A Strategy to Navigate the Housing Cycle
John Burns Real Estate Consulting
By John Burns
June 29, 2012
The housing cycle is usually long and has five major stages, which are shown below. I began consulting to real estate executives’ right before
a downturn that began in 1990 and ended in 1995. The subsequent expansion lasted 10 years. After 22 years of observing this cycle and
studying past cycles, here is the best general advice I can muster for managing in the cyclical home building business.
FINANCE STRATEGY
Stage 1: The Bottom
Cash is king. If public, consider taking yourself private. Start a new company if you can.
Stage 2: The Beginning
At the beginning of the up cycle, secure long-term financing that won’t mature anytime soon. Throughout the up cycle, continue to push financing maturities out and use multiple sources of capital, from multiple industries (banks, pension funds, offshore, etc.). Don’t pay the expenses associated with land banking or option payments unless you are truly so efficient that you can make a great return while doing so.
Stage 3: Nearing the Peak
Consider selling your company because growth-oriented firms tend to overpay for land and companies during this part of the cycle. You might also want to pay yourself a lot of money by going public, although you will certainly create a lot of expenses and headaches if you choose that route. If you are not a seller, stick others with the downside risk by using joint ventures or offbalance- sheet financing. JV capital will be plentiful. Restructure all of your lots to be based on rolling option takedowns. This expense might cost 12% - 15% per year, which is why we recommend this strategy at this stage of the cycle rather than throughout the cycle. Refinance with more expensive non-recourse debt.
Stage 4: The Early Decline
Look around. Are competitive levels and/or affordability levels worse than usual? If so, you can count on the downturn being prolonged. Pay down your short-term debt obligations and build up cash reserves by selling your homes and land as quickly as possible, even at a loss, because the loss will be greater later. Many believe that losing money is somehow a sign of failure and disastrous to the balance sheet. They are wrong. This is a cyclical business. Recovering as much of the cash that you have already spent is what matters. Hire a great tax advisor too.
Stage 5: The Steep Decline
All of your preparation should have paid off. While this isn’t fun for you, it is worse for others. Pay off all of the debt you are obligated to pay.
LAND DEVELOPER STRATEGY
Stage 1: The Bottom
At the bottom, we suggest that you make long-term land investments by buying large assets with cash. Consider buying on the peripheral areas at steep discounts and with your own money so that debt and equity service is not a factor. This is a contrarian view, which is why it is a good view. Opportunity funds want 2-5 year returns and will be buying land in better locations. We suggest being very aggressive here, and avoid generating significant short term expenses such as interest payments or option payments. In most downturns, you can buy fully entitled land from the banks at less than the cost of the improvements that are already in place. If you are like most and can’t bear to think beyond 5 years, don’t plan on making much money from market appreciation.
Stage 2: The Beginning
Buy land in the next cities that will become the great locations as the market expands. Continue making the long-term land investments discussed above. Underwrite aggressively if needed because your downside is limited. Raise money from diversified companies with long-term horizons, such as pension funds and insurance companies.
Stage 3: Nearing the Peak
At this stage, the risk is highest and so is the short-term return. In this last cycle, “Stage 3: Nearing the Peak” lasted for years. You never know for sure when the end of an expansion will occur. Implement an “Asset Light” strategy where you only own the land you need to fund operations, but have plenty of options with well-capitalized land developers and partners so you won’t run out of land during a downturn. Concentrate on locations where there are fewer home builders. Shed any high-density attached projects because the builder demand will be high today, but the consumer demand will be low tomorrow.
Stage 4: The Early Decline
Sell your land. Early on, there will be plenty of optimists willing to buy it from you at a perceived discount. Cultivate your banking relationships, because they will be the land sellers of the future.
Stage 5: The Steep Decline
Advise the banks. Help them decide what to do.
HOME BUILDER STRATEGY
Stage 1: The Bottom
If you bought land in an outlying area, sit back and wait for the market expansion to head your direction. Focus your home building efforts on good locations, and on perfecting an operating company that is efficient and profitable without the benefit of price appreciation. Value-oriented
detached homes sell best.
Stage 2: The Beginning
Put some cash back into the business to improve efficiency, and begin pulling some cash out of the business to diversify your investments and improve liquidity. Grow your business slowly with an emphasis on diversifying into new geographies or product types. Hire the right people and structure their compensation to align their incentives with yours over the very long-term.
Stage 3: Nearing the Peak
Put even more money into process efficiency. Build more cost-effectively than your competitors. Avoid midrise and high-rise construction unless you are experienced at it and underwrite it with the additional risk it deserves. Avoid land development for the same reasons.
Stage 4: The Early Decline
Develop a site-specific strategy to generate cash. This will not be possible at some communities, which should be halted. As one CEO executive told me, “The downturns are
always longer and more painful than people think they will be.”
Stage 5: The Steep Decline
Build homes for troubled banks and equity partners in a structure that provides them most of the upside and, more importantly, protects you from any downside.
DEBT AND EQUITY STRATEGY
Stage 1: The Bottom
Lend and invest aggressively. The downside is limited and most of your competitors will be still questioning the business after the losses they just sustained.
Stage 2: The Beginning
Keep lending and investing aggressively.
Stage 3: Nearing the Peak
Sell or syndicate your investments to other institutions. Syndications or participations are a great way to maintain your builder and developer relationships while reducing your risk. Consider a hedging strategy that will be expensive but will be worth it if the market corrects.
Stage 4: The Early Decline
Sell your worst loans to other banks. Use renegotiations due to covenant violations to reduce our exposure. Keep a small percentage of the debt to your favorite clients. Staff your Special Assets Department early with experienced building industry executives - not just bankers - and
incent them to act quickly. Raise some money for the future, but don’t spend it.
Stage 5: The Steep Decline
Take your lumps. Demand all that you deserve, but don’t push your borrower into bankruptcy. If you do, the lawyers will get rich and customers won’t buy their homes or lots. Hire outside expertise to provide independent analysis to the loan syndication group because you’ll rarely be able to reach consensus. Once you see stability in the market, buy back the loans from the other banks and start planning your expansion strategy.
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