If you decide that you still want to diversify, there are four major diversification options for builders: vertical, horizontal, geographic, and other businesses.
Vertical diversification. Vertical diversification is where you look at the entire process of providing housing to consumers, and try to bring it all in-house. This includes land development, real estate, mortgage financing, and insurance.
Vertical integration usually occurs when a builder becomes larger and volume justifies other operations. There are several problems with vertical integration. The first is that the builder may lack the specific expertise in these related fields, and by taking them in-house, cut himself off from opportunities to collaborate with outside experts. You want those people working with you, not competing against you. The second major problem is that it really doesn’t reduce your risk very much. These vertical markets are not countercyclical. When the economy turns down in one area, it generally turns down in all the housing-related areas. In fact, you may be increasing your risk by having all your businesses turn down at the same time.
There are a few advantages of vertical diversification. If it works, you “feed” several times off the same client—for land sales, real estate commissions, as well as home purchase. In addition, you control the buyer at major points in the purchase process, and have less risk of losing the buyer due to lender or agency problems.
A major builder in the Baltimore/ Washington, D.C., area went this route. It developed land, started a mortgage company, and had a major share in a real estate company. During the last major recession, the land development and home building companies went bankrupt. The mortgage company was sold to another builder. The real estate company survives only as a shell of its former self.
Horizontal diversification. Horizontal diversification uses the same skills as the primary business, but expands the market to other consumers. There are two ways to do this: by building different products for different buyers and by expanding your price range to appeal to a wider buying public. Examples include remodeling, light commercial construction, and rental property construction.
There is a higher probability of success here, since many of the skills needed in one business are transferable to the other. In addition, these businesses can be counter-cyclical. When interest rates go up and prospective customers put off buying a new home, they often remodel their old one instead. Apartment rentals produce income during periods of high or low interest rates. By being able to shift personnel from one business to another, you can preserve key people when times are tough.
This is a great strategy for the smaller builder, who can shift easily from remodeling to new construction. If you have cash reserves, it makes more sense to keep crews busy by building rental or commercial properties during down times, rather than buying down interest rates to keep building homes that no one is buying.
The major builder mentioned earlier managed to survive primarily because it built and managed rental properties during the good times. During the bad times, it fell back on the cash flow these rentals generated.
If you have cash available during a downturn, it gives you the opportunity to buy land and buildings below market cost. This generates additional profit when the economy turns up, and can give you a lower competitive cost basis.
