How do you invest in the future when revenues, expenses, and costs are swinging so wildly that it is difficult to even determine where they are today? Underwriting investments has perhaps never been harder than today because revenue and cost assumptions have never been more unpredictable. Housing executives are learning to hit a moving target, which is inherently much riskier than hitting a stationary target.
Home builders buy land today and, in most cases, won’t sell the homes for at least one year. How should they clarify the home revenue and cost assumptions that will ultimately determine how much they can pay for the land?
- Home Pricing: Home pricing has never been harder. The competition might have raised prices yesterday and then sold out. How deep is the demand at today’s prices? Relying on sales rates over the last few months is no longer reliable because homes are much more expensive than even one month ago. Creative builders are finding out the depth of the interest lists and calculating how many of those prospects can still qualify. Builders who have this information on an actively selling project nearby have a big advantage.
- Construction costs: Lumber prices are 47% cheaper than in early May (as of this writing), but still higher than anytime in pre-COVID history. Does that mean a builder can pay more for the land than they would have last month? Will the builder be able to tackle the labor shortage by paying higher labor costs and passing those costs along to home buyers? Will the supply shortages be resolved soon? The builders with the largest local market share have a big advantage because, no matter what happens, they will have more success with attracting labor and receiving material deliveries. They also have the resources to work with each major material provider to understand their business.
Building Product Manufacturers:
Building product manufacturers build plants and ramp up assembly lines, requiring massive capital investments that often take years to recoup. Should a manufacturer build a new plant to grow their business? Do they risk losing market share if they don’t? What will the demand be 3 years from now? How much supply will their competitors add? To hit the moving target, they must answer these questions:
- Revenues: How much of the recent price increase is permanent? How many homes will get built per year for the next decade? Will customers shift to lower-priced products?
- Costs: How much of recent input cost increases are permanent? Will input suppliers add capacity? What will happen to tariffs?
- Capital Expenditures: Is it time to invest in a new plant or not? This decision requires a long-term view on construction volume, which can be aided by increased productivity at the new plant if applicable. Is the recent surge in demand the long-awaited answer to a supply shortage, or is it temporary? These are important questions that deserve thoughtful analysis and risk assessment.
- Revenues: What are the real rental rates today? Leases of empty homes have been resulting in 10%+ rent hikes from the institutional landlords. Renewals are being released at only a 5% increase. Does that mean renewals are under market? What about the mom-and-pop landlords that make up 90%+ of the market? Are they raising rents fully to market? How much of a premium over their homes can an institutional landlord receive for higher quality service?
- Expenses: How much are expenses going to increase, especially property tax expense? If home prices are up 16%, as they are nationally, will property taxes go up 16% as well? Can you pass that onto tenants?
- Cap rates: Borrowing rates have plunged to the point where income property is trading at less than a 5% unlevered return. How low will returns go? How big of a bet will you make that rates will stay low for a long time?
In summary, big companies appear to have an advantage because they have resources to address each of the issues above. Perhaps this is one reason why industry M&A is booming. Small builders, manufacturers, distributors, and landlords have been selling out in droves this year. The risks outlined above are too much for many of them, and the price they can fetch for their business today is just too good. While we know plenty of smaller companies who succeed year in and year out and will continue to do so, we expect the big players to end up with more market share several years from now than they have today, partially because they have the resources necessary to learn how to hit a moving target.
Special thanks to John Burns Chief Executive Officer at John Burns Real Estate Consulting