan is to continue to match our starts with our sales, focus our sales efforts on homes with more near-term completions and not start building up significant backlog until we see a sustainable improvement in demand.”
“The type and amount of incentive differs by community and by market…we have seen mortgage rate buy-downs, rate locks, and discounts on options and upgrades be effective in getting buyers in the door…”
“…we saw an increase in our cancellation in the third quarter to 35%...cancellations we experienced were both financing related and from buyers opting to walk away from contracts given the overall uncertainty in the market…”
“…we think existing home sales will be constrained going forward as buyers will be very reluctant to walk away from the extremely attractive interest rates that they secured over the past several years…”
“…the homebuilding industry continues to be challenged by municipal delays, supply chain issues, and trade shortages though these pressures are slowly getting better…the majority of lower costs in the quarter were from lumber and trusses…”
“…given weakness in the market this quarter…deliberately slowed opening of new communities…”
Tri Pointe Homes (TPH): TPH is just under the Top 10 homebuilder ranks with a very heavy concentration in California at just under half of home sales revenues (46%). Among other areas, Texas is a distant second at 13%, Arizona 12%, and Nevada 9%. Smaller operations in the East include the Washington DC area and the Carolinas at a combined 10%.
“We are providing below-market financing solutions to both buyers in backlog and new buyers by utilizing forward commitments, temporary and permanent rate buy downs and extended rate locks to lower monthly payments, providing buyers with a peace of mind leading up to their home closing.”
“We can still buy down to about 5.25% and we can still provide some additional incentives for paid closing costs.”
“…we are leveraging promotions such as closing cost contributions, design studio credits, and special pricing on available homes for year-end deliveries.”
“…buyers in backlog who are financing… with Tri Pointe connect (affiliated mortgage company) …our average buyer FICO score is 749, loan-to-value is 80%, and average debt-to-income ratio is 40% with an average annual household income of $182,000.”
“…I think the housing market and starts will pull back dramatically in ’23…we already were undersupplied…I think going into ’24 we’re going to see a bounce back because there is no supply. The resale market (existing homes) is effectively locked in at sub-3.5%, 4% mortgages.”
“…once that settles down, there is a tremendous amount of demand sitting on the sidelines just deciding...”