Why do homebuilders have such high margins?

muzie_IHB

muzie_IHB

New member
<p>So I've seen it stated here that it costs homebuilders around 150$/sq.ft to build here, which seems roughly in line with the nation average. Yet these houses are being sold for something in the order of 400$/fq.ft. for a very hefty 63% profit margin.</p>

<p>In any competitive market I would have expected these fat margins to immediately draw out other homebuilders here, bringing prices down over time until the margins are more reasonable. Basic market forces at work. Yet, this is not happening. I understand Irvine itself is special because of the TIC cartel and the special monopoly that it enjoys, but why aren't the neighboring areas faring any better? In any other region I would have expected small contractors to pop out to drive the margins down - or at the very least prospective homebuyers would have bought land and hired contractors themselves. Anyone care to offer any theories? Or is my reasoning faulty?</p>

<p>Regards,</p>

<p>Muzie </p>
 
Muzie,





Homebuilders historically have profit margins of about 8%. Lately they have been running about 25%. What your missing in your analysis is the land cost. In Irvine, the remaining $250 / SF is going to the Irvine Company for the land. Since their land basis is basically zero, they are making a lot of money. Land development is really where the action is. This is also why the Irvine Company is so protective of house prices. If house prices drop to $200 / SF, the Irvine company goes from making $250 / SF to $50 / SF. That would not make them very happy.
 
<p>So what keeps price up in other nearby locales? Do Alisio Viejo, Costa Mesa, Tustin, etc. all have equivalent cartels keeping the land prices up?</p>

<p>-Muzie</p>
 
<em>"So what keeps price up in other nearby locales? Do Alisio Viejo, Costa Mesa, Tustin, etc. all have equivalent cartels keeping the land prices up?"</em>





Generally, it is just supply and demand because there are few big players. Orange County is a bit unique because you have a small number of very large master planned communities where individual land development companies do have some control of the market. If you go to Riverside county, there are just a few large master plans and numerous small players, so no single developer can exert much influence on the market.





Keep in mind that these land development cartels have limited influence on the market. If they set prices too high and there are no buyers, they don't prosper. The big players in Orange County will set prices as high as they can while still maintaining their sales rates. This is why prices have been dropping with the builders. They will continue to drop until they reestablish the sales rate they desire. It has been said before on this board that the builders will lead the market down, and they will destroy the resale market along the way.





Another thing keeping prices up here are all of the "feel good" factors that contribute to desirability. Good neighborhoods do not get hurt as bad as undesirable ones. They all may drop a significant amount, but some will fair better than others. Irvine may only drop 35% while San Clemente may drop 40% and Palmdale may drop 55%.
 
<p><em>"Irvine may only drop 35% while San Clemente may drop 40% and Palmdale may drop 55%."</em></p>

<p>IrvineRenter- I'm a major bear, but even I don't think those kind of numbers will come true for Orange County. I have no basis of information about Palmdale.</p>

<p>I think we'll most likely see a drop of 20%, and if things get extra-ugly, 25-30% in Irvine between now and late '08.</p>

<p>-SCHB</p>
 
Palmdale dropped 50% in the last bubble, and that bubble wasn't near as large as this one. If Irvine only drops 20%, the cost of ownership still isn't aligned with rents. Why would it bottom there? IMO, what you are describing is a correction or a dip, not a bubble.





It is difficult to comprehend just how large this bubble is because we have never seen anything like it. The drop is just as hard to fathom. Personally, I think Irvine will drop 35% or maybe even more. If you reduced Irvine's prices 30% and factored in a 20% downpayment, you can get your payment on a 30-year conventional mortgage to match your rent. The deduction should about cover the cost of taxes, insurance and HOA. I suspect the market will overshoot because there aren't many people with a 20% downpayments, particularly given the historically low savings rates in the US.





I agree with your projection of being somewhere between 20% and 30% by late 2008 probably being closer to 20%. I just don't think that will be the bottom. I would put the bottom sometime in 2010-2012. Appreciation won't be returning any time soon.
 
IrvineRenter, are you familiar with VoC or the Great Park projects? It seems that Lennar paid the land at some significant cost? So do they really have the high margin as well over there?
 
Red,





Lennar overpaid for the Great Park and Villages of Columbus. The million dollars per acre they paid divided by the 4 units per acre they will probably net results in a $250,000 per lot land basis. Even at that price, if average house prices stay above $550,000, they will still make money. They wrote down the value of many of their holdings last quarter, and these properties were probably among them (I don't know for sure). Lennar, like many of the other builders, has created its own land development company. In fact, Lennar sold its stake in the Newhall Land properties in Santa Clarita to its land development company. The reason they do this is because they don't want to have these assets on their books. Wall Street wants to see the homebuilders obtain a high rate of return on their assets. When they have lots of property assets on their books, it lowers their return on assets; therefore, they create spin-off holding companies to hold property. These holding companies are Real Estate Investment Trusts (REIT), and they are looked at differently by investors. The builders get the best of both worlds, they boost their stock price by taking the assets off their books, and they reduce their cost of capital by getting low-cost equity through their REIT.





Anyway, the reason this is important is because this gives the builders the ability to control their land costs. They can sell themselves property from the REIT, at a loss to the REIT if necessary, to maintain profitability in the core homebuilding business. You will likely see the homebuilder's REITs losing money over the next several years while the homebuilder makes money. Obviously, this can't go on forever because the REIT would lose all its investors, but it can go on long enough to keep the stock prices of the homebuilders at higher levels throughout the market correction/collapse.





Land basis is by far the largest component of builder costs in Orange County. As long as they can lower their basis, they can maintain profitability.
 
<p>IrvineRenter: <em>"Land basis is by far the largest component of builder costs in Orange County. As long as they can lower their basis, they can maintain profitability."</em></p>

<p>Does the difference in land cost basis <em>primarily </em>account for the over 35% difference in average price per sq. ft between newer developments in Mission Viejo like Ladera Ranch vs. developments of similar vintage (2002 - 2004) in parts of Irvine, such as Turtle Ridge? Or, are there other factors at work? Could you speculate on an estimated reconciliation of the difference, such as 20% land cost basis, plus say 10% "Irvine school premium" etc?</p>
 
<p class="MsoNormal">Sales prices have no relationship to cost. Builders sell for whatever the market will bear. If sales prices drop below costs, they will reduce costs if they can, but if they cannot, they will simply stop building in a particular market until prices rebound. The builders could reduce prices 60%-70% in Orange County and still make money just be lowering their land costs.





Maybe this cost structure of a $1,000,000 house will help:<br style="" />

<br style="" />

</p>

<p class="MsoNormal">$ 1,000,000 Sales Price</p>

<u1:p></u1:p><u1:p></u1:p>

<p class="MsoNormal"><strong>Fixed Costs </strong></p>

<u1:p></u1:p>

<p class="MsoNormal"> 2,500 Average Square Footage</p>

<u1:p></u1:p>

<p class="MsoNormal"> $ 75.00 Average Cost Per SF</p>

<u1:p></u1:p>

<p class="MsoNormal"> $ 187,500 Average "Box" Cost</p>

<u1:p></u1:p>

<p class="MsoNormal"> </p>

<u1:p></u1:p>

<p class="MsoNormal"> $ 40,000 Average Per lot Infrastructure Cost</p>

<u1:p></u1:p>

<p class="MsoNormal"> $ 227,500 Average Fixed Construction Costs</p>

<u1:p></u1:p>

<p class="MsoNormal"> </p>

<u1:p></u1:p>

<p class="MsoNormal"><strong>Variable Costs </strong></p>

<u1:p></u1:p>

<p class="MsoNormal">12% Profit</p>

<u1:p></u1:p>

<p class="MsoNormal">5% Marketing</p>

<u1:p></u1:p>

<p class="MsoNormal">3% Overhead</p>

<u1:p></u1:p>

<p class="MsoNormal">5% Finance</p>

<u1:p></u1:p>

<p class="MsoNormal">3% Other (warranty, etc.)</p>

<u1:p></u1:p>

<p class="MsoNormal">28% Variable Costs Percentage</p>

<u1:p></u1:p>

<p class="MsoNormal"> $ 280,000 Variable Costs Dollars</p>

<u1:p></u1:p>

<p class="MsoNormal"> $ 507,500 Total Costs</p>

<u1:p></u1:p>

<p class="MsoNormal"> </p>

<u1:p></u1:p>

<p class="MsoNormal"><strong> $ 492,500 Land Residual (Finished Lot Value)</strong></p>

<p class="MsoNormal">


I wish I could tell you the source of these numbers. Suffice it to say, with my background and current job, I have access to this kind of information.</p>
 
IrvineRenter - As always, thanks for the information.





SCHB - I still find it hard to believe it is going to drop 20% let alone 30-40% or more! But I like reading IrvineRenter's blog as he often provide good insight. To me personally, his argument represents the absolute worst-case scenario to housing price (and not necessarily the most likely).





The thing is if I sit here and do all the calculation and prediction then the worst-case scenario may start to make sense. But then you go out on weekend and you see all these people checking out and buying these new homes. That's why it is hard for me to picture how all of the sudden price housing price can crash 30-40%.





Also, from talking to our friends, we know at least 4 families (in their 30s) who desperately want to move to Irvine eventhough some of them dont even work in Irvine! We also know a couple which can be considered "subprime borrower wth risky loan" and they do worry about mortgage but they have planB which is to rent out 1 or 2 rooms when things go bad.



 
<p>Red, you seem like a smart and thoughtful guy. But don't you see the problem with what you just said? If I may paraphrase you:</p>

<p>"When I look at the facts, I can see a good argument for why prices will decline considerably. However I prefer to trust my anecdotal experience which seems to imply otherwise."</p>

<p>Well, that's your right. But I don't think it's very intellectually honest and isn't a very useful way to go if you really want to know the truth. You have said on other threads that you would be willing to reconsider buying this year if you saw convincing evidence of imminent price declines. Yet one can only conclude from reading the above that no amount of statistical evidence will shake you... you will have to "see it with your own eyes" to believe it. I contend that since you are surrounded by a biased sample of your friends and fellow home-hunters your anecdotal experiece is at serious risk of being wrong about the market as a whole.</p>
 
Well bigmoneysalsa,





Red may be an admirer of Stephen Colbert - to paraphrase - he's "not a fan of facts since facts have a well known liberal bias." He "doesn't think because his brain is untrustworthy - he FEELS the truth from his GUT. "





Red's just doing what every true RED (haha) blooded, RED (double haha) State American is supposed to do.





Using FACTS to make a decision? What, are you a commie?





Well ... Russian commies historically are REDs ... but in America they are BLUE State birkenstock wearing, global warming alarmin', tree hugging Hollywood monkeys. So there.
 
bigmoney - Yes I think I would have to "see it with my own eyes" this spring/summer - at least something similar to what happenned last winter when buyers balked and inventory spiking. FYI - we were planning on buying last winter but seeing how the market just frozen we decided to wait it out. We also made a lowball offer on a few resale homes and one seller decided to take it off the market, one decided to rent it out, and another one was sold to a buyer at 'close to asking price'.





We started looking again recently and was surprised seeing how the market seems to turn after 10-15% adjustment. Maybe this is just a dead-cat bounce. or maybe the old 3X fundamental have changed? I dont know...
 
<p>Red: Apart from some of the hyperbole here, the important "objective" thing for you to consider would be to somehow "track" these people who are showing up in droves at the new development "opening/release events". There is a lot of interest in new developments because many people are (many are readers of these forum threads) addicted to staying informed about new developments. There are plenty of housing shows on cable TV that do their fair share of keeping public interest high.</p>

<p>Some of the important questions to ask the people who are house-shopping over the next few months through the end of summer will be the following:</p>

<p>1. How many model houses have you walked through over the last x months?</p>

<p>2. How many/which interest lists have you put your names on?</p>

<p>3. How many/which developer's salespeople have called you?</p>

<p>4. If you declined any deals put in front of you, state why?</p>

<p>5. If paid a deposit/down-payment for a house under construction, and if a lower cost phase of similar floorplan and square footage was available, would you take a chance and forfeit your deposit and cancel the contract?</p>

<p>Basically, we need to know what is going on in people's heads that is making them stake their financial future and well being on these risky ventures?</p>
 
Come on guys, don't pick on Red. He has a difficult decision to make, and he is just doing the best he can. From what I have read in his statements, our discussions have at least put him back "on the fence."





Red,





There is a kernel of truth in what they are saying. Don't let emotions and anecdotal evidence prevent you from seeing the big picture. The decision to buy a house will probably be the most important one you make this decade. Your head and your gut should be together on this one. From my observations of people, when faced with this dilemma, the gut usually wins, and the head usually regrets it.





If you change your mind on the purchase, you may not have to walk away from the deposit. The contracts from the builders do not have many loopholes, but they may be willing to give you part or all of your deposit back for fear of litigation or bad publicity. One loophole to look for is appraised value. Either through your financing contract or the builder contract itself, there is usually a provision that prevents an escrow from closing if the appraisal does not "hit the number." You can get an appraisal done near the closing that may give you a number that is "too low," particularly in a declining market. This would be a good thing because it may give you an out where the builder must give you your deposit back. Now facing this prospect, the builder will likely try to give you some huge incentives to close, but you can probably cancel at that point if you wish. Personally, even if I knew I was going to close, I would at least threaten the builder to get some more incentives, but that is just me trying to get a better deal.
 
IrvineRenter, thanks for the tips. I still think anecdotal experience is somewhat important. For ex: if you are basing only on statistical, even in 2001 or 2002 you would not even consider buying, and would have missed the train and have to wait for a long time until the next bottom. Market especialy housing market in desirable area will always be somewhat irrational.
 
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