Like home building itself, mergers and acquisition (M&A) activity of home builders and residential land developers is a cyclical business. And the cycle points to increasing M&A activity involving home builders. In just the past few quarters, privately held regional home builders have sold all or majority interests of their companies to a number active serial acquirers.
The buyers all have solid business reasons to be acquisitive. The fundamental initial question for the owner of a private builder interested in selling is simple: How can I make myself highly attractive as an acquisition candidate to the unique universe of active and potentially active buyers?
At its core, selling a home builder generally is fairly straightforward. The nuance is positioning the company so that the seller can achieve the vast majority of non-financial objectives while maximizing the after-tax sales proceeds.
In this article, we attempted to highlight the important steps a thoughtful owner should consider to best maximize the outcome when selling his or her home building company. With a bit of tongue-in-cheek, we’re going to use two hypothetical owners. Simple Seller just wants to sell his company. In contrast, Smart Seller wants the best results – the highest after-tax proceeds and achieving a number of non-financial objectives, too. There is one caveat the reader should consider. By necessity, we’re going to provide a framework premised on a series of general rules. As you will remember from grammar school, oftentimes there are exceptions to general rules. Don’t shoot the messenger.
Table 1 highlights some of the more interesting recent home builder sale transactions.
| Table 1 | ||||
|---|---|---|---|---|
| Selected Recent Homebuilder M&A Transactions | ||||
| Buyer | Buyer’s Profile | Seller | Seller’s Profile | Transaction |
| Lennar | NYSE Public Builder | Kokes Family of Builders | Private Company | Asset purchase and sale |
| Century Communities | NYSE Public Builder | Wade Jurney Homes | Private Company | 50% interest in newly formed joint venture |
| Summitomo Forestry America | Nikkei Japanese Public Company | Dan Ryan Builders | Private Company | Acquisition of a majority equity stake |
| AV Homes | NASDAQ Public Company | Savvy Homes | Private Company | Asset purchase and sale |
| Daiwa House | Nikkei Japanese Public Company | Stanley Martin Communities | Private Company | Acquisition of a majority equity stake |
| Sekisui House | Nikkei Japanese Public Company | Woodside Homes | Nikkei Japanese Public Company | Acquisition of a majority equity stake |
Starting with the Basic Building Blocks
We’re going to highlight the following six broad topics in the remainder of this article. By necessity, we are focusing on the overarching highlights.
1. The buyers. Who are the likely buyers and how do they differ?
2. Motivation. The author has worked with and advised builders and residential land developers for more than 30 years (gulp!). We’ve learned that any number of factors can lead a builder or developer to want to sell. These are just a few of the possibilities.
- Burn out. You’ve been doing this for a professional lifetime–and it’s gotten old. The management hassles, customer complaints and subcontractor demands simply are grating on you.
- Risk management. You’ve accumulated some wealth and worry about continuing giving personal bank loan guarantees. Possibly, your company builds in states with significant litigation risk from disaffected home buyers, including potential class action litigation.
- Family considerations. There are family matters that you want to give more attention–illness or even more time to travel.
- Mission accomplished. You’ve built a solid team and it’s time for them to take control.
3. Value drivers. A simple, illustrative valuation framework that highlights why planning and forethought are key value drivers in selling your homebuilding company.
4. Likely buyers. As a preliminary matter, who are likely buyers for your company and what is important to those buyers.
5. Homework. Preparing today for a future sale, here are some of the things you need to consider.
- Land. What is the “right” amount of land owned and under option? How should the ownership of that land be structured?
- Management. What are the strengths and weaknesses of your management group, including financial management? How important is that to you in a successful sale?
- Accounting and financial reporting. Focus on both the quality and timeliness of your company’s financial data, including financial forecasting. What is the role of an audited financial statement?
- Family goals. You don’t own the business in a vacuum. Integrate family objectives as a consideration for planning an eventual sale.
6. Transaction team. Think ahead about the key qualities you want in your attorneys, financial advisors and external accountants. Consult with them early – a small professional fee today may lead to a substantially more lucrative sale transaction.
7. Life after.If everything goes according to plan, what does life, post-closing, look like, for you, your family and your management team?
The Buyers
Here’s something that is somewhat counterintuitive. As a home builder, if you want to sell your company, one of the key first steps is to think about who the best buyer for your company might be. There are a number of distinct groups that actively will pursue the purchase of a home building company and each group has a different focus. The first distinction is whether the interested buyer might be another home builder or some form of financial buyer.
Probably the easiest sale transaction is to another home builder, either someone already active in your geography or interested in entering your market. Why is this often the easiest transaction? The buyer already in your market knows your industry, has a good sense for your local market, and can readily understand your product type. That can flatten out the buyer’s learning curve. The principal negative for you, as the seller, is that the buyer really oftentimes simply is looking for access to land and finished lots. Thus, the buyer’s due diligence may be limited only to real estate issues, with minimal attention to financial and other diligence matters. A more attractive buyer is the buyer entering your geographic market. In addition to land and lot positions, this buyer often is interested in talent–whether good subcontractor relationships or competent construction superintendents. Many times, the buyer is looking to retain the full management team–including the CEO–of the seller.
The financial buyer can come in many varieties. It may be a private equity firm or a non-U.S. company seeking to enter the U.S. home building market. The financial buyer has motivations that largely differ from the typical home builder seeking acquisitions. A financial buyer may be more interested in retaining existing management and may view the acquisition as the purchase of an ongoing business, rather than a simple collection of lots and land positions.
Motivation
The summary discussion on the diverging potential group of buyers, above, highlights that the seller needs to mesh his or her motivations with the wants and needs of the most likely buyer groups. For example, a builder with a weak management team likely won’t be all that attractive to a private equity or inbound international investor–unless that buyer is comfortable identifying and hiring a new leader. Of course, that creates enterprise risk for the financial buyer.
Conversely, another builder looking to create a pipeline for an existing division in that market really won’t give credit for management talent. Of course, the value proposition for a builder simply selling land positions will differ dramatically from a builder selling a stream of predictable earnings, but we’ll get to that later in this article.
| Table 2 | ||
|---|---|---|
| Summary Motivations Checklist | ||
| Motivational Considerations | Sale of Lots/Land | Sale of a “Business” |
| Burn Out | X | |
| Speed/Simplicity in Closing | X | |
| Risk Management | X | |
| Business Succession/Opportunity Creation | X | |
| Legacy Creation | X | |
| Maximize Sales Proceeds | X | |
So, as you think about selling your home building company, think about exactly what it is that you’re selling.
Value Drivers
Book Value Might Not Be the Best Metric . . .
First, let’s address the common wisdom. Many builders and their advisors think about valuing builders based on net book value or tangible net book value. From an accounting perspective, book value essentially is assets minus liabilities, or equity. Tangible net book value reduces asset value by the amount of any intangible assets on the builder’s balance sheet. The prime example is goodwill, often from a prior acquisition.
For many privately held builders, net book value really is an accidental indicator of the worth of a company. For example, a builder who buys land for cash increases the company’s net book value (and tangible net book value). But that land is on the financial statements at historical cost, so it ignores changes in the underlying value of the asset since it was acquired. Similarly, private builders who work either a “land light” business model or who annually distribute after-tax earnings as a risk management tool reduce the company’s tangible net book value. For these reasons–and others–we believe the sacred metric of “multiples of net book value” often is misplaced. Nonetheless, the thoughtful seller must be prepared to address the often-heard comment, “we’ll never pay more than [insert the number] multiple of book value. Anything more is way above market.”
If Not Book Value, Then What Metric?
If book value is the default valuation metric, how can a builder generate a better value proposition? In our view, the better metric is takes into account both earnings and the timing in generating those earnings. In other words, either return on equity (ROE) or return on invested capital (ROIC).
The following discussion is premised on the assumption that an interested buyer wants to buy an enterprise or an ongoing business, rather than a collection of lots and lot options.
With that premise, the buyer is seeking a predictable earnings stream to which he or she can ascribe a value. To arrive at a fair purchase price, the buyer will look at the projected earnings stream and evaluate what level of return on invested capital those earnings provide. Thus, the valuation analysis has 3 components:
- What are the projected earnings of the business?
- What confidence level can the buyer have that those earnings are likely to occur in the projected time periods?
- How much equity capital must the buyer invest to generate those earnings?
The concepts behind ROE and ROIC are fairly simple. Essentially, both are metrics that analyze how efficiently a company uses its capital. While there are multiple, slightly different definitions, we’ll use the following:
In the following examples, we’ll focus on ROE. Note that some investors or buyers will look instead to ROIC. Since the concepts are so similar, the builder looking to sell may need to run models proving out both.
Example 1. Consider the following example to illustrate the power of ROE. Peters Builders (PB) sells 100 homes per year at an ASP of $325,000, or total annual revenues of $32.5 million. PB has a gross margin of 20% ($6.5 million) and SG&A of 12% ($3.9 million), resulting in earnings before interest and taxes (EBIT) of $2.6 million. PB obtains AD&C financing at 8% interest, for 65% of its costs and uses mezzanine debt for 20% of its costs, at a charge of 12%. Assume PB’s average construction time is 9 months.
| Table 3 | |
|---|---|
| PB Builders | |
| Pro Forma Financial Results | |
| Revenues | $32,500,000 |
| Less: Costs of Sale (80%) | (26,000,000) |
| Gross Margin (20%) | $ 6,500,000 |
| SG&A Costs (12%) | (3,900,000) |
| EBIT | $ 2,600,000 |
| Less: AD&C Interest Expense 3 | (1,014,000) |
| Less: Mezzanine Debt Interest Expense 4 | (468,000) |
| Pre-Tax Net Income | $ 1,118,000 |
| Average Equity 5 | $ 3,900,000 |
| ROE ($1,118,000 Ă· $3,900,000) | 28.7% |
3 $26,000,000 cost of sales x 65% loan-to- cost ratio x 8% interest rate x 9/12 = $1,014,000.
4 $26,000,000 cost of sales x 20% loan-to- cost ratio x 12% interest rate x 9/12 = $624,000.
5 $26,000,000 cost of sales – $16,900,000 AD&C financing – $5,200,000 mezzanine debt = $3,900,000.
What happens to the very attractive returns in this project if sales take 18 months (meaning 15 months of interest carry) or if the ASP drops 10% to $292,500 per home?
| Table 4 | ||
|---|---|---|
| PB Builders | ||
| Pro Forma Financial Results – Slower Sales or Lower ASPs | ||
| Slower Sales Pace | Lower Sales Price | |
| Revenues | $32,500,000 | $29,250,000 |
| Less: Costs of Sale (80%) | (26,000,000) | (23,400,000) |
| Gross Margin | $ 6,500,000 | $ 5,850,000 |
| SG&A Costs (12%) | (3,900,000) | (3,510,000) |
| EBIT | $ 2,600,000 | $ 2,340,000 |
| Less: AD&C Interest Expense | (1,690,000) 6 | (912,600) 7 |
| Less: Mezzanine Debt Interest Expense | (780,000) 8 | (421,200) 9 |
| Pre-Tax Net Income | $ 130,000 | $ 1,006,200 |
| Average Equity | $ 3,900,000 | $ 3,900,000 |
| ROE | 3.3% | 25.8% |
6 $26,000,000 cost of sales x 65% loan-to- cost ratio x 8% interest rate x 15/12 = $1,690,000.
7 $23,400,000 cost of sales x 65% loan-to- cost ratio x 8% interest rate x 9/12 = $912,600
8 $26,000,000 cost of sales x 20% loan-to- cost ratio x 12% interest rate x 15/12 = $780,000.
9 $23,400,000 cost of sales x 20% loan-to- cost ratio x 12% interest rate x 9/12 = $421,200.
The comparative analysis is Table 4 illustrates two key points. First, sales velocity is incredibly important in achieving a higher ROE, even at a reduced ASP. In other words, depending on the change in pricing, it can be very common for pace to beat price as the value driver. Another key lesson is that leverage is a powerful multiplier of either success or failure. Since the cost of debt should be less expensive than the cost of equity, leverage, if used properly, can greatly enhance ROE and operating efficiency. However, the use of leverage in a slovenly manner (meaning taking too much time for land acquisition or commencement of construction until settlement) powerfully eats away at ROE.
Likely Buyers
A key tenet of a successful sale is for the seller to know his or her buyer. What drives the buyer’s decision making process? What are the key evaluative tools the buyer is using? Example 4 highlights another key point. A buyer focused on ROE will favor a lower sales price because the ROE is so much more attractive. A buyer focused on gross margin or EBIT will focus on the higher ASP that drives greater dollars of gross margin and EBIT.
Homework
So, what does all of this mean to the builder looking to sell his or her company? Take the time and invest the money to prepare for the sale well in advance of when you think you’d like to go to market. Yes, and we all like apple pie and the 4th of July. What does that mean, practically? What are the action steps a builder should consider?
1. Accounting and Information Technology
In M&A, information is power and thoughtful, cogent financial information is all-powerful. Invest–spending thoughtfully–in financial tracking and reporting software and hire a proper-sized staff who know how to work intelligently, both with the IT infrastructure and the other folks in your organization. A smart accountant well versed in home building brings substantial value to the table. Remember, that the sales process means explaining the value of your business and that value likely will be driven by financial data that can withstand the buyer’s financial due diligence efforts.
The lead accountant (whether a controller, chief financial officer or bearing some other title) doesn’t need to be a GAAP geek or even a CPA, but someone with integrity and smart enough to figure out the right answer and explain it cogently to you–the owner of the business. Using multiple part-time employees is fine, so long as everyone understands his or her responsibilities. Depending on its size and needs, the company may even consider a part-time CFO. Again, in our minds, the keys are integrity, smarts and commitment. This isn’t just about reporting historical results. A fundamental area of focus is the business plan and financial forecast and how accurate your financial folks have proven over time. Understanding the impact of changes in ASPs, construction costs, gross margin movement and SG&A management are fundamental.
We’ve found that it makes sense to focus on financial reporting software that needs data input only one time. And that software should integrate with the company’s accounts payable and construction scheduling modules.
2. People and Policies
A thoughtful buyer will have as a key inquiry how deep, smart and committed the management team is–especially below the owner level. Recruiting and retaining a smart set of motivated executives–whether operational or financial–is tremendously important. Smart and stable management increases the likelihood that the business plan is thoughtful and provides credibility in the company’s ability to execute and achieve the results of that plan. Create and execute on a personal development plan for your employees. If you help them grow, its likely turnover will drop, job satisfaction will grow and your recruiting efforts will be less expensive and less intrusive to your business.
Well-run businesses, irrespective of their industry, have thoughtful, cogent, written policies that govern everything from people policies (like paid holidays, sick leave and vacation) to expense reimbursement. These policies also are a valuable tool in mitigating employment-based litigation, like harassment, age and discrimination suits. This doesn’t have to be expensive. There are law firm boutiques that can help quickly, thoughtfully and efficiently. Alternatively, there are a number of on-line resources you can review.
3. Land, Lots and Options
The examples above illustrate that turning inventory quickly is a great way to substantially enhance a company’s ROE. For home builders, the largest drag on inventory turns is a multi-year land position that sits on the company’s balance sheet. This is one of the reasons that lot options are so popular for builders.
What if you’re a builder active in markets where a lot option program simply isn’t workable or the cost of the land banker makes the deals uneconomic? There is an alternative–and it has a tax arbitrage benefit, too boot.
As most builders understand, the sale of land held for development, whether a house sits on it or not, results in income taxed at ordinary rates. Conversely, land held for appreciation is an investment, so that the sale of that investment land typically results in gains taxed at favorable capital gains rates.
One practical and well used strategy is for a builder to use two legal vehicles. One is the home building company; the other is the investor entity. The investor entity typically is focused on purchasing and holding land for intermediate–and long-term appreciation. For example, land still zoned agricultural, but in the path of housing development, say 4 or 5 years out. The builder raises money from investors in the investment entity, which then buys and holds those land positions. The investor entity eventually can sell to the builder or option it to the builder or third parties.
As you can well appreciate, there are multiple benefits to this structure. First, the investors generate capital gain. Second, some builders have been able to tranche investor groups, so that those investors seeking long-term capital appreciation will invest in the land position, while investors focused on nearer-term cash returns will invest in the home builder. Third, the builder isn’t burdened by a long-term, slow-turning asset. Fourth, the financing mix between the investor and the home builder can better reflect the return expectations of the different parties. Additionally, the builder may get better leverage from his or her construction lender since the debt principally will be development and construction debt, rather than having a significant long-term acquisition element.
4. Punch Lists and Customer Care
Every buyer of a home builder is advised to spend considerable care evaluating the builder’s possible construction defect litigation exposure, especially if the builder has done merchant building where there may be a risk of class action litigation through a homeowners’ association. A viable way we’ve seen builders deal with this potential exposure is to document the clearance of punch list items and spend some extra dollars on enhanced customer care. After all, happy homeowners don’t sue – and they even refer their neighbors to the community and the builder.
Conclusion
If you’re a builder that eventually wants to sell his or her business or attract a meaningful majority partner, the time to start planning the sale is years in advance of going to market. We’ve found that investing in people, processes, systems and customer care pay huge dividends when it’s time to sell.
