Will Builders Hit Pay Dirt Buying Land?

Posted by on Mar 30, 2015 in Blog | No Comments

Encouraged by recent financial results and prospects for the housing market to pick up from last year’s slow going, some top builders are stepping up the pace of land buying.

They’ll have to pay more than they used to — in a year when several builders have warned they’re facing profit-margin pressures — but they see the higher payments as the price of a rising housing market. And a handful of builder stocks are currently highly rated.

Homebuilders such as Toll Bros. (TOL), Meritage Homes (MTH) and TRI Pointe Homes (TPH) are a few builders actively scouting out land.

“We’re pretty bullish on the housing market right now,” TRI Pointe CEO Douglas Bauer told IBD. “We just reported full-year 2014 and fourth-quarter results, and orders for the first two months of this year have improved significantly over 2014.

Bauer says that TRI Pointe will continue to be a “significant player” in the 10 markets where it builds and that it will keep growing organically in each of those markets.

TRI Pointe operates in markets such as Northern and Southern California, Colorado and Arizona.

Adds Frederick Cooper, senior vice president of finance at luxury homebuilder Toll Bros.: “Speaking for Toll Bros., we are upbeat about the housing market. We just announced (first-quarter fiscal 2015) results, and our contracts were up 24% in value from the prior year.

An improving economy and more job creation are helping to drive up housing demand, Lawrence Yun, chief economist for the National Association of Realtors, told IBD.

Yun forecasts that existing-home sales will rise 7% to 5.3 million units this year. He estimates that new-home sales could rise 30% to about 590,000. Yun says it would be up from “depressed levels,” but still below a “normal level” of 800,000.

Morningstar analyst James Krapfel says that in the aggregate, homebuilders will increase their spending on land in 2015. He says that the trend is toward higher and higher land prices, which could put pressure on margins.

“That’s going to dissuade some builders from reaching their spending budgets,” he said. “It has become more difficult to underwrite land” to “acceptable” margins.

Added Brad Hunter, chief economist for real estate researcher and consulting firm Metrostudy, a Hanley Wood company, in an email: “Many (homebuilders) are running low on their supply of lots bought (cheap) at the bottom. So margins will go down as they start using more recently bought lots that were a great deal more expensive. Lot prices shot up starting in 2011-2012. That will have a significant negative impact on profit per house.

Margin Pressure Debated

But builders, which set “target” margins when underwriting land buys, say higher land prices don’t necessarily mean margin pressure.

“There is a common misconception that when land prices go up, builders’ profit margins will be lower, but that’s not necessarily true,” said Meritage Homes spokesman Brent Anderson. “Land prices normally go up because home prices are going up, allowing you to pay more without sacrificing margin.

And, he adds, home prices have been rising more than land prices over “much” of the last three years.

Anderson says it’s not that difficult to “more than cover” the higher price of land when the selling prices of homes are going up.

“Once the selling price of homes levels out or starts declining, that’s when margins get squeezed and have the potential to come down, potentially below your target level,” he said. “You might even lose money on that land.

Meritage Homes looks to earn a 20% gross margin.

“Starting with the home prices (in a market), you can back into what you can afford to pay for the land,” Anderson added.

Bauer says TRI Pointe looks to underwrite land at a target gross margin range of 18% to 22%.

“The rationale for buying any of our land in any marketplace is fairly consistent (with) our underwriting,” he said. “We’re looking for land that is well located and is along or near the major transportation and employment corridors.

He says TRI Pointe has all the land it needs for the next couple of years. It’s focused on securing land opportunities for 2017 and beyond.

“Each land purchase is driven by finding the right deal in the right market that we think makes sense,” said Toll Bros.’ Cooper. “We already have a multiyear supply of land we own and additional land under option. So we’re not going to run out of land anytime soon.

Land Scouts Pick And Choose

Toll Bros. owned or controlled 45,300 lots at the end of Q1 2015. It continues to search for land where it operates, says Cooper, typically in “affluent and desirable” markets.

Toll Bros. has been expanding in California, buoyed by last year’s roughly $1.6 billion buy of the homebuilding operations of Shapell Industries, whose land portfolio had about 5,000 fully entitled home sites in affluent Northern and Southern California coastal markets.

“We have found the coastal California markets around Los Angeles and San Francisco to be very attractive in terms of demographics and in terms of high barriers to entry, and they’re well suited to our product lines,” said Cooper.

Toll Bros. would like to expand more in Dallas, where it sees “strong” homebuying activity, Cooper says. It is also looking to expand on the east and west coasts of Florida around Naples and Palm Beach.

In a recent Metrostudy report, Hunter said that builders are just starting to extend their geographic reach, looking at land or lots in more “remote suburban regions that exploded during the boom and then collapsed during the late 2000s.

“More builders are going to start looking in more B and C locations,” he told IBD. “To do that, they have to be in more peripheral locations.

In a C location, a developed lot may cost around $30,000, says Hunter, while the U.S. average for a developed lot is around $120,000.

“Builders will be going more to remote locations because they can more cost-effectively acquire lots and grow unit volumes,” he said.

Take Meritage Homes: “Because the few lots available in the inner ring around metro areas are really expensive, we try to go outside that ring and find a sub-market that has lower-priced land and is still close enough to employment centers, shopping and good schools” to be desirable,” said Anderson.

Five homebuilders carry high IBD Composite Ratings above 90, out of a possible 99. Lennar (LEN) leads with 99. D.R. Horton (DHI), Standard Pacific (SPF), Brookfield Residential Property (BRP) and Toll Bros. are in the top five too.

Post Credit: Investors.com March 12, 2015