When demand for a product decreases dramatically and the company overshoots production requirements, what should executives do? Hold prices and be patient or hold a fire sale and take what they can? That is precisely the question facing homebuilders. For the most part, these executives are choosing discounts, including Hovnanian Enterprises which reportedly held a 3 day fire sale with discounts as large as 30% on select homes.
What key issues would guide an executive to hold a fire sale rather than hold the line? For homebuilders, it appears the key issues are (1) industry dynamics and (2) the cost of holding inventory.
Many economists and analysts agree that, compared to the prior industry cycle, the demand curve for new homes has significantly shifted downwardly. Numerous reasons have been cited as to why demand is lower including: (1) higher interest rates thus making the monthly cost of purchasing a home higher or the reference price for homes higher; (2) a greater number of existing homes on the market due partially to the recent challenges in the sub-prime lending market; (3) the investment value of a new home being below that which could be recouped if the homeowner rented the home.
(In Figure 1, demand decreased from Prior Demand to Current Demand, the market price shifted from Pp to Pc while the Supply remained unchanged.)
However, executives are not trigger happy about lowering prices and holding fire sales. Lower industry demand alone does not indicate that discounting is required. An alternative to lowering price would be to decrease supply. In support of that approach, reports indicate that some homebuilders are doing just that, reducing new-home starts and slowing production, thereby leading to an eventual decrease in supply. Yet, that decision alone has not satisfied homebuilders’ executives.
For now, homebuilder executives are providing deep discounts. Lennar stated that their average incentives were $43,700 on houses of average value of $342,000, up from one year ago when incentives averaged $24,700. That is a $19,000 increase in discounts.
What would make a $19,000 increase in discounts rational? If the cost of the discount is less than the cost of carrying inventory at current prices, then the discount is rational. (By the time the home is built, all costs are sunk except for the small cost of paying real estate agents, therefore the remaining relevant decision factors are the cost of holding inventory and the expected price to be attained.)
If we consider a $345,000 home, where the margins in the prior period were 23.3% (KB Homes prior period margins), we find the cost carried by the homebuilder is $262,000. If the cost of capital for a homebuilder is 9.5% annually (KB Homes interest rate on a recently retired note), and the expected time to hold the home is 10 months (National Association of Realtors estimate), then the expected cost of carrying inventory is $21,500. Put in this frame of reference, a price discount of only $19,000 is more profitable than the cost of carrying inventory.
Good executives know that pricing excellence does not always mean holding out for good prices, it also means monitoring industry trends and making wise, profit driven, tradeoffs.
Notes and References
- Michael Corkery, “Rate Cut Perked Up Builders’ Stocks, But Price Cuts Will Sell the Homes”, Wall Street Journal, 22 September 2007, p. A2.
- “Home Sales in ‘Free Fall'”, Washington Post, 26 September 2007, p. DO2.
- “Pace of New-Home Sales May Be Down 18% on Year”, Wall Street Journal, 27 September 2007, p. A1.
- KB Home (KBH), Form 10-Q, July 10, 2007.
- Angela Pruitt, “KB Home Posts Quarterly Loss”, Wall Street Journal, 27 September 2007, online edition.
- Sudeep Reddy, “New-Home Sales Hit 7-Year Low”, Wall Street Journal, 28 September 2007, p A3.