The Expert Podcast

So if the problem of the residential housing market is not enough inventory, why not just build more homes? It seems simple enough where if there's not enough houses to go around and people want to buy more houses than exist, why not just build more single family homes? Well, unlike other products, it's a little more complicated than that. If you need more cell phones, you just crank up the cell phone factory. If you need more even washers and dryers, you crank up those factories. As we've seen even in those products, the cycle and supply chain has even made some of those in short supply but not as urgent as housing.

The reason why is because the building industry has a lot longer lead time and sales cycle. So from the time of inception of building a house, you need to acquire the property, get designs and permits, you need to put together the contractor, start building the house, and that can be a year to year and a half progress even for a single house. If you're building a large subdivision with multiple homes, it can even be a several years cycle. The problem with building is the market today may be different than the market a year and a half from now, as what was seen in the 2008 housing crisis. So if a builder is going to go all in to build large volumes of homes, they have to be assured that their business model is going to work two or three years down the road because if it's not, they could be planning for something that doesn't exist.

The bigger problem is the homes that are needed in the marketplace are homes in the median price range at three to four to maybe five hundred thousand dollar range. When you're building a home as a general contractor or as a building company, those homes provide a very slim margin for profit because a large percentage of the value of a home goes into fixed cost of the permits, the planning, even the carrying costs of the property over the course of the year or two of building it. So if you have a fixed cost of in some parts of the country a hundred thousand dollars before you even break ground for permits, environmental oversight, your fixed expenses of your business, if you build a house that sells for 350, you might think, well, you make 250 profit.

But that doesn't include the cost of the real estate, the property, the cost of the materials, and the cost of labor. Trying to squeeze that all into a property that you're selling for 350 or 370 may be a difficult thing to do. Once you get up into five or six hundred, you can maybe fit some more profit, but the expectation of the buyer at five or six hundred is also going to go up. So you need higher end furnishings, more square footage, which is dollars per square foot, more labor. The profit margin really doesn't start to become appealing to a builder until you get up in close to the million dollar range.

So if you're building homes into seven, eight, nine hundred or over a million, now you're going to be assured of a profit that will keep you in business. If you're not assured of that either, you're not going to do it as a builder or you might take a chance and maybe say, I want to build some entry-level homes. But this is what could happen. This company in Pennsylvania, home building company, construction firm, went out of business and they were building homes. Well, how do you go out of business as a construction firm when there's a housing crisis, people need homes? Well, it's because you didn't guess the math right. If you undersell houses, sell houses too cheap and don't cover your costs, then you're out of business.

What a lot of builders do is figure the price of a house based on materials, labor, and price of the land, and you would think, well, that's enough. But if you don't factor in enough extra profit to pay your fixed business expenses, your office staff, the amortization of your equipment that you own all the time anyways, your insurances, your bonds, all of the other things that are still expenses that run even when you're not building, eventually you're going to run out of money. And you might sell a house for 400,000. You had 150,000 in materials, you have 150,000 in labor, and you might have a hundred thousand in cost of the land.

Well, maybe you broke even, you made a little profit, but you had no money left over to pay the payments on all your excavators, your equipment, your office, your lease, your insurance. And if you're blind to that expense, you're not going to make a profit. So now you have to take that house that would be 450 and you have to sell it for 550 or 600. That kind of puts it out of the median for the current market.

So builders who are allocating their resources to higher-end houses, seven, eight hundred thousand, million dollar houses, are more likely to stay in business. And while that might not seem fair to people who want an entry-level house, the reality is business is just math. It's not an opinion, it's not what you should do or shouldn't do, it's what the math makes happen. And when a home builder in this market can go out of business, it's just not doing the math right. They might have been good at building, but you have to do the math.

So why not build more homes? Well, the type of homes that you can sell in that median range might cost more than the selling price to be able to construct a new home. So what do you do? Well, there's three options, and we'll talk more about this in another video. But expanding the inventory of homes in the U.S. comes down to where are you going to build them? Are you going to build them in rural open land that's undeveloped? You're going to do infill in denser areas? Or are you going to do remodels on existing homes?

Each one of those strategies has a benefit. Open land has the benefit of almost unlimited space. Most parts of the country on the outskirts of the population centers have open land that can be purchased. You buy 50, 80, 100 acres from a farmer or from some unused land, you plant it out in a subdivision, you come up with eight or nine floor plans, you start building homes, and it's a simpler process to do. However, the downside is you're building away from the population center, and now these subdivisions are farther and farther away from the main DMA, whether it's Dallas or Phoenix or Los Angeles or Chicago.

You're instead of 10 or 15 or 20 miles away, now you are 50, 60, 70 miles away where these large subdivisions are being built. Sometimes there's infill of commercial properties that are built closer for job centers, but you still have to take that into account if you're a builder. It's a little bit of a risk. Now, you can do infill, but the land for infill is more expensive to buy. One or two lots in the middle of currently developed subdivisions is a more expensive proposition to buy that property.

However, you can probably sell the finished home for a higher price because it's already in a close proximity to the job centers, the employment areas. The other problem you run into in those areas is there's usually more zoning requirements or permit requirements in the urban dense areas. But you may be able to have closer lot lines, sometimes zero lot lines, you may be able to have an ADU or multiple families in the multi-family properties on that lot. A lot of urban areas are going to eliminating single-family home zoning designations, so you might be able to have a higher use on one property on one legal parcel.

Third is to upgrade existing developed parcels, and it could be a dilapidated house that needs remodel or tear down. One of the areas that's being developed as single-family homes is buying old mobile home parks. If you have a mobile home park that has 30 or 40 units in it, technically that parcel is already approved and subdivided into 30 parcels, so it's a lot easier process. You already have the utilities, whether it's sewer, septic, water, electricity, 30 times on that property.

The downside to that is you're not really adding new units because when you build those houses, you're displacing 30 or 40 existing residents from that area. But you are building new homes, so there's pros and cons to each one. And part of the impetus for having one of these solutions completed is what the motivation behind the government in that jurisdiction is. Some governments are wanting to do development, they're wanting to promote more housing stock. Some areas are actually trying to hold that back.

There's many examples in some of the highest impacted parts of the country where the developer comes in, they want to do a certain project, they get all the permits, plans, it meets the criteria, but the zoning board or the board of commissioners declines it because they don't want more density in that area, even though they're talking about getting rid of homeless and having more housing stock. So as a developer, you have to kind of go where the approvals are and go where the money is. It's not that you want to price gouge as a developer, it's not that you want to sell for more than it's worth, but it has to be enough to amortize your business so that you can be around to build another house later.

So those three options are the most common that are looked at. You can also do multi-family, you know, if you're doing townhouses or condo apartments, although many of those are going direct to rental instead of going to purchase. It does add a housing unit, but rental is not really what the need is in the long term to get more people in owner-occupied residencies.

So the takeaway is the solution to the housing crisis of having builders just build more houses is a little more complicated than it seems. The shortage of houses right now is somewhere between five and six million houses. Builders are currently constructing about a million and a half to two million houses a year, but that doesn't all go to reduce that excess housing limit. Some of that goes to the current need, and the future need builds up just as fast.

There's about 800,000 current pending property permits nationwide, and even if 10% of that or 15% of that goes to chip away, it's still going to take many, many years to reduce the current demand. And the other question is, is the demand going to change? It's probably going to go up. There'll probably be more demand in future years. But as a builder, if you're putting your future financial security into a result that happens two or three years later, you may not know that your guess is wrong until that day comes and you're out of money.