This story was originally published on Builder.
This story is part two in a BUILDER special report about the challenges facing small- and medium-sized builders. Read part one here.
For 25 years, Bob Schroeder worked for a family-owned builder in Michigan that developed its own lots. He’s no stranger to the process of finding, entitling, and developing land, but it’s a part of the industry he thought he’d left behind when he started Mayberry Homes in 2002. That wasn’t the case.
With lots growing more difficult to find coming out of the downturn, Schroeder soon realized that local land developers were not keeping pace with builder demand. Those developers, he says, struggled during the recession and were mainly looking to unload their standing inventory rather than develop new parcels once the market rebounded.
Developer inactivity presented Michigan-based Mayberry, which built about 140 homes in 2017, with a chance to strike, even though it meant a change to its business model. “It’s left land prices at still pretty favorable pricing and terms,” Schroeder says of the current market. “And rather than wait for developers to move in front of us, it seemed like a real opportunity for us to step up.”
As such, Schroeder, who had focused solely on building homes for about 15 years, got back in the land development game. The company now holds three pieces of land on which it will develop more than 600 single-family lots, in addition to one mixed-use project in Heartland, Mich. When Mayberry decided to enter the development space, Schroeder says the intention was to only supply lots for itself. Now, that may change.
“There’s been enough opportunity out there so now we’re looking at that as a separate business,” he says of the development venture. “If we have the ability to produce lots in larger quantities than Mayberry Homes wants, then we could be looking to bring in other builders to some of the developments.”
Schroeder acknowledges that builders are often slow to adapt to a changing market landscape and are prone to a diminished bottom line in the long run. To be successful in today’s industry, that has to change.
“Someone said, ‘Generals always want to fight the last war.’ We get locked into what was smart to do yesterday,” he says of his builder colleagues. “So what we’re looking at is, the world has changed, so we’re trying to adapt to where the opportunity is now.”
He’s not alone. Small- and medium-sized U.S. builders have had to change their strategies in recent years as land becomes harder to find and the pieces that are available require more capital than ever before.
In June 2017, 64 percent of builders reported that the overall supply of developed lots in their areas was low to very low in the NAHB/Wells Fargo Housing Market Index (HMI) survey. That figure was the same in May 2016, but up from 43 percent in September 2012. According to the NAHB, this was the largest share of builders reporting low to very low lot supply since it began periodically asking the question on its survey in 1997.
Builders also said lot shortages were particularly acute in the most desirable locations, including 40 percent who said the supply of “A” lots was very low, compared with 22 percent for “B” lots, and 17 percent for “C” lots.
Looking for Land
In Las Vegas, a market dominated by public builders—the eight biggest builders there in 2016 were publics who controlled 75.4% of the market share, according to BUILDER’s Local Leaders data—American West Homes founder Larry Canarelli says the land competition is fierce. For those in the area who aren’t a public or large private builder, like American West, there aren’t many lots to go around. “The little guy, he is caught by wherever he can find between a 2.5- and 5-acre piece,” Canarelli says. “If the little guy finds a piece in North Las Vegas that he can put 12 houses on and he can buy it cheap, he’s gotta buy it. Because that’s all he can get.
“It’s not like it used to be where there would be 20-acre pieces that you could put 100 homesites on and maybe put a little community park in,” he adds. “Those pieces don’t exist now.”
As most high school juniors can tell you, when inventory is low and demand is high, prices rise. The June HMI survey also found that 81% of builders said the price of developed A lots was somewhat to substantially higher than it was the year prior. In comparison, 74% said the same was true with respect to B lots, and for C lots it was 65%.
Shrinking lot supply and rising land prices make business complicated for any builder. But for those at companies without large development teams or sizable capital backings, finding and buying land is even more of a reason to lose sleep.
Too Many Regulations
For many smaller companies, the No. 1 issue with respect to land is a lack of financing. “The small and medium builders were crushed during the recent land depression in the recession and a lot of their equity base is just gone so they don’t have the cash to close or the equity that is now required for a lender,” says Richard Guerard, an Illinois attorney.
As a result of the recession, says John Bonner, president of First Continental, a Houston-based company that provides non-recourse residential lot development loans to single-purpose entities, the requirements for residential lot development financing have gotten more stringent.
“You can find land,” he says. “The question is can you find land at the right price?”
A major reason why the right price is tougher to come by these days goes beyond more stringent financing requirements, according to Rob Dietz, the NAHB’s chief economist. “Local land use policies [have] made it more difficult to access land and more costly to bring subdivisions and buildable lots to market,” he says.
Exclusionary zoning, which excludes certain types of land use from a given community, is hurting builders, Dietz says. In myriad locations, he adds, builders are required to use “a certain amount of land through minimum lot sizes, or setback requirements, or other kinds of standards that basically force a home buyer to consume more land than they would want to. That acts as a tax on housing unit supply.” Builders would be helped if municipalities reduced “the costs of developing land in terms of impact fees and other kinds of regulations, and push back on inclusionary zoning requirements, which require builders to essentially do below-market-rate developments in order to build in a particular area,” says Dietz.
It’s an issue that Bonner has seen play out a lot in recent years. “When you’ve got these municipalities and these counties making it so much more expensive to develop, it’s just added a tremendous amount of complexity into the equation,” he says.
Vince Barbato, principal of Family Development Homes in Palm Desert, Calif. , which built about 210 homes in 2017, says local fees impact his company’s ability to make deals work. “These fees must be taken into consideration with every deal as they are a part of our cost,” he says. “In many cases, these fees drive the cost of land so high that we cannot deliver homes at the price that the market demands.”
Despite these issues, small- and medium-sized builders are finding lots that makes sense for their firms. Read on for their creative approaches to finding affordable, desirable land.
Diversified Offerings
Canyon Lake, Calif.–based Gallery Homes builds homes in Southern California and planned to deliver 55 of them in 2017. In one of the most populated regions of the country, it competes with major public builders like D.R. Horton, Hovnanian Enterprises, PulteGroup, and Toll Brothers. Gallery tries to avoid direct competition with public builders whenever possible and instead looks for underdeveloped infill projects, which tend to be smaller and in more intimate neighborhoods that do not attract much attention from publics.
Gallery recently diversified its portfolio to include senior assisted living facilities, senior apartments, and multifamily housing units because of the single-family land shortage in its markets.
“We will continue to look for good single-family projects, but are also looking for these and other opportunities,” says Rick Hauser, Gallery’s president.
In Southern California, the market is too fierce for builders to have only one focus, a problem that’s exacerbated by the struggle to find a way to pay for the handful of lots available. “Land development is problematic for the smaller builder, as it is extremely difficult to find financing for site work and vertical debt from institutional lenders,” Hauser adds. “Also, landowners have a false image of what their land is worth.”
According to Hauser, landowners are not factoring in a builder’s rising costs for items like regulations, labor, and materials, which affects the land’s residual value.
Financing Alternatives
Available developed lots are a welcome sight for any builder. But when a piece of land is up for grabs, rising prices can present challenges for builders without quick access to capital. To overcome pricing hurdles, some companies have elected to get creative, either with their financing or design strategies.
By utilizing so-called creative financing, Gallery Homes is able to greatly reduce the amount of cash equity needed for a given piece of land based on the lenders loan-to-cost/loan-to-value requirement. To do so, Hauser explains, his firm tries to convince its debt sources that the land value and existing improvements—on semi-developed or finished lots from a previously failed project—have an as-is value based on what it would cost the builder to re-create those lots. Gallery then uses a reverse land residual calculation based on current market pricing for its product/lot size to produce the as-is lot value.
Hauser notes that most conventional lenders will not consider this type of financing, so Gallery often has worked with private lender sources “that see the opportunity in this lending space.” The company also seeks joint ventures with land owners in Southern California to reduce its exposure, which Hauser sees as a win-win since Gallery brings added value to the joint venture partner through building out the project.
Changing Products
For many smaller builders, the “adapt or die” mentality is always on the front burner. To help meet the demands of shrinking land availability and rising prices, small- and medium-sized builders in many markets are getting creative with lot sizes, architecture, and, ultimately, home prices. According to Trulia, lot sizes first stopped growing, then began shrinking, in the early 1990s. For homes built since the start of 2015, the average lot size is 8,940 square feet, or 0.2 acre. In the 1970s, the median lot size was 12,430 square feet, or 0.3 acre.
While Gallery is utilizing “imaginative architectural design” and creative floor plans to entice buyers based on its market research, like flexible spaces that cater to buyers’ changing needs, Mayberry is building fewer homes at a higher price point to keep returns on track. Schroeder estimates that his company has increased prices about 20 percent this cycle.
Barbato says Family Development Homes, which builds in California and Arizona, sets itself apart in competitive markets with its innovative designs and marketing, like its four-plex building designed for empty nesters that includes two single-level units on the ground level and two units upstairs.
Although it’s difficult to find land “at a price that allows us to be competitive,” Barbato says his company focuses on acquiring land in certain areas. "We try to find land that allows us to build homes in niches that emphasize the importance of design,” he adds. “We feel that we can ‘out-design’ the competition, but we can’t ‘out-price’ them.”
In the previous cycle, Family Development competed more directly with larger builders, offering similarly sized and priced product. It now buys land for buyers who “appreciate the value of great design,” says Barbato. “We are acting more as a specialty builder, rather than a big-scale production builder with fairly generic designs.” He says the firm can keep prices down because it's building smaller homes for a specific client base.
Advanced Planning
Larger builders not only have an advantage in capital, but also in staff sizes as well. Smaller builders can’t easily compete with a public company’s well-staffed land division in a given market, says Jeff Corbett, vice president at First Continental.
“They can look at land and they can find a piece, but the time that it takes to research it, check utilities, work with municipalities, they just don’t have the personnel and resources,” he says of smaller builders. “They’re worried about the operations of their company and making sure that they can build a home effectively.”
To stay competitive, smaller firms must have a plan in place for when land becomes available so they act quickly. Joe Leal, co-founder of San Joaquin Valley Homes, a private firm that competes with large builders like D.R. Horton and Lennar and built about 400 homes in California’s Central Valley in 2017, says his company now does more forward planning with respect to land, and entitlement responsibility is assumed in-house.
Not being a large builder affords Leal and his team the ability to make quick decisions. “I have worked for Fortune 500 companies,” he says. “Even the best large companies have a bureaucracy in place that makes even small commonsense decisions take too long. Our philosophy is that the difference between excellent and average companies is the speed with which you make good decisions.”
That philosophy, if executed correctly, could equate to higher returns for smaller builders, Guerard says. “A small guy can do something in a day that takes big builders a month,” he notes.
For builders like Gallery, Mayberry, San Joaquin Valley, and hundreds more across the country, firsthand knowledge of local buyer preferences and demographics, coupled with key stakeholder relationships, is tough to duplicate.
Despite not having the biggest staffs or deepest pockets, smaller builders are delivering quality homes in every U.S. market. The best ones use their company size to their advantage, like Barbato and Family Development Homes. “We strive to build strong relationships with local land brokers and land sellers who know and appreciate our reputation for closing on the majority of deals we enter,” Barbato says. “We stress that we are a nimble group, which allows us to make decisions quickly without the burden of corporate red tape.”
In other words: Avoid being the general fighting the last war.
To read more stories like this, visit Builder.
