A Builder's Take

Posted by Dave Fratello on Sunday, January 13th, 2008 at 5:06am.

You know things are getting strange in the local real estate market when a noted builder takes out a half-page ad (click to enlarge) not to market a home, but to persuade fence-sitting buyers that prices "will not and cannot come down another 10% this year."

We'll reproduce the text of the ad here and comment below:
The Crystal Ball Story

Advice for New Home Buyers

I've been in the real estate development and sales business in the South Bay for more than thirty years and you can rest assured that prices on new homes will not and can not come down another 10% this year. Here's why:

New homes currently on the multiple listings service that are between $2.1 million to $2.6 million were purchased as building sites in the ballpark of $1.3 million (cost to purchase an existing home as a construction site).

The development cost to build a 3,300 square foot home is around $1,000,000. This is higher than one would initially expect but breaking down the components of this high figure is telling. It includes building costs ($825,000 @ $250/ft.), interest ($100,000), sales commissions ($125,000), permits, liability insurance, workman's compensation insurance, etc.

Using these approximations, since sites and plans vary, one can see the break even point for the builder is $2.3m. In order to sell new homes under $2 million, the price of building sites needs to drop 40%, down to $700,000-$800,000. This will not happen in Manhattan Beach because there are too many investors and home buyers willing to pay much closer to $1 million for a site to build their dream house and still manage to accumulate equity. There are currently no homes in Manhattan Beach for sale under $900,000. So, my advice to you is to make the best deal you can on existing inventory now and enjoy your new home. Watch the value of your home rise in value by 20% over the next 5 years.
This is a fascinating window into a builder's perspective on the slowing market – particularly the glutted Tree Section new-construction segment. We'll break this all down in a minute, but let's try to translate the overall message:
Listen, you muddle-headed market-timers, the best you're ever going to do is to make a good deal on the stuff that's on the market now. Don't worry, even if you lose some paper equity, it'll all come back in spades. By the way, I'm selling some of that lingering inventory and would appreciate it if you all got your heads on straight and started buying.
Fair?

The argument is pretty simple:
  1. On most current inventory, high lot acquisition prices ($1.3m on average) are going to preclude builders offering deals. They've got "break even points" to worry about. So prices are stuck where they are, sorry.
  2. Lot prices will have to drop 40%, as low as $700k – doesn't that sound absurd! – for new homes to sell for less than $2m. (And only $1.9m, at that.)
  3. Therefore, you can't get a big bargain now and you won't get one later. So buy now.
Surely you noticed the first flaw in the argument: Builders can lose money instead of breaking even. Let's consider 3 recent sales of new construction on which we're reasonably certain the builders lost money:
  • 648 35th (5br/5ba, 3600 sq. ft.) – lot price: $1.33m; sold price: $2.075m – difference: $745k
  • 2807 Elm (5br/5ba, 3550 sq. ft.) – lot price: $1.475m; sold price: $2.1m – difference: $625k
  • 2310 Palm (5br/3ba, 3150 sq. ft.) – lot price: $1.45m; sold price: $2.2m – difference: $725k
For illustration's sake, if we just assume this builder's $1m flat estimate of building costs across the board, then on these 3 sales, builders lost $255k, $375k and $275k. So much for the break-even points.

Could lot values drop? By 40%? We're seeing modest deterioration already, if the start point is $1.3m in the Trees. (The lots referenced above were higher in '05 and '06.) Some sales of likely or certain teardowns in 2007:
  • 3521 Elm: $1.150m
  • 2103 Elm: $1.1m
  • 3404 Pine: $1.2m
  • 2503 Valley: $1.03m
  • 1713 Oak: $1.08m
  • 848 14th: $1.35m (a counterexample)
Now, few of these are good examples – several so-so locations, and all but 3404 Pine slipped to the MLS instead of being snapped up first by builders. That would generally mean that you should expect lower prices.

Still, we know builders aren't paying as much for lots anymore, pinching the market that this ad suggests is full of demand. As losses mount, banks grow skeptical and investors take a hiatus from new-home developers, of course demand can shrink further and lot prices can take a further dip. Is it 40%, or an average lot price near $700k-$800k? A bellwether to watch for now is 3009 Poinsettia, a lot in a great location that's had no takers at $1.4m.

Are you really better off buying now, rather than waiting for some future new home to come on the market at a better price? You almost certainly are better off buying now if this builder's numbers turn out to be right. His market projections are specific, and worth tracking: new homes "will not and cannot" go down 10% this year, and, if you buy now, your home will be worth 20% more in 5 years.

Yet the ad's author has surely seen down markets surprise builders, banks and buyers before. Has he never witnessed a 10% drop year-over-year in new-construction prices? Fat chance.

So why can't it happen now, again? Because builders have to break even?
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