KB Throws A Curve

Forty years ago, KB (then Kaufman and Broad) shocked the housing world by becoming the first builder to launch its own in-house mortgage subsidiary. On June 30 this year, Karatz loosed another lightning bolt — announcing that KB Home will sell its mortgage subsidiary, KB Home Mortgage, to Countrywide Financial Corp., the country's largest mortgage lender. Those two firms are now planning to form a 50-50 joint venture specifically to make residential loans to KB Home customers.

The shock waves are already rolling across the industry, as housing analysts and competitors try to fathom whether Karatz's move will trigger other Giants to follow his lead by divesting their own mortgage lending operations.

Karatz seems hardly able to contain his mirth at the consternation he has caused. But make no mistake, this was no isolated event, but rather just a pawn in a unified offensive strategy aimed at maneuvering KB closer to the top of housing's leader board. Karatz has been working on his plan for a new KB for half a dozen years, and the changes are now becoming a lot more obvious.

Why does Karatz want out of the mortgage business?

"I think our deal with Countrywide is very important for all big home builders," he says. "The mortgage business is heavily consolidated and rapidly evolving. It now requires huge investments in systems software to meet borrowers' needs for a vast array of mortgage products. It's not a one size fits all business anymore.

"Today, Countrywide has 180 different mortgage products," Karatz says. "They have invested hundreds of millions of dollars a year on systems and software. They have their own trading desk to facilitate a hedging program that allows customers to benefit from reduced risk. All this is something KB Home Mortgage couldn't develop on its own. We would never put up anywhere near the kind of money Countrywide invests every year to stay at the top of the game."

Karatz says KB's geographic expansion into the Southeast and Midwest also put strains on the mortgage subsidiary. "Eventually, they would catch up, but we had to depend on Countrywide until we got our own mortgage offices up and running," he says. "You can't compare any builder's in-house mortgage operation to a company like Countrywide.

"Theoretically, we could offer 180 different mortgage products," Karatz reasons, "but to do it, you'd need well-trained agents who can explain every one of those products to home buyers. We don't have training or systems to do that anywhere near as effectively as Countrywide. We had a dozen or so mortgage products we felt we could handle and explain easily.

"That's all we reasonably needed," Karatz says, "but we couldn't help thinking it sure would be nice to have everything."

KB has seen its retention rates drop significantly in recent years, and believes competition from specialists like Countrywide is the cause. "At the end of the day, our business is home building," Karatz declares. "And our future success depends on our ability to anticipate and deliver on our customers' needs. We spend a lot of time and money trying to figure out how to please people. Countrywide helps us do that.

"Honestly, from the perspective of our shareholders, this deal makes eminent sense. We've not done a great job of maximizing mortgage revenues for several years. We'll be much better off financially with this Countrywide deal in place," Karatz says. "That was not the major motivation, but it is an important byproduct."

The new joint venture will emphasize the Countrywide name. KB has no desire to mask the identity of its mortgage partner. "That's totally consistent with our strategy of taking great brands and making them KB Home partners," Karatz says, "just as we take advantage of Kohler's brand in plumbing products.

"We don't believe in vertical integration. Other big builders are following a different path, but that's OK."

Within several months, if you walk into a KB Home sales office, you will know instantly that KB is building the house and Countrywide is financing the purchase. The question other big builders have to ask, especially the other Supernovas at the top of our Giant 400 rankings, is whether they think they can match those 180 mortgage products KB now has at its disposal, and whether the 180 will turn into 360 in five years. Whatever the number is, Karatz is confident Countrywide will be right on the cutting edge, and that will put KB ahead of the curve.

"I think we look pretty good," Karatz says. "I like it."

Take a close look at what Karatz has been up to for the last six years, and it's clear the Countrywide deal is just another piece in the puzzle that is the new KB Home. The firm was once stuck in the Far West (mostly California), and typecast in the starter market segment, with a less-than-stellar reputation for quality and customer satisfaction. None of those assumptions hold up to scrutiny today.

KB now has a strong presence in Texas and Florida, Chicago, Indianapolis, Atlanta and the Carolinas. And Karatz is now broadening his product lines to include all price points, even luxury.

The move into higher price points is facilitated by a new emphasis on quality and customer satisfaction. KB insiders might call it an obsession. It's clear the boss has something on his mind. KB is now perhaps America's biggest proponent of J.D. Power customer satisfaction measurement. "It's now a huge element of the success of our business," Karatz says. "We've tied our compensation and recognition within the company to J.D. Power scores.

From off the charts in most markets, KB now stands in third place nationally in J.D. Power's rankings. This is not the old KB. "We're one point out of second place," Karatz says, "and we want to keep moving up."

"I will not go so far as to say that J.D. Power affects sales," Karatz cautions. "I've bought lots of cars without ever checking their J.D. Power rank, but we believe this is an absolutely independent evaluation of our business, and we really have 40 different businesses across the country in our company. Tying our own internal measures and compensation to J.D. Power scores is a way to cause our people to run their businesses consistent with our national standards.

"There are no ifs, ands or buts — it's a very good control point. It's a way to ensure that the product we're delivering is of the highest possible quality, but in the end, the satisfaction of a buyer doesn't just depend on the windows not leaking," Karatz says. "It has to do with how you execute every aspect of your business. If you offer a delivery date of October 31 and don't close until November 30, after Thanksgiving, you will have a very unhappy buyer — even if the house is perfect."

Setting expectations is vital to customer satisfaction, says Karatz, especially in the first-time buyer market. "That seems counter-intuitive, but it's true. First-timers have never been through the process," Karatz says, "so their expectations can be wildly unrealistic. Move-ups have been through it before, so they know that weather can cause delays and affect a delivery date. Coming out of an apartment, first-time buyers can't imagine that a big company would quote them a move-in date and then not meet it.

"Your ability to meet their expectations depends — to a huge extent — on your ability to set those expectations by explaining the whole sales and construction process thoroughly and understandably."

Karatz's business is still 30 percent with entry-level buyers. And he's proud of the progress KB has made in J.D. Power rankings while competing with builders who don't build nearly as much to that market segment. But half or more of KB's business is now at higher price points, and that's by design.

"We've been diversifying product for half a dozen years," Karatz says. "It just takes a while for perceptions to change. We're now broadening our pricing even more. We're going much more high-priced on one side, and much denser with our lower-priced product. Our strategy is to broaden our product to get better penetration of sub-markets in areas where we already have operations — rather than expanding more geographically with the products we already have.

"That doesn't mean we aren't going into new markets, but we're doing it at a slower pace. We haven't done any acquisitions lately. We're going into Washington, D.C., but we're doing it as a green field."

Karatz admits he's well down the path toward a commitment to do high-rise condo buildings soon. "In the most attractive markets, land costs are very high," he explains. "The only answer is condo development. We've been doing high-density condos in France for 20 years. We'll build over 4000 condos there this year — everything from townhouses to apartment flats.

"Condo products are also more attractive to certain types of buyers today. Singles in major cities are not interested in detached houses in the suburbs — even when they can afford them. We think we can open the door to home ownership for legions of young buyers by coming up with the right products, in the right locations, to fit their lifestyles."

When we look at the Big Five at the top of the American housing industry — the Supernovas — it looks to us that any of those five could be No.1 in the revenue rankings, including KB Home. Yet Karatz refuses to allow that to be a goal. "It doesn't add value to the company, so why have it?" he asks. "We're not going to double our market cap by being No.1 on the revenue line."

Still, he cautiously admits to the quest for growth. "If you are not a growing company, you are viewed differently on Wall Street. We all know that. I do believe there's a value when market cap exceeds $10 billion. That is a goal!"

Don't count KB Home out of that run, or even the one for No.1. This is a company that has really changed in the last six years. For those who didn't notice, the Countrywide deal should be a wake-up call. And Bruce Karatz deserves the credit. He's a man to be reckoned with, and he's got a growth strategy worth emulating — whether you aspire to be the biggest builder in one town or the whole country.