Overdue Diligence, Part II: The Builders Speak

I read the article and found it insightful and informative. I share much of your skepticism regarding the traditional due diligence process and feel sometimes it is used to justify a desired conclusion, rather than an objective and thorough evaluation. Depending on what kind of asset is being reviewed, I can see value in each of your 10 value criteria.

The key to due diligence, like most things, is execution. No matter how well a land deal or acquisition may look on paper, we have to challenge ourselves: “Can we execute the plan?” Your suggestion to ask for 10 reasons why not to do the deal is intriguing. Our builder optimism always gets in the way, and we know every deal comes with risk. I really feel that our people/staff are our biggest asset. So in acquisition, reviewing the company’s culture is vital. Efficiency is critical, and you address that mentioning an evaluation of trade base, cycle time, and systems and processes. The efficient companies are going to be the survivors and thrive on the next go-round.

Your advice to discuss the evaluation on a land or lot purchase based on what we as a company can produce is well-taken. Is there a fit? This goes hand in hand with the culture aspect. We need to ask, “Can we build our existing product in that location?” rather than having to create product to fit. I have found that so many builders have a hard time answering questions about their goals or what size they want to be. And don’t forget that our consumers’ wants are changing faster than ever. The company and our land acquisition strategy needs to address the quickly changing consumer environment as well.

Many builders add additional considerations for asset deals such as tax and deferred tax assets, land entitlements and permits in place, not expired, and the removal of any warranty tail. With the number of broken communities these are more critical than ever. All assets are valued using a net present value/discounted cash flow model yet the discount rates vary between buyers’ impact values. Strategic buyers may not value management other than at the community level and may plan on using their own product and systems. Publics will use their own systems for sure. Financial buyers require a platform, including all the areas you highlighted and should require management to stay. And remember that land controlled by the company but not owned (not on balance sheet) is an area that needs as much due diligence as owned assets, since the controlled land is the future of the acquired company.

Risk assessment and quality audits by a third party help protect the downside risk and provide a baseline for measurement going forward. It is smart to survey customers under warranty for satisfaction, and run a third-party evaluation of internal talent and outside stakeholders such as architects, engineers, suppliers, trades, inspectors, realtors, etc. Learn as much as you can.

Management, culture, quality, and customer satisfaction are the difference between a good company and a great company. Outperforming the market and maximizing returns only happens with outstanding talent aligned to the goals of the company.

Your observation that equity-fund types need a minimum 20 percent because of risk is spot on. They have short fuses on deals. A 20-percent return is not generally sustainable over the long haul (unless there is underlying and ongoing house price inflation) so they have to be in and out of deals quickly. This creates an opportunity to buy; however, sellers to funds or recipients of equity fund capital should beware. After all, the implicit deal gives the fund a 20-percent return based on their analysis. Equity-fund types are not people persons. Generally, they don’t really care about legacy, customer satisfaction, or building a long and good track record because they will soon be gone. They are not bad or evil people; it is just the way it is. Many builders have fairly significant due diligence processes, but the real Achilles heel is undue optimism, and most builders and developers have that characteristic. When a graph shows you that you have to sell for $30K above the competition and you can rationalize a purchase, there is a problem.

This issue of how to value assets is important both in timing, as the market improves nationally, and in content regarding process integrity. I have worked now with multiple national, regional, and local builders and have seen the consequences of the “buy the land, then figure out what to build” approach. There is certainly room for those tactics in a survival mode or as a purely opportunistic strategy, but it cannot be the core methodology or the operation becomes scattered in its priorities, which translates into no priorities.

As builders we will always face outside factors trying to get us to compromise the integrity of our process. This is prevalent in improving or hyper-competitive markets where timing pushes us to make decisions on land more quickly than our process can support—which equals decisions without all the data, which leads to bad decisions. The answer is to improve our process, not compromise it.

The most obvious compromise is the schedule. We have this process, except in the last two weeks of December when we ram 40 percent of our annual closings through. Long ago I worked for a manufacturing company. Our chairman happened to be the son of the retired chairman for International Paper, a Fortune 100 Company. We presented to the father and described our challenges in the plant. He asked some questions, and then he gave us some of the best advice I have ever heard.

“Get rid of all of your calendars!” he said. “Those calendars are screwing up your processes and making you do things you know are not right. Throw them out. Measure the time, but get rid of your calendars!”

Deep due diligence is indeed important, but very hard to do. Shallow due diligence is the norm because it is easy to do, easy to replicate, and can be done quietly when someone is being bought. Deep due diligence requires smart people to do the work; ones who have a vested interest in finding the facts to develop the whole picture. My experience with a large builder staff is that most are really good at the piece of the pie they handle, but not when they are out of their element and have to wrap their arms around the whole package all at once. This observation is supported by those in my Builder 20 Club. When they hire someone from a big builder, that person always gravitates to the game plan and processes used at the big builder job, and then fails because of it. The 10-step model is good for thought, but over the head of most. There is a reason that so many smaller builders operate much more profitably than the big builders.

Generally speaking, the “significant seven” in your original model are far more important than the “usual three.” Obviously if the numbers do not work, then the deal does not work, but those seven other items are what eventually determine if the acquisition will be successful or not. If you are buying raw land, then I would lean on more of the usual three. Price, permitting, off-site costs, development costs, location, and market research all are a huge factor. If purchasing an existing community that has a track record, then yes, the significant seven all play a role. Unfortunately many of the problems that arise when buying into an existing community do not surface until after the fact. Issues with the original developer, broken promises to the current homeowners, HOA issues, ARC issues, and unhappy customers with previous builders can all affect sales and ROI. These items are usually overlooked when looking at a deal, yet they are just as important as the numbers. A building company is only as good as its systems, personnel, trades, and reputation. It’s hard to buy those; that takes years of hard work, and it never ends.

Due Diligence Dozen: A Total Cost Valuation

1. Legal Clear title is a basic requirement.

2. Entitlements For developed land or lots, all in place and current.

3. Physical Assets Includes topography, soils quality, visual appeal, lot-fit analysis, drainage, site contamination, environmental impacts on land, animals and noise, historical/archeological concerns, and even crime rates, among others.

4. Market and Demographics Knowing the growth patterns, the target markets, and how well they are served translates to opportunity.

5. Warranty Tail For existing community assets, a total cost analysis of all warranty obligations.

6. Management and Staff Is the management team up to the task of building the right product, at the right cost, in the right place, while maintaining quality and controlling cost?

7. Trade Base No single factor drives profitability more today than securing strong trades at a competitive price for the long haul.

8. Supply Chain Price increases are rattling all up and down the supply chain. This is a significant wild card today and must be actively managed.

9. Systems and Process Strong systems and process throughout the operation that both help manage the details and provide continual feedback are essential to profitability.

10. Cycle Time The best builders are the best schedulers, and the best schedulers are the best builders. Period. Responsible due diligence is impossible without understanding a builder’s cycle time.

11. Customer Franchise The strength and reputation of a builder with their potential customer base makes a significant difference in velocity, pricing, and ultimately profit.

12. Community Franchise The broader relationships with zoning boards, planning commissions, inspection departments, and even other builders can make or break a project.

Due diligence has changed over the years. Drees has a standard due diligence package that is prepared for every land deal, whether raw land or fully developed lots and it addresses all of the items in the model you present. We determine exactly what we are buying, each entity involved, and the expected timing. From there we analyze the risks, including current and future market, location, timing, competition, development, school district, location, etc. We undertake a detailed competitive analysis against both new homes as well as resale. Specific risk factors we consider include land development, sales pace, gross margin, length of project, deposit risk, and cash investment.

With all of this reviewed, we have to look at every potential deal and ask, is this a good deal? Can we perform in all areas to make this successful? Do we have the resources (talent, partners, etc.) to accomplish our goals? Is this something we want to do? What is the down side if this deal does not perform? What is the worst case scenario? Every deal has different factors and every deal is analyzed by the resource committee. We always go above and beyond our land acquisition package requirements when making our decisions.

Some deals of course are easier than others. Risk is the main factor we consider. Short-term, low investment deals are the easiest to approve. The longer the term and higher the investment the more due diligence that is performed.

In our financial pro forma, cash investment, sales velocity, and gross margin are what drive the IRR up and down. You have to use past history of sales velocity and gross margin as a benchmark in your pro forma. Too often I see pro formas that are using velocities and gross margins that are questionable based on past history. When you see that, you have to do more due diligence to test those assumptions. We often see other builders doing deals that we have not been able to make work and all we can do is scratch our heads and wonder. Was it us or them that made the mistake in due diligence?

I also see many pro formas today that only achieve acceptable IRRs when escalation in the sales price is included. That is very risky for any project to be banking on inflation to help you make acceptable returns. And when the project is long enough to go through a down cycle the risk is even greater.

All said, there is no such thing as a risk-free deal. We just want to be sure that when we go forward with a transaction, we have identified all of the risks and are prepared for what may happen.

There are many factors that impact gross margins such as pricing strategy and sales velocity, but for any given gross margin/business strategy, the faster you can build the home, the better the ROA. Since this is a key metric for the private equity folks (ROA sooner or later converts to IRR), cycle time is important. Those who work on turning manufacturing businesses around get this. You have to understand the constraints on a project, including architectural restrictions, covenants, and their embedded costs. For example, I’ve seen a master plan community (MPC) that was entitled with architectural standards requiring an extra $50/square foot compared to the rest of the market, but there is no way customers will pay the extra for the doodads. They devalued the property by $150,000 per unit for the average 3,000 square foot house and the developer still doesn’t believe it.

Sam Zell will tell you to run the base case for the property/acquisition and get your dollar profit and IRR. Then run two other cases: the very slow and expensive case (what if velocity goes in the tank, costs go up, prices can’t, etc.) and the happy music case (velocity is faster, prices rise more, etc.). In both cases, they should be based on the best and worst experiences that builder has experienced, or that you can find in that marketplace. What Zell does is measure the risk/reward by comparing both the base case and aggressive case to the worst case, both in absolute dollars and IRRs and percentage change. The idea is that, over time, you begin to understand where a deal is on a risk/reward scale that is pretty simple to understand.

Your model challenges the status quo. We have not been able to do a single deal with the types of investors you mention: private equity or other investors that are not familiar with land. The 18 -to-20-percent-plus IRRs are just not realistic and blow the deal. We have pitched a lot of deals, and I am not even going to those types of folks anymore. We are trying to form alliances with two to three investors and/or former land developers that have money so we can go into deals together and create win/wins. We are also forming alliances with other larger private builders, so we don’t have to compete against publics who have different goals than us. The strategy is working well.

Due diligence is a process. When I think of land acquisition issues I definitely believe the physical characteristics of the site need to be fully understood. We were a pretty good builder at John Laing and knew our market well, but the most costly mistakes we made had to do with specific soils conditions and resultant development costs. Said another way, you can be a 10 in items four through 10 on your model, but if you buy a site with physical challenges that are missed in due diligence, it can cost you a fortune once you launch site development and building. Granted this is why you do soils evaluations and get a geo-technical engineer to evaluate the results. The full 10-item model you have identified is definitely necessary if one is evaluating a builder’s business for acquisition.

What you are proposing is to look at the heart of the people involved. How much is the primary question, but that is not nearly as important as who and how. As a builder, who are we and how do we run our company? Genuinely good people will hire good trades and have strong relationships and together they will create good processes. And over time, that will pay off in profit.

We like to say that we don’t pursue profits. Rather, we pursue strong relationships and develop strong processes through those relationships and profit is the result. In fact, is it possible that good land, happy customers, quality homes, and profits are the results of good people and good relationships?

We have probably made every mistake imaginable when doing new projects, and each time we have improved to where we do not miss much anymore. The first key is to recognize that each new piece of land is truly unique and you cannot copy and paste numbers and assumptions from another similar project. House construction cost is often the easiest to predict and control provided you do not use yesterday’s numbers. Determine what things will change when you start this project by asking trades about material increase, labor, or material shortages, and if there is anything unique about the location of this project or local requirements that could affect the cost to build. One surprise for us was a town where we had to be union. So add 35 percent and oh, the same town was by the ocean so add another $15 per square foot to build for driving rain, wind, and corrosion. Our land guys at the time took the same plans from another project 80 miles away and used all of the same numbers—whoops. So always ask what is different and what can go wrong. Talk to everyone you can ahead of making the deal.

Where we and other builders have really been handed our lunch is in land development and governmental approvals and requirements, both in direct cost and incredible delays in time. The team must first make sure the ones in love with the land (the land guys) are either out of the due diligence process or do not have too much of a vote, or they will turn a blind eye to big issues. With the land development and governmental requirements just assume everything will go wrong and talk to everyone involved during the due diligence. Vet everything. Do every bit of testing you can with the land, soils, drainage, earthquake faults (in California), creeks, rivers, wetlands, etc. The governmental issues are really big now and not just in California. Every agency that has any say or possible regulation that could affect the property should be contacted and a sit down arranged to fully understand what they will require, how much time it will take, and how much it will cost. This typically involves federal (Corps of Engineers, EPA, etc.), state, city, county, local, and other jurisdictional agencies, such as flood control and fish and game.

We have learned every new project is completely unique and must be treated as such. They will require lots of time and investigation. Turn over every stone and ask every question or it will haunt you. Ask what is new and different about this location. Then set out to investigate each of those items. True due diligence should be some of the most time consuming and intense work that a builder ever does. This effort needs to involve a huge team—consultants, engineers, architects, trade partners, local Realtors, governmental agencies—and yes, getting most if not all of the team to the site to see it and the surrounding areas in person. In a boom market, builders might get away with using yesterday’s construction costs and tomorrow’s inflated sales prices while giving short shrift to the impact of governmental requirements. In today’s markets, that thinking will take you down.

This article and the model hit a lot of salient points that the suits will never get. I have been to a number of these conferences and found them like a Hollywood set—a pretty façade but nothing behind it. All of these factors are required to make the deal work. My caveat is that market research is by far the most important part of due diligence. I was amazed through the last downturn at how many properties were developed that never worked and would not work even in the best of times. Banks and developers were looking at appraisals to help them make decisions. Appraisers have a great purpose, but it ain’t enough to make an informed decision. Appraisers look in the rear-view mirror and tell you about history. Market research tries to predict the future.

Market research is not like a balance sheet, which is a picture of the company at one time. It is more like an income statement that if properly analyzed on a monthly basis will tell a story about trends. Market analysis must look at trends and try to look at the direction of the trend to see if a deal makes sense. All of the other elements of the model must be there to be profitable. However, you can be great at all nine of the management practices but if the market research is wrong and you cannot sell—you are dead.

This model is true to the core. I believe most builders/developers still don’t perform basic steps 1, 2, and 3 very well—especially step 3. They make huge financial decisions based on gut instinct as you mention in the article. I made the same mistakes prior to 2008 and thus took it on the chin hard with lots of projects. Your suggestion makes perfect sense, particularly in the example you provided, yet these are just good business practices across your entire operation, independent of risk evaluation on a specific land deal. If you are not constantly evaluating steps 4 through 10, then you are not managing the inherent risk of being in this business. This separates the marginally profitable companies from the highly profitable companies. For those builders who don’t keep their eyes on steps 4 through 10, all it will take is another small recession to put them out of business.

As emphasized in Part I of this series on due diligence, in the building business it is impossible to buy a risk- and liability-free asset. Instead, we optimize asset return at the lowest level of manageable risk. Yet this is simply not possible without knowing where the risks and strengths lie. Without that knowledge we are merely guessing. We will never identify all the information we’d like at the 100-percent level, yet builders tell me that a buy decision on 50 percent or less of the needed information is the norm. That is not due diligence. As a couple of our builders warn, however, getting this done without becoming tied up in bureaucracy can be a genuine challenge, especially in the large regional and national companies. They run the risk of being mired in the analysis stage while a strong local builder buys the land right out from under them. But the answer is not to skip the steps. The answer is developing an efficient process to get them done in a hurry.

Observant readers will note that the Full Value Due Diligence Model has been edited a bit and increased from 10 elements to 12, based on input from the builders. A few builders pointed out that buying land alone may require a shorter list of the criteria, as opposed to acquiring a builder. Fair enough. The goal, however, is to present the comprehensive requirements as a basis to establish your own model and then execute with discipline. Without strong execution, any model is ultimately pointless. I hope you find the model useful and it is still, of course, open to improvement. Please send me your comments and suggestions. Next, we’ll see what the developers have to say.