HOMEBUILDING: DEPOSIT AND PREACQUISITION COSTS

Recent slowdowns in the absorption of housing inventories have resulted in a series of earnings charges from writeoff. of land deposits, preacquisition costs, goodwill and other intangibles, and the creation of valuation reserves for land, work in process and finished homes.

This article explores issues associated with land/option deposits and preacquisition costs.

The land grab in recent years resulted in homebuilders trying to "control" as much land as possible. Frequently, this was done through the use of "option contracts" giving the homebuilder the right to purchase additional land parcels or finished building lots.
Even in scenarios where the homebuilder intended to acquire the land parcels outright, there are delays from the time the property is placed under a purchase contract until the ultimate closing. This delay could range from several months to several years if it involves multiple tracts of land in the same transaction.

Normally, purchase contracts, including option contracts are secured by the homebuilder placing a deposit of up to 15 percent of the purchase price with the seller. This deposit can be cash or a letter of credit. Such deposits normally, are refundable during a "feasibility period" of up to 90 days. Thereafter, cancelation or nonperformance under the contract may subject the deposit to be forfeited to the seller.

During the time from contract to close, preacquisition costs may be incurred by the homebuilder for outright land purchases or options. Such preacquisition costs may involve land use,feasibility, market studies; entitlement expenses, etc. These costs are capitalized as incurred and expensed over the inventory as it is sold as long as the project moves forward.

Recently, poor home sales have caused all homebuilders to revisit their "controlled" land/lot positions and evaluate whether they will actually close on these purchase/option contracts and in a number of instances, land/lot absorptions are not able to support closing of these contracts. Homebuilders are electing to forgo their deposits and preacquisition costs, resulting in a writeoff. However, before this occurs, the homebuilder normally, will attempt to renegotiate the contract with the seller to gain time extensions and/or price revisions. Based upon the amount of open contracts, especially with land bankers under lot option contracts, the homebuilders have been reasonably successful in modifying these agreements. This generally is because the sellers choices may be limited. If the project doesn't work for the current homebuilder, why would it work at the same price for someone else? There have been numerous, recent instances where homebuilders have reported writeoffs of land/options deposits and preacquisition costs.

Many "land bank" finished lot option contracts provided for around a 12 percent annual return to the land banker, which often is paid monthly(current pay). So, while an extension of the timing to actually purchase lots may help prevent the buildup of lots on the homebuilders books, there is still an ongoing monthly cash charge if the contract continues. When land prices were appreciating rapidly, this may have been a successful strategy for off balance sheet leverage. However, in the current environment, homebuilders are forced to do a thorough evaluation of these positions to determine whether they continue to be economically viable.

A situation where there is one purchase contract with a third party is easier to evaluate. In addition to the economics, the homebuilder must consider reputational risk with the seller and whether cancelation and deposit forfeiture will hinder their ability to do business in the community in the future.

The evaluation becomes more complex when dealing with a land banker that may have financed 10-30 projects with the same builder. Given the small universe of land bankers and their involvement with homebuilders this would not be uncommon. And, given the breathe of the land banker activities, they may also be partners in or financiers of joint ventures with the homebuilder.

Therefore, before canceling an option agreement with a "land banker" , the homebuilder has additional considerations due to the extended relationship. If one agreement is canceled, will the "land banker" be accommodating about revisions to other open contracts? Moreso, would there be an appetite to enter into new land bank option agreements? And, given the limited number of "land bankers" on a national scale, will the homebuilder be prohibited from future "land bank" arrangements by the market.

Potentially, this scenario could leave many homebuilders in a quandary of whether to continue to perform under these contracts including the cash draining "current pay" scenario or to cancel these contracts, resulting in a writeoff of deposit amounts and preacquisition costs.

Each homebuilder will make individual decisions in various markets, given inventory levels, sales activity and overall cash needs to determine whether to perform under these land/option contracts. It appears that many homebuilders have built up significant levels of finished building lots in their inventories and the length of the overall slowdown will plan an important role in these evaluations.

Should the spring selling season continue to be disappointing, homebuilders will have to make decisions whether to forfeit additional deposits or to try to build their way out of their inventory by heavily discounting the finished home. My impression is there will be difficult choices that will lead to additional writeoffs of deposits and preacquisition costs because of current finished lot inventories and cash needs.