Financial Risk

The Timing Risk of Buying Land?

The age-old mantra in real estate has always been location, location, location.  But in markets where there are big cycle swings, such as here in California, the newer mantra has been timing, timing, timing.  And I think the importance of timing in land acquisition cannot be overstated.

In the markets where land is at a premium and the land buying is highly competitive, I have watched how difficult is for homebuilders to turn off the spigot and stop buying land in anticipation of a market downturn.  When you have a business plan for the next 3 – 5 years that requires land, it is a very difficult decision.  I sat in land acquisition meetings around 1999 – 2000 and the discussion was whether to stop buying land in anticipation of a recession.  As it turned out, the market continued to rise until 2007, which means a homebuilder would have missed out on a lot of home sales and profit if it didn’t have land to build upon.

A typical scenario of bad timing would be a builder buying 100 lots at top of the market land prices, but with an unexpected recession starting in two years.  Let’s say the builder spent the first year obtaining building permits and getting models built.  Then by the end of the second year, the builder has built and sold 30 homes.  The recession hits and the builder is holding another 70 lots, at top of the market prices, with homes that will not sell.  With recessions that can last a few years, and have declining home prices, the financial outcome is not pretty.

I am not sure exactly what the answer might be.  Builder operations that need to build 500 homes a year must have a pipeline of land, which creates the land risk exposure once the market turns.  One large land developer sells land in “rolling options”, which means the builder can purchase lots in 15 – 20 lot increments.  Thus, the risk of owning 70 lots at the downturn is mitigated.  But these rolling options usually come at a price with the land seller escalating the price for every takedown of lots and usually having a price/profit participation in the project.  But not many master developers sell land in this manner, so builders must face this timing risk as the up cycle moves forward.

In this last devasting recession, I did see one large national builder acquiring big chunks of land during the depth of the recession at reduced land prices.  This strategy takes some stomach and capital, which is somewhat tough when the builders were just trying to work out their existing land and financial problems.

If we only had the magical crystal ball.

As always, we welcome your comments and questions below.