Can Components Help Builders Revive 'Starter' Homes?

Originally published by: Builder OnlineFebruary 26, 2015

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If you’re an American home builder of an age, here’s something you know: If you can build and sell new homes for two-and-a-half times median household income in a neighborhood, people line up around the block to buy them. Bill and Al Levitt knew it, and when they first put their stripped-down two-bedroom, one-bath, single-story Cape on the for-sale market near Hempstead, N.Y., in March 1949 for $6,990, they had 1,000 couples show up on the grand-opening weekend with their $60 first payment in hand. Median household income in 1949 was around $3,100—so two-and-a-half times that wage got you into homeownership. In today’s dollars, two-and-a-half-times the median household wage gets you to $130,000. Not a home builder out there, save for a few isolated markets, can sell a new home for that price and keep his or her shirt. Question is, can home builders build for the low-end buyer any more at all?

Another question is, what does American society, the economy, and the culture itself risk if the iconic badge of the American dream—the pristine and new, if unashamedly modest, starter home—is allowed to become a figment of history rather than part of a entrepreneurial solution to housing’s all-too-anemic clutch at recovery? Forget, for a moment, two-and-a-half times median income and instead look at median sales prices for existing homes of around $210,000. Can home builders develop and build homes in new communities for less than that? The scary answer is maybe, in a few places, and perhaps not for long.

One decade ago, at the crest of the last real estate boom, the number of new homes sold for less than $200,000 totaled 297,012. Each year since 2005, the number of single-family homes sold for less than $200,000 has declined, cratering to 46,718 in 2014.

With personal savings sapped, joblessness rising, and qualifying for a loan increasingly beyond reach, demand for the $200,000 (and lower) home plummeted after 2008. But that’s only part of the story. As the Great Recession wounded demand for the modestly priced new home, supply constraints—like soaring land costs, burdensome entitlement fees, and rising labor and material costs—seem to be adding up as nails in the coffin.

“If you look at the trajectory over the last few years, that new single-family detached $200,000 home is mortally wounded,” says Tony L. Callahan, president and CEO of Kennesaw, Ga.–based Callahan Consulting Group, which advises builders and manufacturers on managing the product supply chain. “I don’t know how much longer it will be possible [to build that home] if things keep going on this trajectory.”

While some builders are still out there building sub-$200,000 homes, it’s getting harder and harder to make the numbers work. “$200,000 is not possible in many markets right now,” says Stephen East, a partner and senior managing director at New York–based ISI Group, an investment research firm. “LGI [Homes] is doing it. Horton is doing it with Express, but in reality, it’s very, very tough.”

And getting tougher.

Getting to $160,000

Making a $200,000 home work as a home builder is junior-high–level arithmetic. Solving for profit—say, 20%—land and building direct costs can not exceed $160,000. Problem is, a 20% margin on a sub-$200,000 house has become frighteningly elusive in the past decade. 

“The lowest build cost is around a $50 a foot,” says David Goldberg, a home building and building products manufacturers analyst for UBS, New York. “If you do a 2,000-square-foot house, which is what you’d have to do to compete with existing stock, that leaves you with $100,000 of sticks-and-bricks cost. The maximum cost on the land would be $60,000.”

That math can still work, but not in many locales. Saun Sullivan, senior partner at Denham Springs, La.–based DSLD Homes, won’t sneeze at building a home for less than $200,000, or even $160,000. Finding qualified buyers, even at that price, is another matter. He can buy a developed lot at $35,000 and spend $100 to $200 per foot to build a three-bedroom, two-bath home ranging in size from 1,400 square feet to 1,600 square feet. “We’re in a cheaper market than most,” Sullivan says.

Still, that price band is rare, and growing rarer. In Summerville, S.C.—hardly New York, Washington D.C., or San Francisco—Kenneth T. Seeger, president of MWV Community Development and Land Management, which is developing the Nexton master planned community, estimates that it will cost $100,000 to build a house and $40,000 to $50,000 to buy developed lots. Add in soft costs, and there goes the gross margin on a $200,000 home.

The catch to all this is that it’s not just one problem. No single culprit is killing the new starter home. A stream of factors—land, operational risk, labor, material costs, entitlement fees—converge at a single, all-too-real vanishing point where affordability becomes unaffordability.

“They’re all moving pieces of the equation,” Goldberg says. “If you got your land for free, you can make it work. If the municipality waives permitting fees, I can make it work. It’s the confluence of everything.”

Start with land. During the Great Recession, lots went for pennies on the dollar. Those days are long gone as rough Metrostudy guidelines say estimated price per bulk lots has gone up from around $50,000 in the recession to over $80,000. “It’s really difficult, given what land prices moved up to, for a builder to make that entry-level product pencil out,” says Rick Palacios Jr., director of research for Irvine, Calif.–based John Burns Real Estate Consulting. “More and more builders have been chasing that luxury and 55-plus buyer, and all of that stuff is at higher price points.”

Even if land can be secured at a reasonable cost, cash-thirsty localities heap fees upon fees that weigh more and more heavily on final home price tags. Chris Cates, co-owner of Fayetteville, N.C.–based Caviness & Cates Communities, estimates that regulations that stipulate he has to convert stormwater ponds to permanent ponds and bond items such as street lights, sidewalks, landscaping, and retention ponds have doubled his development costs.

“What we don’t have any more is entry-level costs because of all of the regulations that we do have,” Cates says. “The days of developing an entry-level home [site] for $25,000 are over. Now, it’s $50,000. You can’t build a $175,000 home on a $50,000 lot. The numbers don’t work.”

The logical result of onerous local fees is that attainable for-sale housing gets jeopardized. In this way, local government interests directly oppose federal housing policy, which has pushed to spur homeownership among entry-level buyers by reducing Federal Housing Administration (FHA) insurance premiums and offering Fannie Mae and Freddie Mac mortgages with 3% down payments.

While Goldberg says encouraging homeownership is a “popular bread and butter issue” for national politicians, the issues are different at the local level. “You have a lot of municipalities that are struggling with the tax issues and need to make more money,” he says. “Land is a finite resource. On one hand, you get property taxes, development, and job growth [with new homes]. On the other hand, you only get one chance [to monetize those new residential properties and offset infrastructure and school costs, etc.]. You can’t charge someone a permitting fee again.” Plus, there’s the political ramifications of introducing lower-income, lower status citizens to established communities, potentially impacting property values and community “ethic.” So, entry-level buyers new to the neighborhood take the not-in-my-backyard hit.

Rising Costs

The pain goes on. When the recession hit and many contractors had to close their doors or at least cut head count, laborers went in droves back to their home countries or found work elsewhere. “In Texas and fracking-heavy markets, I think a lot of people left construction to work in that sector,” Palacios says.

As builders kick-started operations, labor suddenly was a lot harder to find. The Associated General Contractors of America (AGC) says labor costs have risen from $22.51 per hour in April 2012 to $25.13 in December 2014. The jump in residential materials is even more striking—it rose 45% over the past decade, according to AGC chief economist Ken Simonson.

Materials and labor volatility make it tougher to pencil out the $200,000 home, even in Texas, where the land base is less. Houston-based Legend Classic Homes has secured a perennial place on our BUILDER 100 list by building entry-level homes.

Yet Mark Tollefsrud, vice president of sales and marketing at Legend, contends the window of opportunity to build $200,000 homes is closing rapidly.

“The idea of under $200,000 price point really in the next couple of years, even in the Texas market, may go away,” he says.

Not for the Faint of Heart

Still, any quest for a below-$200,000 home starts on the ground. “Land is step one, if you can’t do that, you don’t have a shot at step two,” Callahan says.

But finding land at a price that works for a sub-$200,000 selling price means going to deeper suburbs and outlying areas, which is something many customers—including the coveted millennial—say they’d avoid if they can. “You need to fill up with gas before you go look at [these communities],” East says.

If you want to build homes on more expensive ground—closer in to job centers and business hubs—a solution is to build in density. Again, local governments tend to hit reject.

Emile Haddad, president and CEO of Aliso Viejo, Calif.–based Five Point Communities, an independent real estate development and management company jointly owned by Haddad and Lennar Homes of California, thinks the first step to allowing builders to increase density and lower costs starts with the neighborhoods. In the previous cycle, they entitled expensive, bigger-lot projects. Since then, the market has adjusted and these bigger-lot homes have lost some luster with consumers. However, many local governments haven’t detected the change and altered their own stances.

“Right now, the entitlement requires you to build a certain [large lot] size, and you’re not able to build that,” Haddad says. “If certain cities want to activate the market, they’re going to have to go back and redo entitlements and downsize. If you can do that, you can build a single-family detached home, price it to the market, build it, and make money on it.”

Materials costs are another place builders need to find savings to get homes below $200,000. Tollefsrud says builders are pulling out the value-engineering stops to get to $200,000, including staying below 1,700 square feet; sticking to 8- or 9-foot flat ceilings; eliminating features like fireplaces; shifting to laminate countertops and 30-inch-high cabinets; avoiding crown molding or tile backsplash in the kitchen; and limiting brick to the front of the home. “There would be a lot of value engineering where you keep things structurally simple,” he says.

 

In the Charleston, S.C., market, Seeger thinks the only way a builder can hit the sub-$200K threshold is to build a vinyl box with minimal finishes. “I think it’s very, very difficult,” he says. “It’s not impossible, but you’re right at the edge of possibility. It would be a very, very inexpensively built house. You can’t afford Hardie Plank siding or real plank siding [like many municipalities demand]. You have to go with vinyl.”

But there are exceptions for builders who can gain efficiencies with materials and labor, and the nation’s No. 1 home builder by volume, D.R. Horton, is one of them. East has studied Horton’s product and sees some trends in its lower-priced Express homes.

“In Dallas, it’s brick on four sides with ceramic floors and granite countertops,” he says. “It’s very much a box set up. In Houston, it’s brick and vinyl with Formica and vinyl floors as well.”

Speed is another key part of keeping a home under $200,000, but to get there a builder has to put together the no-frills box. “The construction cycle is extremely quick,” East says.

To make it work, a systematic Levittown-like process—where builders have crews do the foundations and then construct the framing—works best. Tollefsrud says Legend sticks to a 40-foot-wide lot product and works efficiently. “The key is basically panel building a community and keeping your trades in the community and through the cycle,” he says. “Where we have gone into a community and prepaneled the homes out, including the color choice, we gained some cost efficiencies.”

But, as always, there’s a downside. These homes often are giving up something in aesthetics. “When you talk about price points like that, the curb appeal of the home is going to be more boxy in design because boxier is more cost effective to build,” Callahan says.

So, to build these homes under $200,000, builders work faster, which creates a boxier design with no-frills finishes. The question is does today’s starter-home buyer—a millennial adult more often than not—really want to move into a boxy, no-frills home with Formica and vinyl after living in high-tech student housing and ritzy apartments with granite countertops?

“The expectation of what a customer thinks should be in a house at that entry-level price point is kind of crazy,” says Matt Riley, director of sales and marketing at Raleigh, N.C.–based Royal Oaks Building Group. “They want granite countertops, tile backsplash, and stainless steel appliances. People are used to the newer apartment complexes.”

Even if you can cut enough corners and build fast enough to get a home under $200,000, you’re going to be building spec homes and you need to keep the pipeline full on the demand side for them. “Then you have to be very confident about your absorption assumptions,” Goldberg says. “And if they miss those absorptions, they don’t hit their return targets.”

East says Horton and LGI go about driving velocity in different ways. LGI, whose average selling price for its homes in 42 active communities is about $166,000, ties its very identity and nature to successfully extracting people from rental apartments, plastering their buildings with fliers. Horton uses traditional methods but won’t budge on price.

“LGI did a great job driving volume with its sales process,” East says. “Everyone is pre-qualified before they get to walk through house. They don’t spend a lot of time with people they won’t make a sale to.”

A Difficult Proposition

Once the sales process, speed of building, location, and simplicity are figured in, it’s no mean feat for a builder to try to build a $200,000 home. What’s more, why would builders jump through hoops to build starter homes when their margins on those are razor thin as move-up and second-time move-up homes are moving?

Ironically, given the need for new housing stock and the means of society, new entry-level housing is where most of the home building business could be, but it’s also where the market can be its riskiest, as was abundantly clear in the past decade.

“Realistically, you won’t see a lot of builders go down into this price point for a variety of reasons,” East says. “One, operationally, they can’t make money on it. They don’t know how to run that [production] process. Two, they don’t have the sales process. Three, they’re not a spec builder. So, I don’t think we’ll see everyone heading for below $200,000.”

Others are more optimistic. Palacios argues that the sub-$200,000 level buyer is ready to come back to the market. And, with lower FHA premiums and gas prices and easier underwriting, they can make their dollar stretch about 15% more.

Brad Hunter, chief economist for Metrostudy, the research arm for BUILDER’s parent company, agrees, suggesting that no matter how daunting it appears now, builders eventually will figure out how to meet this high-volume below-$200,000 market.

“I do see certain builders who are actively serving the under-$200,000 segment,” Hunter says. “Express Homes is expanding aggressively into this segment, and meeting strong demand. LGI Homes is also actively serving this segment. I expect this segment to grow rapidly in the next year or so. The under $200,000 segment is a huge underserved market, so builders who can profitably serve them will have a ready set of buyers.”

In that case, maybe the starter home is math, political science, and geography—but not history.

 

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