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Housing, the Economics of Builders, and Negotiating a Deal

Housing, the Economics of Builders, and Negotiating a Deal.  

Considering the purchase of a new home, but concerned about falling prices and negative equity?    With a little thought you may still be able to get the house you want and sleep well too.   

I recently advised a real estate transaction for a family friend.  This may be somewhat of a unique situation, but something to consider.
 
Summary of the Situation

The Buyer, a family friend, lives in a very nice well established neighborhood, but was interested in a slightly bigger new house.  They were interested in a newly developed (unfinished) subdivision.  By unfinished I mean there are empty lots existing (about 1/3 remain).  One of the builders offered to purchase the buyers house if unsold by closing.

Housing Summary

Supply will increase in the near term as foreclosure stalls pick back up. Increasing unemployment which currently stands at 9% and likely to increase to 12%, promises to depress housing demand further.  Increasing unemployment has a twofold effect-it increases foreclosures and decreases mortgage qualifications which reduces demand.  Reversion to normal lending standards, means there are less qualified home buyers, many of whom are currently in a negative equity situation and therefore won’t sell or can’t refinance.   Shadow inventory e.g. homes near foreclosure, bank owned homes not yet listed, homes taken off the market by homeowners waiting for a more favorable market, etc., have not yet saturated the market, but will-which will only increase downward pricing pressure.  With all the uncertainty does it make sense to buy a new home right now?  I think with a little thought, patience, and selectivity the answer is yes.   

Builders

Many builders have way too much vacant land-equal to several years of inventory based upon the builders previous 12 month unit sales.  This is manageable when volume (units sold) are reasonable and sales prices are increasing.  However this is no longer the case and many builders are having a difficult time funding land holdings.  

As land values fall, so too must the selling price of existing home inventory and new builds.  Builders are doing what they can to resist negative price competition.  But for builders to reduce vacant, non-performing, inventory, i.e. vacant lots, they must continue to sell (existing complete or near complete) standing inventory before they can start to eat into vacant lots.  Prices must give and builders face increasing pricing pressure from existing home sales, foreclosures, short sales, and the like.  Builders are also getting pressure from lenders to remove excess capacity as quickly as possible.  Land values are certainly in many areas in decline.  Material costs like cement, wood, and other essentials have come down over the past 12 months.  In many cases, houses that are standing currently as unsold inventory were built with materials purchased months ago.  These costs have come down so the cost to build the next house costs the builder less.  Good for the buyer, bad for the builder.  Knowledgeable buyers will not pay more when they can pay less, but builders again are resisting the loss.  No doubt, builders are happy to transfer their problems onto unsuspecting home buyers.
 
Pricing

New developments often have several builders to choose from.  Builders of similar or equal quality must price their houses competitively.  As one offers buyers more attractive prices, the others must eventually follow-an unfortunate reality to those with decent balance sheets.

Many builders are offering “new architecture” that is, smaller, less expensive (to build) houses in attempt to spur unit sales. (e.g. building second story master bedrooms are less expensive to build compared to main level masters bedrooms.)


“Green Shoots”


I believe the so called “Green Shoots” will turn out to be weeds.     

Foreclosures are certain to increase.  In many markets foreclosures have been quickly purchased and quickly taken off the market.  But as more and more of these sprout they will begin to saturate local markets.  Homeowners and builders will soon be forced to price homes in accordance with these foreclosures.  Meaning housing is artificially high.  Both Builders and homeowners are reluctant to lower prices, but will soon have little choice.  The intelligent buyer wishes to avoid overpaying.  With all the uncertainty, you should require an adequate margin of safety.    
 
Negotiating with Builders

With land values in decline, builders need to reduce empty lots quickly, but can’t.  Meaning you get to call the shots.

A few items to keep in mind:

Housing in many areas likely have another 5-10% to fall
I suggest you think about the value of a new house as its replacement cost
You have the upper hand in negotiations
Be smart not greedy


Incentives

Go visit new developments and see if the builder(s) agent offers you an immediate incentive. In my friends case the builder offered to purchase his existing house.  Often, the bigger the incentive the more room you have to negotiate.   

The Situation - Details

A homeowner is interested in upgrading into a new home in a newly developed subdivision (about 1/3 of total lots unsold).  As is often the case the buyer must sell their existing home before they can buy a new one.  As an incentive the builder offers to purchase the buyers home if the buyers home hasn’t sold by closing.

The Negotiation Process

    •    The buyer writes up an offer for the builders property.
    •    The builder looks it over and accepts or declines the offer.
    •    If accepted, the builder then looks over the buyers house and makes an offer on their house.  If the buyer accepts the builders offer, a deal is made.  

Now lets throw in a few numbers to illustrate.

Builders listing price:                      $570,000


Most buyers try to figure out how much they can afford and then try to make the numbers work.  If the buyer is comfortable with the payment schedule on a $460,000 mortgage and has $120,000 in cash, the buyer might put down 20% (i.e. $110,000,) pay closing costs, move into their new house, and be perfectly happy.   

But this would be foolish and irrational especially when dealing with a builder.

You want to make an offer on the builders property in relation to what you estimate the builder can afford, not in relation to the amount you can afford.

So the first step is to come up with what you think is a reasonable estimate of the builders total costs.  

Don’t get caught up with precise calculations they will be wrong anyway, a rough estimate will do just fine.

Gather Needed Information

My friend was looking at a 276 acre subdivision.  The first homes were purchased several years ago.  The property was previously farmland.  Part of the land acquisition was donated for public use.  I could not easily find the details of the developers acquisition cost however farm land in this area typically went for about $40,000 per acre.  My estimate however derived from information I acquired on value of the donated property.  These two numbers were more or less the same.  

A 366 Acre Land Acquisition of which 90 Acres (estimated value of $2.6-2.8 million in 2006) were donated for public use.  That comes to about $30,000 per acre.

Developer Costs
Developer Costs

Builder Costs



 

Reverse Cost Plus Method

I took $456,000 - $500,000 as the estimated total cost range.

(Note this does not include financing costs for builders that own several undeveloped lots. This could be included, but in my friends case, it was a non-factor.)

Quick Summary

New Home List Price                     Builders total cost
$570,000                         $456,000-$500,000 (My rough estimate)

Home builders have for some time earned way too much money (20%+ on equity for a commodity product), and you might be tempted to try and stick them while their down, but this is not the optimal approach. (We’ll get to that in a moment.)


The Buyers House

I gave some information about my friends house earlier.  Their house was in a well established neighborhood and was reasonably priced such that they could expect to sell the house for its listing price. 

Buyers listing price: (current home, resale)        $370,000

The Negotiation

I suggest you build into the offer a five to ten percent return for the builder.  (FYI The best builders are lucky to earn 9% right now)  I assumed the builders cost was $490,000.  To give the builder a 5% return the buyer might offer the builder $515,000.

Remember, your offer should be in relation to what the builder can afford, not in relation to the amount you can afford. 

I gave this example earlier:

“Most buyers try to figure out how much they can afford and then try to make the numbers work.  If the buyer is comfortable with the payment schedule on a $460,000 mortgage and has $120,000 in cash, the buyer might put down 20% (i.e. $110,000,) pay closing costs, move into their new house, and be perfectly happy.”

This is consistent with my friends case.  If they sold their house for the listing price, they would have $120,000 to put toward the new house. 

My friend initially wanted to offer $550,000 for the builders property and wanted to ask $370,000 for his house, because the numbers worked.  Again, this would be foolish and irrational especially when dealing with a builder.


Recommendation

Avoid the temptation to offer $510,000 and ask $370,000.  Instead, offer the builder $550,000 for his property and ask $410,000 for yours (adjusted as desired). 

If the logic is not immediately obvious, here’s why I’m suggesting this approach: 

You want to deal with a solvent builder and solvent builders, though definitely feeling pain, are not immediately facing bankruptcy.  Such builders will be less likely to accept $510,000.  They are much more likely to accept paying a premium for your home if you pay a premium on theirs. Though, it’s effectively the same from your perspective, it’s certainly not the same from the builders perspective.  That’s because the builder is concerned not only with this sale but with each incremental sale.  If the next buyer sees that you paid $520,000 are they more likely to offer $530,000 or $510,000?  So by offering a higher price you are helping the builder by doing what you can to keep market prices elevated.  Land values are a big part of builders profitability.  A vacant lot in a partially developed subdivision loses value way faster than a house in a well established neighborhood that commands high rents where vacant lots are typically scarce.  This, helps the builder, the bank who finances the builder, and the poor souls that bought a few years ago when prices were high.  More importantly, you the buyer effectively get what you want-a nice house, at close to replacement cost and very likely below market value.  You  are also better protected from future price decline.


Builders Inventory

To get a sense for the builders urgency & financial situation figure out the builders inventory in months.

Find out how many units the builder has in inventory (already built).  Also find out how many lots the builder holds.  If the builder has more than one development try to get this information as well.  This will give you a good idea as to how many months the builder has in inventory.