Stephen Kim on Leverage, Land Value, and Loose Credit

The macroeconomic fundamentals for home building look solid, so would that mean the next downturn, when it comes, will be a mild one?

April 3, 2018
Executive Corner_Stephen Kim_Evercore ISI

There’s a sentiment that because the tight supply for labor and land constrains home builders from building as many houses as demand warrants, the economic downturn, when it comes, will be a mild one. Stephen Kim isn’t one to say the sky is falling, but the senior managing director for Evercore ISI’s Building and Builder Product Equity Research isn’t so sanguine about the ride through the next recession being a soft one. He notes that publicly traded home builders are more land-leveraged than they were just before the Great Recession. Also, the notion that loan defaults during the next downturn wouldn’t be as severe because credit is tighter this time could be a fallacy, considering that the percentage of homeowners who bought houses in affordable price ranges with less than a 5 percent down payment is greater now than in 2005. Kim has more observations about the current recovery cycle and the impact of tax reform on land value.

Q: You noted that the top public builders haven’t become asset-light compared with where they were regarding land ownership and options before the recession. What’s your take on land spending as a percentage of revenue?

A: Essentially, what we have observed is that builders have been talking a lot about becoming more land-light, but their actions speak louder than their words. A couple of things I would note are that if you look at the amount of land builders own today relative to prior periods, you would actually see that builders own more land than they did in prior cycles, not less. What’s also interesting is that the amount they spend as a percentage of their revenue has actually been increasing. After falling from the unsustainable heights they reached in 2012 and 2013, those land-spend levels, as a percentage of revenue, came back last year to the industry average. But now they’ve actually started to nose back up again. 

My point is that if you’re making a call that the builders are substantially more asset-light, you have two main problems: One is that they’re not more land-light, they’re more land-heavy than they were, and secondly, they’re not spending less, they’re spending more. It’s like when you’re on a diet; if you want to lose weight, you have to eat less. Well, the builders here, if they want to get the ownership down, they have to buy less, and they’re not doing that. That was the one-two punch that we were seeing on the land side.

Q: Does it make a difference if builders control the land but they don’t actually own it?

A: It would if it led you to a different conclusion than what we arrived at. One of the things we’d heard was that builders were saying that they are optioning land. They were saying they’re land-light. But they are actually land-heavy. 

In particular, one of the things we’ve heard is, “Oh, the builders want to option 50 percent of their lots.” We said, “All right. That’s great. Let’s take a look at history.” What you find is that throughout almost the entirety of the mid-1990s to the mid-2000s—the latter half of the last cycle—optioning 50 percent of lots was totally the norm. There’s nothing unusual about optioning half of your lots. You would absolutely not say that makes this industry different from what it was in the past. It doesn’t. 

The second thing we point out is that it doesn’t really matter what percentage of your lots you option. What matters is how much land you own. So let’s say you option 90 percent of your lots, but you own 10 years. Does the fact that you have a 90 percent option ratio make you less land-heavy? No, you own 10 years of land. It’s the wrong metric to begin with. But even if you look at the metric, you would see that there’s nothing special about it.

Q: Would that lead you to say that the industry hasn’t learned its lesson?

A: I think it’s worse. It’s not that builders don’t see the risk inherent in owning land. It’s that they don’t have a choice. One of the things builders will readily admit is that, unlike in the previous cycle, there isn’t a large stable of land developers that have the ability to hold land for builders, like they did during the last cycle. I guess you can think of it this way. We went through the real estate downturn of the century. If you think it was tough to be a builder, imagine having a business where you borrowed money to buy land. That’s even worse.

Those guys went out of business and banks were not, and still aren’t really interested in lending to that kind of a business. Now those businesses, to the extent they exist are primarily financed with equity, and they’re more expensive. And therefore, the builders don’t want to use them as much, and so they don’t. So now the builders have to take on more of it themselves. The reason why I say that it’s worse is it’s not just a matter of education and the builders need to be reminded of the risk. It’s that they already know about the risk. It’s just they don’t have any other option. They have to do this.

Q: What impact do you think tax reform will have on land value? 

A: I think what this gets to is the question of who gets to keep the benefits of tax reform. The idea here is that the margins that exist in the marketplace for builders versus the land developers are a reflection of supply and demand. Tax reform doesn’t increase the number of lots that are available. What it does, is increase the amount builders can pay for it, but it doesn’t increase it just for a builder here or a builder there. It basically increases the amount that all builders can pay because it’s a general corporate tax benefit.

My point is the homebuilding is particularly susceptible, relative to other industries. The reason for that is because land is a very unique raw material because it’s not fungible. Every piece is unique. It’s not like you’re going out in the marketplace to buy the lumber. Every builder can afford to pay more for lumber, but that doesn’t mean that they’re all going to pay more for lumber, because lumber’s there, and there’s a spot price, and they just pay for it. You just need a certain amount of lumber to show up at your job site and that’s it.

Land isn’t like that. Every piece of land is auctioned, so you have a unique asset of which there’s one of it. The only bidders for that are builders, and they’ve all benefitted (from tax reform) and only one of them is going to get it. Therefore, that is exactly the kind of scenario, which lends itself more quickly for all the builders to have an extra five bucks, and somebody spends an extra buck to get that land. 

It’s a perfect set up for the benefits to be competed away and result in higher land prices, much more so than in other manufacturing industries where most of the raw materials are fungible commodities. Land is really unique in that way. That is not just something you find in very many other industries.

Q: There is a perception that credit is tighter today compared with pre-2008 but you suggest that credit availability is more lenient today. What do you see is happening?

A: First of all, when you sail into the credit availability discussion, you’ve got to take away 2003 to 2005. There’s no question that was a highly unusual period of time when credit was unbelievably loose and were not going back there. What you’re really left with here is okay is it reasonable to think that credit is going to get easier from here, and my answer is no.

Most people would say no because it’s really tight and it’s going to stay tight. But there are a lot of people who would say, “Well, it’s really tight now, but it’s going to get a little less tight because the economy’s doing better. We’re saying so don’t think that it’s unusually tight. It isn’t. We talked about the loan-to-value ratios. If you compare loan-to-value ratios today versus prior periods of time, it’s impossible to make the case that the things are tight. For example, in the early 1990s, 20 percent of conventional purchased mortgages had less than a 10 percent down payment. Only a fifth of all homes, all mortgages put down less than 10 percent, so not very much. Eighty percent paid more than 10 percent down. Today 70 percent of buyers put down less than 5 percent. Before 80, percent put down more than 10 percent. Today 70 percent of first-time buyers put down less than five. LTVs are very, very high. 

Another thing that I thought was really interesting is there is a chart we like to look at that CoreLogic put together, which shows LTVs (loan to value ratios) by purchase price of the home. You have a scale that goes from zero to a million bucks for homes, and for each price point all the people who bought home on that price, how much did they put down? What you would expect to see, and what you do see, is that more expensive homes, people put down more, because it’s rich people buying the homes, and they have more money. They put a bigger down payment.

What’s also interesting about this chart is that (CoreLogic) ran it in 2000, and ran it in 2005, which is the ‘bubble’, and ran it last year with 2016 data. In the price points between $140,000 to $300,000 – sort of the affordable price points – LTVs are higher now than they were in 2005. Affordable price points is the area that you would be most concerned about. Those are the people who need credit, they need the leverage; these are actually closed transactions. These are not people just looking to buy. They put less money down than they did for those priced homes even in 2005, at the peak of the bubble.

Q: Does that, perhaps, portend, that the next downturn could be worse in terms of default? 

A: I would say it this way: I would say that it suggests that the next downturn may not be as mild as everyone has been saying, because I think the prevailing assumption is that housing is significantly under-built, and therefore, the next downturn is nothing to worry about. It’s going to be fine; it’s going to be super, super mild. It’s not going to a downturn of any consequence. What we’re basically saying is that, well, if one of the things that made the last downturn so bad was that you had the over-extension of credit, you have a little bit of over-extended credit here too.

Q: You pointed out in a recent presentation that past recovery cycles for builders typically started by catering to the bottom of the market in terms of product. The current one started with building high-end, higher margin homes. Now you’ve got more public builders that are looking at building affordable, or entry-level first-time buyer-type product. You made the point that Wall Street’s reaction is going to interesting because Wall Street wants you to be better than what you were, and so builders are going to have to make a case for getting into this market. Can you elaborate? 

A: When you move into more affordable price points, you generally make a lower margin. Not that you make fewer dollars, but you make a lower margin on top of that, generally. There’s a rule of thumb. Wall Street doesn’t like it when your margin is down year-to-year. Wall Street is all about improvement. 

I guess, probably, for your readers, that’s worth elaborating on for a sentence or so, which is that Wall Street doesn’t care whether you’re good or bad. They just want to know if you’re better. Are you better than expected? Are you better than you were last year? Because what you did last year, it’s already priced in. Whatever people thought you were going to do, it’s priced in. That’s why your stock is trading where it’s trading.

What gets your stock to move up or down has nothing, really, to do with whether you’re good or your bad, it’s just whether you’re better or you’re worse. That was the preamble. In that regard, if you accept that, the problem with this cycle – it’s not really a problem. It’s only a perception problem, but it’s a Wall Street problem – is that you are seeing more strength at the lower price points, which can be a weight on your margins and it’ll be very difficult for the builders to show as much margin expansion as they historically would have, given growth in units. I’m saying that very deliberately that way because in the past, when you sold more homes, that was good for your margin. The reason why it was good for your margin is because in every other cycle, besides this one, the cycle began with entry-level homes. As the cycle heated up, you sold more move-up homes, and then more luxury homes.

Q: Then Wall Street could see the builder getting better.

A: Right, it was like concentric rings of richer customers who could afford more goodies in their homes. There was this natural upward trajectory in the margin you would get on those homes which was really helpful, because as you go through the cycle, your costs are going up, too. Your land is more expensive later in the cycle than it is earlier in the cycle. But, hey, not to worry, because we’re now selling to luxury home buyers. I’m over simplifying here, obviously, but the thing to understand about a normal cycle is that the first-time buyer kicks it off because he’s the only one who has nothing to sell – everybody else does. So the first-time buy usually kicks off your cycle because when he has the baby, or he gets married, or whatever, even in a crummy market, what does he care? He’s just coming in and buying. Then, because he comes in, he allows somebody to sell to him. Now that person has a liquidity event, and now they have money, now they can buy the move-up.

Housing strength pushes up from the bottom; it does not trickle down. In a normal cycle you have entry-level homes to kick it off; you get some first-time move-ups, and then later in the cycle you get the second-time move-ups, and then later and later you get the vacation homes, and the second home. That’s the way it normally works. This cycle didn’t work that way. This cycle, because of the peculiarities associated with the housing bust, you actually began with move-up buyers; buyers that had a lot of money. Buyers that were insulated from the problems. We’ve got a sluggish economy, with bad job growth, so it was the high end of the market that actually recovered first, and that caused the builders’ margins to be really high at the beginning of the cycle. Then, as the cycle is heating up, you’re getting more activity at lower price points at a time when your materials and labor have been rising. So it’s just completely reversed and it’s really bad for the trajectory of margins. That was the point I was trying to make.

Q: The general movement of the industry is towards the lower-margin product, while costs are going up?

A: Yep. There’s nothing different about the cost situation. Labor’s more expensive today than it was four years ago, so is land, so is lumber. Everything’s more expensive now because we’re seven years into the housing recovery. The type of homebuyer you are targeting is coming down.

Q: Because that trajectory is at odds – margins and costs – what can happen? 

A: The main thing is to not overstate the issue and make it like, well; therefore, the builders are all going to go out of business. Again, getting back to what I said earlier, what I care about, because I’m in the business of trying to figure out what the stocks are going to do. The stocks don’t care if you’re good or bad, they care if you’re better or worse. Then, of course, the builders care a lot about whether it’s good or bad.

The builders are generating good margins. The bigger builders are generating very good margins. It may very well be that they sell more homes, the margin’s a little lighter, but they still make more money, and earnings per share goes up because they sell more homes, and it’s all fine. But, it’s just not going to be impressive to Wall Street because you’ve got that margin drag, and so the valuation multiples that investors will place on those earnings may be lower, and that’s the call we’re making. That’s why we see the builders stocks probably are going to be relatively unchanged from the beginning of the year to the end of the year. That’s, essentially, what we’re anticipating. But at an industry level, I think that you’re going to see the large builders make more money this year than they did last year. They’re just not going to make as much more money as they normally would have because you’re going to have this margin drag.

Q: Last, but not least, you mentioned about the industry, how you’d like to see the industry act like we’re in the last phase. Can you elaborate on that? What would you like builders to be doing if they’re acting like they’re in the last phase of the cycle?

A: What I was saying there was simply trying to say that you only know where you are in a housing cycle at two points in the cycle. It’s kind of like a broken clock – it’s right twice a day. You know where you are when the cycle is beginning to kick off. Everybody in the industry loves when that happens. You can just smell it. It’s like springtime, or something. It’s like, holy mackerel, buyers are starting to show up. The whole industry starts kicking up into gear and there’s excitement. You know when you’re at the beginning of a cycle.

Certainly, with the first year or nine months of a cycle, you know where you are, and you're at the beginning. That’s a great feeling, and you also know when it’s like, where the hell are all the buyers? And my cancellations rates are going up, and everyone starts freaking out. You know when the cycles overdue. So you know when the cycle is really beginning, and you know when the cycle is really ending. You know that. You don’t know where the bottom is, exactly, and you don’t know how far you are in the decline, and you don’t know how far you are in the assent, except at the very beginnings of both.

We are not at the beginning of either. Therefore, you only really know where you are in the cycle twice, and you’re not at one of those two points, you should act – particularly on the upswing – you should act like you’re late in the cycle, because you don’t know when the cycle’s going to end.

Putting that practically, what I think builders should be doing is they should be looking to de-lever. They should be looking to pare their land assets down. They should certainly try to get their own land down to two years, like they were last cycle, to the degree they can, because that two years can turn into four years once their sales slow. That’s what they should be doing. A couple of the builders are doing that, but a lot of them are not.

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