Sic Semper Tyrannis

Is the swan dive of home builders finished? I have long suspected not, after seeing the following segment from Barron's "The Trader" column back on June 5 ($$$ required, excerpts posted below):

While much bad news is certainly priced into home builders' shares--some have been cut in half from their 52-week highs--investors still may not appreciate the drag that might come from off-balance-sheet financing if there is a sharp correction in the market. These off-balance-sheet joint ventures often use equity and debt to buy land and sometimes buildings. Home builders contribute equity and may provide limited guarantees on the joint ventures' debt. The home builders enjoy earnings from the JVs when land is sold at a profit--as it has been of late. But they will also book losses if land is sold at a loss.

Hmmmm. This sounds like the now-familiar pattern of companies and other financial entities taking on more risk via leverage to increase return on capital, but totally ignoring the risk component. But surely home builders are playing it safe and not relying on this for a significant chunk of the bottom line...

Joint ventures have had a sizeable impact on the bottom line. Last week, for example, Hovnanian's first-quarter results included $9.5 million of income from consolidated joint ventures. While miniscule relative to the company's $1.57 billion in revenue, it's a nice slug of Hovnanian's $162.5 million of income before taxes. After tax-adjusting the joint venture income, we estimate it added about nine cents, or 6%, to Hovnanian's bottom line of $1.55 a share.

Wait, that doesn't sound so insiginificant. How are they justifying this?

Hovnanian has $211 million of investments in, and advances to, nine home building joint ventures and nine land development JVs. In a recent quarterly report, the company explains: "We enter into home building and land-development joint ventures from time to time as a means of accessing lot positions, expanding our market opportunities, establishing strategic alliances, managing our risk profile, leveraging our capital base and enhancing returns on capital."

So let's see... increasing risk through taking on more leverage, which works great for enhancing returns on capital only while everything is appreciating, is called "managing risk." I think I understand.

But surely these questionable practices aren't widespread...

Hovnanian certainly isn't alone. Lennar Corp. (LEN) reported $38 million of equity in earnings from unconsolidated entities in the quarter ended Feb. 28, more than twice the $16 million from the same quarter in 2005. Tax adjust that amount, and we come up with about 15 cents added to the quarter's bottom line of $1.58, or 9% of earnings.

"We do joint ventures for strategic business purposes," explains Bruce Gross, Lennar's chief fiancial officer. "It allows us to invest in more areas and lower our risk profile" through diversification. Instead of buying one large lot in one neighborhood, and keeping of the risk of the project, Lennar can use the same amount of money to invest in four joint ventures, which each may be in different geographic areas or produce different types of buildings.

There it is again: levering the same amount of capital to buy many times the assets (or rather, potential cash flow) is supposed to be "risk-lowering diversification". I guess this is why it was so necessary to believe the bubble wasn't everywhere, present in most regions and nearly all real estate asset classes. Because if they were all to go down at the same time, it'd be pretty clear that the diversification wasn't, and all that would be left exposed would be the downside of the leverage.

To place all this in perspective:

Joint ventures keep land off a builder's balance sheet and boost returns on assets and capital, financial measurements some home builders highlight in their earnings press releases. "In the last two years or so [off-balance-sheet joint ventures] have really taken off," says Snider of Moody's.

Because off-balance-sheet ventures grew popular in a heady housing market, it's unclear how they'll perform in a downturn. Theoretically, the joint ventures must develop land and sell it off to service debt and generate income for investors. In a down year, land prices could fall and the equity income home builders enjoy today might turn into equity losses.

Ruh-roh.

But that ain't all: the questionable financing takes many forms:

Home builders have also bought options to purchase land in the future. They're supposed to be able to walk away from the options if they don't want to acquire the land. But many options have wrinkles that look a lot like "disguised ownership," says Snider, who's in the midst of doing a report on the off-balance-sheet liabilities of the home builders.

More on that little nugget later. For now, note that the usual suspects are involved in this game:

Through joint ventures and options, new investors have joined in real-estate joint ventures. Pension funds, private equity dollars, investors looking to recycle oil profits and endowment funds have become partners in JVs or are willing to hold land on which there are options, explains William Mack, an equity analyst at Standard & Poor's. These investors are using leverage, too. So if financial investors in this market start looking money and head for the exits, the amount of capital available to home builders could shrink sharply, he fears.

The always-feckless pension funds have apparently jumped in the water, as has private equity (which I assume includes hedge funds--you didn't think they'd sit this one out, did you?) Everyone's using leverage, which is interesting, as it looks like there is no party in these joint ventures that is un-levered. Mack astutely points out that in a contraction where everyone rushes for the exits at the same time, things will start imploding very quickly.

Because of these off-balance sheet entities, home builders and their joint ventures have had more access to capital and have been able to sell more homes than in the past. As a result, the business may be more cyclical than it has been, despite increased geographic diversification, Mack says. He adds: "The typical dynamics of a home builder are not the same as they were 20 years ago."

In other words, the crash could very well prove more severe than anyone expected, since it was structurally more extreme and unsound than comparative historical episodes.

Finally, lets return to that bit on land options. This piece has more:

Options are one of the primary means used by home builders to secure land off the balance sheet. Typically, a builder will pay a landowner a fee, as little as 2% of the expected purchase price, for the right to buy a parcel of land at a set price at a future date. If the builder decides against purchasing the land, it can walk away from the deal and forfeit the fee. Until the purchase is made, the land doesn't show up on the balance sheet in most cases. Centex Corp., Hovnanian Enterprises Inc. and NVR Inc. control more than half their landholdings through options.

But some arrangements, though often called options, might seem more like purchase obligations. One kind is called a land-banking option, in which the sellers aren't interested in optioning the land but want to sell. In this case, the home builder must find a third party -- called a land banker -- to purchase the land. The land banker will then option the land to the builder. In this case, the builder is less likely to walk away, partly for fear of sullying the relationship.

I have to wonder who these "land bankers" are. We probably won't know until very bad things start to happen. My guess is that these are investment banks and hedge/private equity funds--the typical "we don't need no stinking risk control" parties. Looks like some mix of these land bankers will get burned along with the builders. Oh, the litigation we'll see.

Snider gives us a bit more perspective on this practice:

So while the builder may call it an option, it may come closer to a purchase, says Joe Snider, a senior credit officer at Moody's Investors Service in New York. When Moody's finds these types of options, it adjusts its estimates of the home builder's balance sheet to reflect it. Mr. Snider says options are a sound business practice because they help to improve the return on capital. But because some options are so heavily nuanced, "they do tend to mask the true financial profile of a company."

Sound in the hands of the sound. That's a big qualification.