In 2008, I was a partner at a private equity firm investing in homebuilding and land. We weren’t perfect, and we made our share of mistakes. But we were fundamentally conservative, and when we didn’t like what we saw in the market, we significantly reduced deployment. As the downturn approached, we had $500 million in unfunded, discretionary commitments. We thought we were positioned for the moment that matters most in this business: when distress creates opportunity.
Then in March of ’09 our lead investor came to us with a request. Please don’t spend the remaining commitments on new deals. They had problems of their own.
We had been prudent, and we were in a bind anyway.
It got worse. Over the years, other investors had approached us about coming into the fund. Each time, our lead said: “Don’t, we’ll put in more.” It’s hard to say no to your original backer. When that backer later pulled the plug, no one else was there. We started over at the worst possible moment.
The lesson: no capital other than your own is 100% certain, especially when all correlations go to one. That’s why risk exists, no matter the source.
Two kinds of capital risk
Most builders think of capital risk as one question: will the money be there? There are really two risks.
The first is capital that leaves. Flexible capital, meaning sources that can invest in other sectors, has options. When your sector looks worse than the alternatives, it exercises those options. That isn’t disloyalty. It’s their job.
The second is capital that stays, then evaporates at the worst moment. Capital tied to one industry has nowhere else to go, so it typically stays too long. It keeps funding and hoping, and drives the car off the cliff with everyone else. Then it’s gone, all at once, when you need it most.
Going into the GFC, most of the money in our business was considered permanent: dedicated funds, and banks with heavy builder exposure. Most of it drove off the cliff together. Afterward, the mix changed. Diversified private equity came in, and banks cut their builder exposure so that leaving would no longer devastate their income statements. Today’s capital is stronger and more diversified. That also means it’s easier for it to say “no thanks.”
Why now?
Much of our industry believes we’ll get through the affordability problem, and then the housing shortage will carry us. I’m growing concerned about something else: that as the affordability cycle plays out, we’ll run straight into a demographic cliff. Not one problem followed by a rebound, but one problem after another.
The numbers are blunt. Even if immigration recovers to its long-run average, Harvard’s Joint Center for Housing Studies projects about 8.6 million new households from 2025 to 2035. That’s fewer than in any of the past three decades, which ranged from 10 to 13.5 million. But the killer figure is this: roughly 7.5 million of those 8.6 million will be households headed by someone over 75. The decade after that is projected to total just 5.1 million. Births are falling, deaths are rising, and the households we do form are smaller and less affluent.
Near-term conditions aren’t helping. Cancellations seem to be rising, DTIs are way too high (see the excellent Lance Lambert), and even with those high DTIs, we’re struggling to qualify people. It’s a feeling, not a fact, but I feel more edgy than I did after the initial rate spike.
What would change my mind? A strong rebound in immigration, combined with strong job growth in high-end sectors (financial activities, business services, information) and growth in the younger population. A drop in rates without those could produce a bounce. It won’t solve the core problem.
If capital is going to reassess this industry, it will likely do so before the industry does. The time to build options is before you need them, while they’re still talking. Once they get in the bunker, it’s hard to get them to engage.
The one-trick pony
Consider land bankers. Public builders rely on them heavily; private builders also get access, though less of it and at higher prices. A public builder’s best play is probably to use land banking as long as it works, then drop options or retrade prices when conditions change. The builder holds the option. The land banker sold it. Watch whether the big builders continue doing cross-collateralized deals with land bankers. If they seem more willing to pay extra for individual deals, that’s your signal they’re scared too.
I suspect land bankers and those long on land will be the ones holding the bag this time, but the point is broader: if you’re a one-trick pony, you’re reluctant to give up the trick. Watch the capital that has nowhere else to go. And if distress does arrive there, ask yourself a harder question. When deals come up for sale, will you be able to buy? Do you have the capital?
How to prepare
Accept a somewhat higher cost of capital in exchange for more options. No single source should be all of your capital. For a builder, that might mean:
- Broadening your bank relationships. Most builders have more than one bank. If they’re all borrowing bases, consider adding a project lender. If they’re all regional banks, consider a local bank that may be more insulated from national problems.
- Using more than one land banker rather than routing every deal through a single one.
- Bringing in a JV equity partner, such as a family office, for land you’d otherwise hold yourself.
Diversify by type, not just by count. Five similar institutions can hit the same wall at the same time. Look for sources whose stress won’t coincide.
If you depend on one or two main backers, make the case that diversification is good for them. “You don’t want me so dependent on you that if you have good reasons of your own for saying no, I’m crushed. That won’t be good for you either.” The old line applies: borrow a million and the bank owns you; borrow a billion and you own the bank. Neither of you wants that relationship.
Add others without pushing them out. Don’t shut them out or seem disloyal (even capital has feelings), but work in others as you include them. You’re not telling them you don’t want them to have more, just not all of it.
Watch your counterparty’s balance sheet, not just your own. Ask what could force them to say no, regardless of how good you look. It’s not just their exposure to you or your industry. The denominator effect occurs when they’ve allocated capital to your sector and believe they are within their allocation, only to see other assets fall enough to push them over their allocation. So if they are anywhere near their allocation limit, that’s a risk.
Not yet, but sometime
In 2009, a builder reached out about doing business with us. We’d get together periodically to get to know each other, and at the end of each evening he’d clink glasses and say, “OK, not yet, but sometime!” It became a running joke. We ultimately did do business because we knew each other before the real opportunity arrived.
That’s how you cultivate flexible capital. Do it now, through deals if you can and through relationships if you can’t. Make yourself useful. Ask if they need help with anything. Share information. Ask for their opinion. Resist the temptation to ask for something borderline. Wait until it’s good for them, not just for you.
How do you price survivability?
I can’t give you a formula for how much more to pay for options.
But I’d ask: “What is it worth to survive?” A firm that doesn’t make it through loses not only this cycle’s returns but every return thereafter. In a business where the best opportunities arrive at the worst moments, the ones still standing with capital in hand capture them.
