Summary
Homebuilders have recorded large inventory impairments over the last couple of years. Most of these impairments have been for land and lots. As these previously impaired lots are built on and a completed home is delivered, the land component as a percentage of Cost of Goods Sold may decline significantly.
Analysis
Traditionally, the components of Costs of Goods Sold are: Land (20-25%), capitalized interest (3-5%), materials and labor (65-70%), and capitalized indirect costs such as insurance, property taxes, construction superintendents (4-5%). However, these traditional relationships change when the land portion has been written down for impairment, particularly considering the impact of present value discounting that occurs with impairments. In this scenario, the land component of Cost of Goods Sold could be 5% or less of Cost of Goods Sold, causing an overall improvement in the gross margin from the home sale. Thus, as homebuilders begin to work through previously impaired land, it will be important for investors to understand the impact such impairment reversals have had on the reported gross margins. In some cases, much of the reported gross margin may have come from such recoveries. This is important to know when evaluating overall gross margins and whether, in fact, operating results are improving or whether the improvement is due to accounting. My expectation is we have and will begin to see some significant reversals occur. Lennar’s last quarter contained significant, yet unquantified boosts to the gross margin when listening carefully to their conference call. These recoveries will be spread out over the next 2-3 years and then the impaired land should have worked its way through the system. In the meantime, it will continue to be important to measure this impact.
