Analyzing Homebuilder Risks

Implications: There are risks associated with homebuilding assets and contingent obligations.  This article alerts the reader to areas of interest.

Analysis: ANALYZING HOMEBUILDER RISK

Many investors are familiarizing themselves with homebuilding as a source for potential profits due to its present distress. This article summarizes some areas to consider when evaluating individual homebuilding companies from a risk perspective.

Joint Ventures

Does the homebuilding company invest in joint ventures and if so, what is the amount of the investment and advances? It is important to understand many things about this activity including: the number and size of joint ventures; who the joint venture partners are and their capacity to support the joint venture or fulfill their commitments; whether there are guarantees to the lender to the joint venture for capital infusions under remargining agreements or other types of guarantees such as completion of the land development, firm commitments to buy lots from the venture,etc. Many joint ventures are financed by the same lenders involved in the homebuilder's line of credit. This relationship may cause a reluctance for the homebuilder to walk away from a joint venture.

Option Deposits

Is there a large asset on the balance sheet associated with deposit under land/lot option purchase contracts? It also is important to evaluate whether standby letters of credit were used as option deposits in lieu of cash. These will not be recorded on the balance sheet and must be determined from the footnote disclosures to the financial statements. Such standby letters of credit will either be replaced with cash or result in funding under the bank revolving credit facility. Again, it is important to understand the number of option agreements and the gross amount associated with exercising options as these represent future cash requirements, if consummated. The number of option agreements with the same party is a consideration as there may be implied performance with multiple relationships with the same entity.InventoryGeographic diversity is important to evaluate given that certain markets(CA,AZ,FL) are particularly stressed today. Whether individual subdivisions are large in size could indicate the amount of flexibility to move to other locations, redesign product, etc. Certainly the components of inventory are important. A greater percentage of land suggests a longer conversion period to cash and greater risk verses a large component of finished homes and work in process that can be converted to cash at some price.

Income Taxes

Large income tax refunds receivable by homebuilders represent the carryback of tax losses and the recovery of previously paid income taxes. However, there are limitations on the ability to do this. Many homebuilders have very large deferred tax assets. If tax losses are not realized in 2008, there may be significant issues associated with the ability to continue to carry these deferred income tax assets or to recognize additional income tax benefits from future losses.

Summary

Certainly, there are many areas of risk when evaluating the current homebuilding industry. This article attempted to highlight a few for consideration when evaluating investment opportunities.