Homebuilders

Current state of the market and my favorite choice

Many investors might be familiar with Norbert Lou. He wrote a very famous Value Investors Club writeup on NVR, and NVR went on to prove him right, compounding at roughly 16-17% for two decades.

This article is not on NVR specifically, but we must tip our hats to NVR because they are truly the pioneers of the new land light model that has taken over the home building industry. Not every home builder has implemented this strategy, but in my humble opinion, this model should be the “standard of care” for my medical people or “best practice” for the management types.

The reason this model is so effective is because land often times takes the brunt of the impairment in a housing downturn. This phenomenon occurs because the other costs associated with building a house like labor and construction are fixed. So, if you had a 5% downturn in the housing market, your profit losses are magnified. This impairment trickles down to the pipeline of land sitting on the books that the builder will have to throw the same construction costs into. Just to make this crystal clear, in an extreme downturn of say 20% in housing prices, that 20% would more than erase a builder’s entire 15% profit margin. Thus, the builder would wish they were not sitting on a giant pipeline of land they will be unable to make a profit on as they plea to the banks for them not to foreclose on their land.

The fix to this scenario was quite brilliant on NVR’s part. They simply optioned the land. If we assume they paid 10% for the deposit option, they now control the same amount of land while capping the loss at the 10% deposit instead of the full impairment.

The brilliance of this model does not stop here, however. Now that the land is optioned, you now have 90% more capital, that would have otherwise sat in land, available to repurchase shares, pay dividends, pay debt, etc. And just like that, voila, you have partially turned a heavy capex business into an asset light model.

Now that we have established the model and given credit to NVR, let’s now turn our attention to the hero of this story.