Homebuilding--The Hidden Cash Requirement

Implications: Payment requirements under land option contracts are an important consideration when evaluating the cash flows of homebuilders.

Analysis: HOMEBUILDING--THE HIDDEN CASH REQUIREMENT

Analysts are attempting to forecast cash flows for homebuilders to evaluate their ability to service debt.  The general consensus is that the contraction in the housing market will lead to reduced inventory levels, thereby generating cash.  Overall, this should be a reality.  However, to date, the cash generation has not occurred as, exclusive of writeoffs, the looked for inventory reduction has not occurred.  This cash generation should commence during the back half of 2007 and increase significantly in 2008 as the current glut of finished homes finds lower levels.

As analysts work through their cash flow models, they must be alert for cash requirements associated with option contracts, particularily those financed with land bankers under "current pay" scenarios.  A "current pay" option contract requires that the homebuilder spend monthly cash flow to pay the land banker for his investment in the underlying lank.  This means that a homebuilder with a 15 percent cash deposit with a land banker on land with cumulative purchase and development costs of $10 million also is paying the land banker up to 1 percent monthly on the $10 million investment, net of the cash deposit.  To further illustrate the point, if there is $1 billion in aggregate "current pay" land bank exposure, the homebuildermay be spending $8.5 million( $1 billion less $150 million cash deposit) per month to carry these options. And, the aggregate amount of exposure under option contracts can easily exceed $1 billion.   It is difficult to analyze this, as these "current pay"  payments are hidden by being capitalized on the balance sheets as deposits or land under development. 

Therefore, to evaluate future cash flow requirements, it is important to know the aggregate exposure under this form of option contract, to know the extent of "current pay" contracts(estimated at over 50%) and to evaluate the rate that may be paid on a monthly basis(1% was common).

In evaluating the aggregate exposure, it also is important to consider all option contracts, including those deposits secured by standby letters of credit rather than cash.  In this situation, if a standby letter of credit rather that cash secures performance, the monthly cash payment would be $10 million under the earlier example($1 billion times 1%).

In summary, homebuilders should begin to generate cash flows as their inventories actually decline.  However, these cash flows will be partially offset the continued monthly payments made to some land bankers that can be quite significant in aggregate.  Thus, it is important to evaluate this comitment in projecting future cash flows.