In 2006, Arizona-based Fulton Homes opened Fulton Ranch in Chandler, a 520-acre upscale, master-planned community. That was the height of the residential housing boom and high demand justified the financial risk.
With cash flowing, Fulton spared no expense, with homes expected to close at prices between $1 million and $1.5 million. The company had a credit line of $250 million at that time.
Six months later, as the market began to deteriorate, 100 of the 1,000 lots expected to sell for $1 million sold for $400,000. Projections didn’t look good. The large, private company, like many other homebuilders both large and small, had to change, including reducing the sizes of communities it built and how it paid for them going forward.
Since then, homebuilders throughout the Valley have been forced to find innovative ways to stay alive until the next housing boom. Current market conditions are forcing builders to focus more intently on feasibility, projections and rate of return on their investments, says Jim Lundy, president and CEO of Alliance Bank. Buying and developing “infill” – land that is close to where people work – fits into that strategy.
“The big players have been very active buying land in the last six-to-eight months,” Lundy says.
Some companies spent so much money on huge, high-end residential developments in the mid-2000s that the housing crash left them with no alternative but to reinvent themselves on a smaller scale. Dennis Webb, Fulton’s vice president of operations, says the company spent $100 million just on infrastructure, including building lakes, trails and open spaces to attract high-income professionals to Fulton Ranch.
“That didn’t count the price of the land,” Webb says.
Although Webb says Fulton Ranch today is almost sold out and ended up profitable, the company, which went through Chapter 11 reorganization, uses its own cash, rather than credit, to finance its now scaled-down projects. “You’re not going to see those huge master-plans. You’re going to see 100-200 units,” Webb says.
Several partially built residential communities around the Valley serve as a reminder that securing appropriate financing is the key to success for homebuilders of any size. Without it, residential homebuilding can be incredibly difficult, says Paul Hickman, president and CEO of the Arizona Bankers Association.
Hickman says it is now more difficult for private builders to arrange financing for large, master-planned communities because regulators and underwriters have tightened lending guidelines.
“Since 2008, 14 community banks have failed,” Hickman says. “If you want to do that you have got put a lot of capital in reserve.”
Mark Stapp, director of the Master of Real Estate Development program at Arizona State University, agrees.
“It’s very hard for them (private builders) to be competitive in the market right now,” Stapp says, unless they are building a highly niche product.
Access to capital is where the large, publically traded builders have a distinct advantage over smaller builders. They can sell stock to raise money and finance their own projects if necessary. Access to capital also gives them the flexibility to make cheaper financing arrangements if they decide to borrow from a bank.
Lundy says the residential new home market is improving, but slowly. The slow pace, however, is not because of a lack of capital to lend. It’s because of an overall lack of demand based on low job growth.
“We’re going along at half of the typical volumes. While the activity has picked up, the overall demand is not as strong as it was,” Lundy says.
In the absence of traditional financing, some private builders turn to alternative sources of financing that carry higher interest rates, says Hickman.
“Now there is a higher-risk premium. They are finding themselves dealing with hard money lenders,” Hickman adds.
Developing has always been a risky business with few guarantees. Lundy explains that typically, approved builders will get an advance to buy land and pay for infrastructure, which includes utilities, roads and other government-mandated improvements. The land becomes the equity and the loans are paid back as homes are built, Lundy says.
The longer the timeframe for build-out, the riskier the project, which raises capital reserve requirements that are based in part on a builder’s projections of costs and sales. Ultimately, demand drives those projections, Lundy says.
While statistics indicate that demand is up in the residential home market in general, it is still way down as compared to six years ago. Michael Orr, director of the Center for Real Estate Theory and Practice at the W. P. Carey School of Business at Arizona State University, says new home sales in Phoenix are averaging about 700 per month.
“Seven hundred per month is still a relatively small number for Phoenix. We were doing that in 1996,” says Orr, in comparison to 2005-2007 when new home sales were about 3,000 per month.
“It’s a lack of inventory relative to demand,” Orr says, which has forced new home prices 57 percent higher than they were last year.
That might indicate higher inflation, but Stapp says that development costs are only slightly up. Moreover, the price of raw land – one of a developer’s biggest investments – is only moderately increasing. Land values, he adds, were not affected nearly as much as home values by the housing bubble and subsequent crash.
“Where there was a precipitous drop in the value of homes, you did not see a precipitous drop in the cost of buying a lot,” Stapp says.
Stapp, a land developer, says that land values for desirable locations in metro Phoenix are fairly high, and those areas have been very active in terms of new home sales. They are the safe bet.
“Developers like certainty. They are not wild risk-takers,” Stapp says.