The Economy

Housing Smarts

Clever financing and a “long-land” business model helped Toll Brothers weather the recession. Now, business is picking up for the luxury-home build...
Edward TeachApril 15, 2013

In 2006, when U.S. housing prices peaked, Toll Brothers saw its annual revenues reach an all-time high of $6.1 billion. But when prices plummeted and the recession ensued, sales fell for the luxury-home builder, resulting in four straight years of operating losses. Like so many other companies in the housing industry, Toll Brothers had to make layoffs, nearly 5,000 in all. “As painful as those were, it was the right thing to do when there wasn’t enough work to go around,” recalls CFO Martin Connor.

But unlike so many other companies in the housing industry, Toll Brothers maintained a strong balance sheet, and as the economy gradually recovered, its business revived. In 2012, the housing market picked up steam, and the publicly traded builder recorded its first positive pretax income since 2007, $112.9 million, on revenues of $1.9 billion. Fiscal 2013 began auspiciously for Toll Brothers, with new-home contracts up 49% for the first quarter and 40% for the first three weeks of the second quarter, when the prime spring selling season begins.

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“From a sales perspective, our second quarter is historically our best for contracts,” says Connor. “As we get to Super Bowl Sunday and then through the end of April, the season really picks up.” That’s because customers with children need to contract for a house in time for it to be delivered before the new school year starts, he explains.

Connor, 49, is an experienced hand in real estate, having previously been CFO and director of operations of a large Philadelphia-based developer. Before then, as the audit partner in charge of Ernst & Young’s real estate practice in Philadelphia, Connor had Toll Brothers as one of his clients. Recently, he told CFO how the company was able to maintain an even keel during one of history’s biggest housing busts.

Many home builders went out of business during the housing bust. How did Toll Brothers ride it out?
It’s one of the benefits of being a public builder. You’re able to borrow money from the capital markets in 10-year increments. You don’t have to pay 10-year debt as you go, just periodically. So if you ladder the maturities and spread them out, not so much comes due in any particular year.

Also, we are a long-land company. That is, we own a lot of land in relation to the number of homes we deliver in any given year. So when things slowed down, we were able to sell homes on land that we had paid for a long time ago. In each house we sold, we kept about 50% of the revenue generated as cash. Had the market been growing, we would have used that money to buy more land.

Lenders like companies with cash on hand.
Sure, it’s always easy to borrow money when you have money. We went from having around $500 million or $600 million in cash on our balance sheet in 2005 and 2006, at the height of the market, to having more than $2 billion in 2009. So in some cases we chose to pay off some of the 10-year bonds as they came due; in others we chose to raise new 10-year bonds to pay off the old ones.

How large are the communities that Toll Brothers builds?
They are generally in the 25-to-150-home size, although some have a couple thousand homes.

Who are your typical customers, and what are they typically buying?
Our typical customer makes $175,000 to $225,000 as a household. It may be a husband and wife. They are probably buying a house for the third or fourth time. Eighty percent of our homes are for $700,000 or less. We don’t sell entry-level homes, and we’re not building $5 million custom mansions in the Malibu Hills.

In 2007, the average size of a new house in the U.S. peaked at 2,521 square feet. But the average size in 2011 wasn’t much smaller, at 2,480 square feet. Are bigger homes here to stay?
We haven’t seen any indication that Americans want smaller homes. Before the downturn, during the downturn, and now, we have seen consistent levels of upgrades in our homes. People continue to choose bigger and better. Our mix has shifted a little bit. We are selling more homes to empty nesters and active adults, and selling urban product. All three of those are generally smaller square footages than our large single-family suburban home.

When you buy land, what do you look for?
We look for land that is well located. The markets where we operate are in good school districts that people will find desirable and that support the luxury product we’re known for.

Fifty percent of our business is between Boston and Northern Virginia, in areas where there’s not a lot of land available. So when you see an opportunity to get land you get it, even if you’re not choosing to build houses on it right away. In many cases the ideal situation for us is to option a piece of ground.

How does that work?
The classic example involves a farmer who’s had enough of farming. His land is worth only $5,000 an acre as a farm, and he may not have the expertise to go in front of the town council and get it rezoned. So we’ll give the farmer a deposit for the right to position his land over the next five years so that it is rezoned into something more valuable to him and more valuable to us. If we are successful, we will give him a price for the land that’s far in excess of the $5,000 an acre it’s worth today, say $50,000 an acre. Our expectation is that the land will be worth more than $50,000 an acre when the process is complete. So we get to capture some of the value we’ve created, and the farmer gets to capture some of the value we’ve created.

It looks like both the housing market and the economy are getting stronger. What’s your outlook?
We’re optimistic about the housing recovery. It seems to be proceeding at a faster pace than the economic recovery. It’s important for housing to recover in order for the economy to recover further. Two-thirds of Americans own a home. An improving housing market is important to the consumer’s confidence and the consumer’s balance sheet. The amount of employment that is tied to home construction is significant. Between 10% and 20% of all employment is associated with house or apartment construction.

For 40 years the industry built about a million and a half homes a year. And for the last four or five years we’ve been building roughly one-third of that. Existing- home inventory is at all-time lows, roughly four months, and new-home inventories are similarly near all-time lows. That bodes well for us.

Mortgage rates are still great.
They’re phenomenal. Thirty-year money is 3½%, 15-year money is 2¾%. Those are all-time lows.

Is there more for the federal government to do in boosting the market?
We’re encouraged that the Administration seems to understand how important housing is to the economy and is going to continue to take a do-no-harm approach. They have not unwound Fannie Mae and Freddie Mac. They have not changed the mortgage-interest deduction. They have addressed the qualified residential mortgage legislation [with] what I would call reasonable rules.

On a personal note, what makes you eager to go to work every day?
I really enjoy the people I work with, the product we produce, and the challenges we encounter. For many people, home ownership is the American Dream, and we’re privileged to be able to provide it. People move into our houses and it’s a great day in their lives, and we take a lot of pride in that.