This year marks Chuck Shinn’s 50th anniversary in the housing industry. His reputation and influence as management consultant and forecaster are unmatched, with a career that began by rising through the NAHB’s ranks, establishing countless systems that are now standard for builders. Shinn started the University of Denver’s MBA program and created its School of Real Estate and Construction Management. He ran his own successful home building company, as well as others.
Much has changed in the last half-century. But after working with thousands of builders, Shinn has observed that five essential truths remain constant and are as important for builders in a boom market as they are in a downturn.
Truth No. 1
Gross profit = The first line of defense for net profit
Anyone who has hired Shinn or heard him speak has heard him say that builders set their sales price the wrong way: setting a target price, subtracting direct land and construction costs and operating expenses, and considering whatever is left over as profit. When sales are slow, builders often discount. This rarely affects velocity, but it does affect profitability.
Instead, the target profit rate should be the first item deducted from the price. Builders should start with a target gross profit of 30 percent, with 70 percent to pay for the land, construction, and operating expenses.
Within that gross profit, costs to run the business—sales and marketing, finance, and administration—should run about 18 percent. This offers the chance for a 12 percent profit margin, “2 percent of which typically disappears,” Shinn says. But most builders’ gross profit margin isn’t that high. “Most builders have gross profit of 21 to 25 percent,” Shinn explains. “If they make 21 percent and use 18 percent to run the business, their profit is 3 percent. That’s too risky.”
Truth No. 2
Discipline = The differentiator
Shinn says that, as entrepreneurs, builders find it difficult to be disciplined. But discipline starts at the top and must involve policies and procedures. Mick McGraw, CEO of Grand Rapids, Michigan-based Eastbrook Homes, says that attending a one-week seminar of Shinn’s drove the discipline message home for him and helped to turn his company around back in the early 1980s. Eastbrook dedicated itself to changing its entire accounting system and committed to performance metrics, giving the builder the tools to have confidence in the numbers.
National Housing Quality Hall of Fame inductee Tom Gillespie says he got that message loud and clear when he hired Shinn for some consulting work in the early 2000s. Famous for not sugar-coating advice, Shinn wrapped up his time with Gillespie’s company with this: “When you’re really ticked off at the company and want to find the problem, go into the washroom and look in the mirror. The problem will be staring back at you.” Those words, Gillespie says, “kept me focused on being the best leader I could be.”
Truth No. 3
Direct construction costs = The only variable
Direct construction costs are a builder’s largest cost category, with the greatest potential for increasing profitability. Once the cost of building is reduced, savings are realized every time a home is built. It increases both gross profit and net profit the same as a sales price increase, without the risk of scaring off buyers.
Typically, a house has about 100 cost codes. If a builder set a goal to reduce each direct construction cost code by $10, profits would increase by $1,000 per home. A builder that sells 100 homes a year would generate an additional $100,000 of profit.
One way to control direct construction costs is to establish scopes of work so each trade contractor understands what’s expected of them. Without it, “many builders pay for the work twice, with laborers and punch-out crews,” Shinn says. Another is to eliminate variances—unplanned costs that have no counterbalancing revenue—such as extra or damaged material, extra labor, rework, theft, estimating errors, and sales concessions.
Detailed estimate and purchasing procedures allow for better variance analysis and control, Shinn says. Variance purchase orders with source codes identify the unplanned costs and indicate how to eliminate the variance in the future. Monthly variance meetings help to identify the source of variances and establish a game plan to eradicate them.
Truth No. 4
Scheduling = The driver
Leaving scheduling to superintendents is a terrible mistake because, Shinn says, “Scheduling is the spine of the management system. It needs to be centrally managed.”
Taking control of scheduling is essential to profitability. Results will be felt throughout the entire company. Profitability affects the number of homes a superintendent can carry at any one time, and the number of homes a builder can close in a year. It pushes up the cost of fixed expenses on everything because each item ends up being allocated to a lower number of units.
If your financing is based on 90 days and it takes you 120 days to build a home, that’s 30 extra days of financing. Your cash flow is negatively affected because it takes longer to collect closing proceeds. That could lead to a need for operating lines of credit, thus increasing financing expenses.
Developing a master schedule showing the sequence of events for the trades will cut down on idle time, dry runs, and inefficiencies. A complete start package, with everything the field needs to build the home, should be assembled and shared with the team before construction starts.
Truth No. 5
Buyers = Unchanged
After intensive study, Shinn doesn’t think Millennials’ buying habits are an anomaly. “They’re not different,” he says, “they’re just postponing.” He adds that, historically, people buy a first home at around 31 or 32 years of age after getting married and having kids. Millennials are holding off on both. “A child generates the purchase of a condo or townhouse,” Shinn says. “When the child is school-age, the family will move to the suburbs for the schools. They’ll buy their ultimate home between 45 and 50. For Millennials, it will be more like 50 to 52.”
The big generational difference Shinn observed was Generation X, whose members were buying houses during boom years. Supported by low interest rates and easy access to credit, they overbought. “Now interest rates are increasing,” Shinn says, “Gen X is over-housed, and they’re a little sticky on buying another house. Those are the little tweaks.”
He’s keeping a close eye on interest rates, which are creeping up after years of historic lows, and sees potential trouble. “People don’t care about the price of the house,” Shinn points out. “They care about the monthly payment. If interest rates get too far out of line, we’ll go to a 35-, 40-, or 50-year mortgage.”
By the Numbers
For builders to achieve the profit levels Chuck Shinn insists are possible means paying slavish attention to the numbers. Shinn says the following activities are as important to monitor today as they have been for half a century.
Cash balances: Cash is king. Know what the company’s cash balance is every day. Builders go out of business not necessarily because they operated at a loss but because they’re out of cash.
Contract backlog: That is, houses sold not started, is a weather vane for future sales. Increases in backlog will indicate improvements in the market. Backlog decreases are a caution flag.
Contracts, starts, and closings: Tracking these translates to keeping a finger on the pulse of sales, construction activity, and company revenue.
Conversions: Applying conversion rates to traffic numbers helps builders anticipate future sales.
Customer satisfaction: Measured as willingness to refer, this provides customer feedback.
Cycle time: Measuring cycle time is critical to ensure that closings happen as planned.
Debt to equity: This measures the level of debt relative to the owners’ investment. The higher the debt-to-equity ratio, the higher the financial risk to the company.
Financial ratios: These should be tracked at least monthly (see gross profit, next).
Gross profit: Keep track of this by division, community, product type, and home, looking at net profit and operating expenses—including field, financing, sales and marketing, and general and administrative expenses. The financial ratios provide objective measurements on how the company is being managed and they will provide expectations of the company’s annual profitability.
Lots available: The number of lots available, expressed in number of weeks based on present sales volume, becomes insurance for not running out of lots, providing enough warning to react to market changes. “I’ve seen too many builders that haven’t been able to sell because they have no lots available,” Shinn says. “The length of time required to bring lots to the market doesn’t allow for making this type of mistake.”
Sales: Should be measured weekly.
Spec inventory aged: The number of spec homes and the length of time in the market is another important indicator of market changes. Reaction time is important. Builders should know how many spec homes they have in the market and the maximum number they should hold.
Traffic: Should be tracked by community. It sets the stage for the market.
Variances in construction costs and time: Time and cost variances reveal efficiencies and effectiveness of the construction process. Most builders don’t track variances at all, Shinn says
Writer Pat Curry covers design, real estate, and home building.