Sic Semper Tyrannis

Following up on the teasers given in the June 5 Barron's (which I commented on here), Jacqueline Doherty has a more in-depth exposé ($$$; apparently available non-subscription here, though I don't know if its identical) on home-building finance in this week's issue. The basic setup:

Unlike in past housing cycles, when they borrowed heavily from banks, home builders today also use options and off-balance-sheet joint ventures to buy land. When times were flush, these financing vehicles enabled the industry to expand without bulking up its debt. But now that the housing market has weakened, land options and joint ventures could come back to haunt some companies, their financial partners, and the broader economy--not to mention stockholders.

This is becoming a familiar credit bubble refrain, isn't it?

Follow up:

The upshot is that, while most builders may now trade at a slight premium to book value, in fact, this book value is likely overstated in most cases---sometimes dramatically, as we will see.

Now, on to the details:

Land options are an agreement with a financial counter-party (generally called a "land banker") giving the option to buy a parcel of land for a specific price, for either a one-time fee (e.g. 5%) or a 10-20% deposit, often with 10-20% monthly payments required, depending on the specific agreement. But they all have the feature that the builder can choose to "walk away" from the option (elect not to buy), and lose just the initial option fee and/or deposit.

Here is one example the article gives of a builder's position regarding options and its burgeoning impact on the bottom line:

Hovnanian Enterprises, which has $454 million of option deposits and letters of credit outstanding, wrote off $11.4 million of deposits in its fiscal third quarter, ended July, and expects to walk away from additional options, says CFO Sorsby.

Humm. Given the slowdown in building, I would be pretty shocked if a majority of those deposits ever went into land acquisitions. So let's say, conservatively, that Hovnanian is eventually going to have to write off $300-$400 million of deposits. At a $1.8bln market cap which is essentially matched with present stated book value, a $350 write-down would be a 20% hit to enterprise value. Wouldn't you agree that such a thing should be actually reflected on the company's book?

Well, it isn't.

The damage does not stop with up-front fee loss for un-exercised land options, at least, not for the market in general:

If home builders walk away from land options, the impact is likely to be widespread. The land owner presumably would shop the property anew, and at a reduced price, particularly if it has associated debt.

...

Jeff Barcy, CEO of Hearthstone, a San Franciso-based land banker ... cites a deal in which a publicly-traded home builder recently walked away from an option to buy land in Florida for $60 million. The parcel was recently resold for $32 million.

Which seems to me like it'd cause other builders to walk away from their land options, accelerating the downward price trend in property, and putting the squeeze on any entity banking on price increases (both individuals and financial companies).

Joint ventures (JVs) are the second kind of popular legerdemain among home builders. In a JV, the builder takes a minority equity stake in a venture, which itself is a minority of the nominal value of the property being purchased. The rest of the equity is put up by a partner (typically a private equity fund), and the rest of the money is raised as debt. Since the builder's equity stake is below 50%, the debt appears on the joint venture, not with the builder.

Here is an example of how this might look:

... a developer seeking to purchase a $100 million piece of land with 40% equity might put up $19.6 million, or 49% of that equity stake, with a partner contributing $20.4 million, or 51%. The JV would fund the remaining $60 million with debt, which, because the builder's equity stake is less than 50%, would not appear on the company's books. Private-equity funds have been active participants in such deals.

So here the builder puts up about $20 million to control $100 million, but could lose up to $80 million. This would, I take it, show up on the books purely as an asset--a 49% equity stake in a venture which will hopefully generate some income, as it always has in the past. But that's only if property and houses continue to be flipped and flogged like hotcakes.

Who thinks that is going to continue?

And if you think I'm being unfair by suggesting the builder would be on the hook for most if not all of the debt in a JV:

Some home builders guarantee the debt of their joint ventures, which could come back to bite them if market conditions worsen. Lennar, for example, guarantees $1.2 billion of debt for its JVs and enters into option contracts to buy land from them. When the builder is also the guarantor, industry insiders say, a joint venture tends to get more favorable terms from lenders. But if things unravel, the company could wind up with a lot more debt than it discloses on its balance sheet."

So if that $100 million joint venture suddenly becomes worth $50 million, you have primarily the builder on the hook for most of that money (depending on the degree to which the private equity fund is exposed), even if their equity stake hasn't increased to 50% or more, and even though no such liability was stated on the books. That will surely require some 'splainin' to auditors and shareholders when it happens.

I have a hard time understanding how these JVs could really be considered arms-length with this kind of entanglement, and what kind of morons would actually lend to them. Perhaps part of the answer is... morons like these:

Some of the largest land bankers include IHP Capital Partners, Acacia Capital and Hearthstone. Hedge funds such as Stark Investments and Farallon Capital Management reportedly have jumped into the business, as well; both declined to comment. "I've seen a lot more hedge-fund involvement over the last five years," says Dale Goldsmith, a lawyer with Armbruster & Goldsmith, a Los Angeles firm specializing in land use and entitlements.

...

Lennar used a joint venture to purchase the 3,718-acre El Toro Marine base in Irvine last year, with equity partners including MSD Capital, the investment vehicle for Michael Dell; Rockpoint Group; and Blackacre Institutional Capital, the real-estate arm of Cerberus Capital Management, a hedge fund.

Well, isn't that cute--hedge funds with fully-fledged real estate front companies to better take part in the housing bonanza! I'm going to hazard a guess that many of these guys are not truly "hedged" against the bubble deflation--especially with nearly all other financial assets deflating at the same time.

Here's an example of how both option agreements and joint ventures have effected Lennar already:

Miami-based Lennar (LEN) last week reported it wrote off $15.8 million in option deposits and related costs and made a '$16.5 million valuation adjustment' to the company's joint ventures, which contributed to a $5.9 million joint-venture loss in the third quarter, versus a gain of $16.8 million a year ago. Total profits in the latest quarter, ended August, fell to $206.7 million from $337.3 million a year earlier."

So Lennar's profit was about 10% lower ($21.7 million) than otherwise would be the case, based on write-downs. This is on top of the already dramatically-declining profit, which has more or less been priced in to the whole sector this year. And the downtrend looks only to accelerate. (And this is not even to speak of the hit to book value!)

Doherty also points out that none of the other builders have yet written off equity in joint ventures. Gentlemen, fire up your short-selling brokerage accounts. Here's a portion of the cheat-sheet in the article giving the top dubiously-financed builders:

company	ticker	option deposits / book	JVs / book	price / book	P/E
NVR	NVR	64%	2%	3.2	8.5
Technical Olympic	TOA	42%	23%	.5	4.9
Lennar	LEN	23%	25%	1.3	12.8
Hovnanian	HOV	22%	11%	1.0	9.5
Beazer Homes	BZH	20%	7%	1.0	10.9
Standard Pacific	SPF	7%	18%	.8	9.6
KB Home	KB	5%	13%	1.4	8.7
Ryland	RYL	13%	1%	1.4	8.7

(If you want the rest of this list, as well as the details, and some hint at who is not in it, you'll have to acquire the full article.)

So allow me to sum up the situation: Not content with the book values and profits attainable by borrowing "normally" to buy property, many builders this time around resorted to accounting exotica to hide debt in option agreements and joint ventures. When the counter-parties in these agreements were smart, they left all the risk with the builder, and simply served in the role of a facilitator of borderline-fraud. When the counter-parties were dumb, however, they genuinely were taking on part or all of the risk.

Either way, it is bad for the market. The dire straits of builders quickly turn into dire straits for other property holders, in a self-reinforcing downward spiral. And banks and other financial entities are definitely exposed; not only do banks have a record-high 42% of their assets in direct mortgages and 55% in real estate total when including mortgage-backed securities (as Stephanie Pomboy has pointed out recently), but apparently there is a vast hidden mine-field of hedge funds and private equity firms that stand to lose from questionable deals with home builders.

As is the style of the time, these deals always look risk-free on paper, but the reality is much different (especially when the debtor is also acting as the guarantor of itself--come on, people!!). But for hedge funds, banks, and most observers, looking good on paper is considered more than enough.

Note: This same issue of Barron's has another great housing article, by Mike Morgan, entitled "Florida's Housing Hurricane" on how Florida is screwed--but more from a perspective where Florida is a 'canary in the coal mine'.