Commentary: A Scary Stretch Of Vacant Lots

If demand for homes slows, builders' recent land grabs could hammer profits

In past housing cycles, rising interest rates have usually spelled trouble for homebuilders, leaving them sitting on huge inventories of unsold homes. So with rates on the rise again, is the industry headed for another bust? Not if you listen to some of the country's largest builders, who swear they've learned from past mistakes. Says Richard J. Dugas, Jr., chief executive of Bloomfield Hills (Mich.)-based Pulte Homes, Inc. (PHM ). "We've got a much more disciplined business than we had in the past."

Maybe so. But even if builders have scaled back on overzealous construction, they are quietly engaged in a different form of speculation that could inflict real damage in a downturn. With suitable tracts of land increasingly scarce, many builders have been scarfing up new sites in the Southeast and West at a dizzying pace in recent years. Pulte, for instance, now controls about 290,000 lots -- a seven-year supply, based on the 40,000 homes it expects to complete this year. Dallas-based Centex Corp. has a 76-month supply of land, roughly 18 months more than it had a year ago, notes Kathy Shanley, senior bond analyst at Gimme Credit, an institutional research service.

Problem is, if the Federal Reserve tightens credit more sharply than expected, this land grab could create a serious drag on builders' profits for years. That's due to the interest expense of sitting on all that empty land, since most big builders finance their property purchases with bonds. The expense would soar if the land remains undeveloped for years because housing sales decline. That's why Gregory E. Gieber, housing analyst for A.G. Edwards & Sons Inc. (AGE ), believes builders and developers may be setting themselves up for a fall with their rosy scenarios. "You can still see the optimism rising," he says, "even as mortgage rates are on the way up."

Many in the industry maintain that such concerns are unwarranted. They argue that even with rising rates, they can keep up their heady double-digit 25% annual growth pace -- but only if they keep snatching up land. "For the large builders to continue at the pace they're growing, they have to buy more land just to stay where they are," says Stuart A. Miller, chief executive of Miami-based Lennar Corp. (LEN ). Even if growth slows, builders say they have little choice but to stockpile land because local municipalities often take up to three years to sign off on building plans. And they note that they don't always purchase land outright: Often, they simply take out options for later purchase.

Even so, such options, which usually require deposits of 1% to 20% of the property's value, are hardly risk-free, since they could become worthless. At Pulte, which holds 58% of its land this way, CEO Dugas contends that even if Pulte were forced to let all its options expire, it would not take "a significant hit." Its existing options on land cost Pulte roughly $190 million, or a third of the $624 million it earned on $9 billion in revenues.

Even if housing demand remains as strong as builders are banking on, the current bidding wars for new land could take their toll on future profits. As housing values have soared, builders have reaped lush margins by building on the cheap land that they acquired several years earlier. In the past year, however, the bidding for raw land in hot markets has become heated. In mid-May, Pulte outbid Toll Brothers Inc. (TOL ) and D.R. Horton Inc. (DHI ) when it paid a record $100.5 million for 276 acres at an Arizona state auction -- nearly three times the property's appraised value. And last June, 995 acres auctioned off by the Bureau of Land Management just outside Las Vegas went for $231,979 an acre -- a 46% jump over the previous year's auction and nearly three times the average of all earlier auctions.

Given the spiraling costs of obtaining new land, analysts contend that homebuilders need housing values to keep rising sharply just to maintain their margins. But if demand for housing slows, builders could be left with shrinking margins and flat profits. That could leave them nursing a hangover once again.

By Dean Foust

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