Avoid High-Leverage Financing

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Reduce financing costs by cutting construction times and the number of spec houses in inventory.

December 01, 2003

 

Chuck Shinn, President, Lee Evans Group

cshinn@

leeevansgroup.com

 

 

Financing expenses include interest on all lines of credit, notes payable and construction loans (including points, fees and closing costs). The target here is 4.0% of sales, but in today's low-interest-rate environment, many builders hold this category below 3.5%. If you're not among them, carrying costs on developed lots and completed inventory homes might be the culprit.

 

If your financing costs are high, reduce your leverage. I like to see the debt-to-equity ratio between 3-to-1 and 5-to-1. But banks are throwing so much money at builders that I see ratios as high as 14-to-1. High-leverage builders have high loan-service costs and are more exposed to interest-rate risk - not a good idea. With the economy strengthening, there could be upward pressure on rates.

Try to move from individual construction loans to a revolving line of credit. That cuts points and fees. Also try to negotiate a lower spread between the interest-rate index and your rate. However, probably the best way to reduce financing costs is to cut construction times and the number of spec houses in inventory.

 

 
Target
Typical
Sale price
100.0%
100.0%
Cost of sales
70.0%
78.0-85.0%
Gross margin
30.0%
15.0-22.0%
Indirect construction costs
3.5%
5.0-6.0%
Financing Expense
4.0%
3.0-7.0%
Marketing expense
6.0%
5.0-10.0%
General administrative expense
4.5%
4.0-7.0%
Total operating expense
18.0%
16.0-22.0%
Net profit
12.0%
3.5-5.0%

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