This is a longer version of an article that appeared in the May/June 2022 issue.
Current economic conditions and housing demand have contributed to unprecedented growth for several small start-up home building companies, many of which have ramped up to as many as 500 home sales per year in a short time. But with that rapid growth come what I call “high-speed wobbles”—unsteadiness caused by lack of the management processes and systems needed to keep pace. The result: builders operating in crisis mode and running the risk of stall-out and failure.
Rising From the Ashes of the Great Recession
Over the last 10 years, the housing industry has been recovering from the Great Recession when single-family housing starts plummeted over 80% in three years and more than half of home building and trade contractor businesses went bust.
The silver lining: It was an opportunity for new home builders to enter the market as it recovered, and demand for new housing slowly but surely accelerated thanks to a Recession-induced shortfall of 3.8 million homes by the end of 2020, according to Freddie Mac.
As a result, the 2020s are poised to be the best decade for housing demand in U.S. history due to low inventories of existing and new homes, low mortgage interest rates (even with recent rate hikes), Baby Boomers downsizing, and Millennials entering the for-sale housing market en masse. While all of that is good news for home builders, simply ramping up volume and sales isn’t synonymous with increasing net profits.
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Growth Patterns and Growing Pains as Volume Increases
The typical growth pattern for a home building business follows an S-curve. The bottom of the curve consists of the early years, which involve setting up the organization; establishing relationships with banks, trades, and suppliers; and developing a set of standard plans and a land bank.
Once a builder is established, growth can be exponential, but there are typical points along the curve where management systems must change as production increases to 25 homes, 75-100, 150-200, 250-300, 350-400, 600, and 1,000-plus homes. Blowing through these mileposts without taking time to implement the management systems necessary to operate efficiently and effectively at those volumes tends to limit the ability to grow without chaos, or worse.
Historically, fewer than 2% of the roughly 100,000 home builders in the U.S. build more than 100 homes a year. But new start-ups—financed by outside investment firms also new to housing—are reaching that production volume (and in many cases far greater) almost overnight.
Our firm is dealing with two such companies right now: one is likely to sell more than 200 homes this year, the other more than 500, and both are out of control, squandering great opportunities, and hardly making any money because they lack management systems and the discipline to standardize their procedures. With some of the headwinds we’re facing as an industry, including increasing mortgage interest rates, I fear neither builder will survive the year.
That’s because these start-ups, and many more like them, are woefully unprepared to manage the volume they’ve accumulated. They still use small-business accounting software and simple spreadsheets, without appropriate management systems and reporting processes in place. They also make a lot of custom structural changes—even after construction has started—and bid out and sign trade and supplier contracts based on the last house they completed and without detailed (or any) scopes of work. They pay vendor invoices without any variance documentation. Schedules are controlled by individual superintendents, becoming merely job status reports with a lot of fluidity. In short, these builders run a sophisticated business without standard processes and procedures, and with a high number of variances and lack of commensurate financial and management reporting. In other words, they’re operating more like a small, local custom builder.
Work Smarter, Not Harder
When production builders operate as small, custom shops, it’s only a matter of time before their basic management systems, processes, procedures, and controls take a toll on the business.
Often chaotic and operating in crisis mode, the lack of adequate staff, trades, and suppliers puts them on a treadmill that has them working harder than necessary and fighting fires due to mistakes and miscommunication with everyone involved—including homeowners.
And, by focusing on volume instead of profit, these home builders soon discover the financial returns are extremely low for the risk and effort involved. Many of them are living off their cash flow and getting upside down on their construction draws, which can be the kiss of death. When you’re out of cash, you’re out of business.
15 Integrated Management Systems for Production Builders
To turn things around, there are a minimum of 15 integrated management systems production builders should implement to adequately manage volume, growth, and profitability:
1. Organization and job descriptions for all employees
a) Determine the reporting relationships of staff
b) Determine responsibilities for each employee
c) Reduce chaos, duplication, and omissions
d) Allow for delegation of authority
2. Integrated management software
3. A standard construction scheduling sequence
a) Standardize and simplify everything
b) Establish consistency
c) Get rid of the noise in all processes
4. Monthly management reports
a) Eliminates mistakes
b) Ensures consistency
c) Reduces errors and omissions
5. A comprehensive, detailed purchasing system
a) More robust ERP systems
b) Designed for production builders
c) Has a database for standard pricing and PO releases
6. A purchase-order system
a) Job logic should be consistent
b) Duration may differ
7. Weekly job variance reports
a) Follow scheduling sequence
b) Allows for cash flow forecasting
8. A standard job-cost sequence
a) Release to construction when complete
b) Checklist of items needed
9. Construction start packages
a) Standard price for each plan
b) At least three bidders per category
c) Recruit adequate trade base for volume
d) 80/20 rules
i. No sole sourcing
10. Annual, quarterly, and monthly financial plans
a) Follow scheduling sequence
b) Purchase order (PO) per pay point
c) Pay POs not invoices
i. Document differences with a variance PO
d) Facilitates cash flow forecasting
e) Allows the elimination of invoices
f) Facilitates cost variance documentation and control
11. Standardized, streamlined processes and procedures across the operation
a) Don’t sign trade/vendor proposals
b) Document relationship
c) Builder controls relationship
12. Process checklists
a) Job descriptions for trades
b) Job completion checklist for each trade
c) No payment until scope of work is complete
13. Trade partner and vendor agreements
i. Job cost
iii. By reason code
14. Scopes of work for trades and vendors
a) Job cost
i. Corrective action
i. Corrective action
15. Planned and priced customization; no changes after construction allowed.
a) Pre-plan, pre-price allowed customization
b) Reduce red-line customization
c) Eliminate customization after start of construction
Inadequate management systems, inefficient operations, and lack of discipline can sink not only profit margins but also the business.
Surviving Softening Demand
For those of you experiencing high-speed wobbles, beware of the potential economic changes facing our industry toward the end of 2022. Inflation remains high, affecting housing affordability. Construction costs have increased by about 12% overall and lumber is back on an upward trajectory, or is at least volatile. Supply-chain issues persist and construction schedules continue to be extended, adding costs and hindering profits.
And as the Fed fights inflation, mortgage interest rates have risen from 3.29% at the start of the year to 5.36% on May 19, according to Mortgage News Daily, a source of mortgage rates and other market data.
These looming dark economic clouds signify a high probability that housing demand will be negatively affected. If demand softens, home building companies that are highly leveraged with very tight cash flow, high land inventory, and weak management systems will be at risk for failure.
Charles “Chuck” C. Shinn Jr., PhD, has been improving the management standards and profitability of home builders for more than 50 years. Download “The Roaring 2020s: Housing’s Best Decade,” at shinnconsulting.com.