The Rising Popularity of Land Banks, and Its Risks
While a land bank deal helps home builders offload balance sheet risks, who is the counterparty that assumes such risks?
FALLEN ANGEL
The US housing market remains depressed due to high mortgage rates, historically high housing prices, and stagnant wages. US home builders are thus conservative in building new homes. In a traditional operating model, builders acquire land as reserve and build homes based on market demand. These lands become fixed assets that tie up a lot of capital.
Come to help the land banks. A land bank is a pool of land that a homebuilder controls without having to pay full cash for it upfront — usually through option contracts rather than outright ownership. Home builders like Lennar (LEN) promote it as a “land-light” strategy to free up capital for builders and make them more nimble in this turbulent time. In return, they pay an upfront fee in cash–usually 10-20%--as the deposit to their land bank partners as an option to secure the rights to build homes on such land if the housing market improves. They also agree to a “take down” schedule–a time table to build homes on these lots over a period of time. If the market turns and a builder decides not to take down lots, it loses that deposit. But at least it does not have to take losses on market value of land (mark to market rule) if they own the land and carry it on their balance sheet.
While a land bank deal helps home builders offload risks, who is the counterparty that assumes such risks? A land bank owner is traditionally a fragmented group of capital providers (asset managers, PE-backed land funds, JV partners), not government or large banks. In fact, banks have scaled back land-based financing after the 2008 financial crisis, which gave rise to a grass-root of investors looking for higher yields than the normal debt market. This used to be a specialty finance business run by companies like Walton Global, Hearthstone, Acacia Capital, and several asset funds. But home builders’ risk-averse and large banks’ retreat has opened the door for new types of investors, particularly private equities and pension funds. For instance, Guggenheim Investments — traditionally a credit/asset manager, now stepping directly into this space as a capital source financing residential land development. They hedge their risk by working with Bedrock Land Finance, a subsidiary of TWG Global that provides land banking origination and development management expertise. PGIM, the asset-management arm of Prudential Financial, financed roughly $4 billion in residential land-bank deals through a partnership with New York-based Domain Real Estate Partners. These new entrants are enticed by the higher yields underneath such investment than traditional corporate bonds and the assumption that the housing market will turn around eventually due to the structural shortage of housing supply in the US.
By exchanging land ownership with an option contract to buy the land, home builders’ land-light strategy creates a complicated credit product tied to the fundamental health of the US housing market. The land bank owners and investors are not regulated by the US government and their risk profiles are lesser known. The market can only assess such risks through home builder’s bond ratings, or ratings on any debt issued in the public market by land banks or their investors.
Is there any imminent risk? Not in the near future according to my analysis. First of all, home builders sometimes are investors of such land banks. Second, there is no concentration risk currently in the land bank market as it is quite fragmented. Home builders want this market to be fragmented to increase their bargaining power. Lastly, their credit risk on land bank deals, even though no ratings from rating agencies, is relatively straight forward. Unlike subprime asset-based securities that caused the 2008 financial crisis, the risk currently is not stratified to create more complex asset tranches to confuse investors. In short, the system risk is not concentrated, not covered by complex financial vehicles, and most importantly, home builders and land bank investors currently do deals based on each other’s credit profiles–thankfully, current deals are between solid players.
But just like the subprime crisis starting from financial innovation and ending with disastrous results, this corner of the housing market is without its own risks longer term. Successful land bank deals will drive greater builder interest and draw interest from hot money. It this happens, less established builders will inevitably participate, and the greed of capital will find a way to cover up any risks through financial engineering.
For this model to work, the US housing market has to find its way out of the current slump. Flared up inflation, persistent high mortgage rate, and any economic downturn could suppress housing demand further and weaken home builder’s financial strength. Home builders can walk away from the deal by forfeiting the option fee, the land bank owners can get stuck with distressed land assets for an extended period of time. Although the option fee can cover some of the losses, this risk can grow exponentially if the land bank becomes the dominant asset strategy for home builders. Even the home builders may not escape eventually, because the increased risk would demand higher option price by land banks, which can drag down margins and weaken home builder’s earning power at a time when they need such financial strength to weather persistently sluggish housing demand.
So back to the home builder industry–Lennar is the pioneer in this “land-light strategy.” But Bank of America’s analyst called out such impact on earnings while the company is aggressively selling the land-light story to Wall Street. As long-term investors, whether you buy Lennar’s turnaround story based on their land-light strategy hinges on three things:
Lennar’s growing appetite for land bank deals needs to be reality checked by its gross margin and amortized expenses related to option contracts.
Health of the US housing market and home builders financial strength as reflected in their cash flow and credit ratings.
Monitor any systemic risks related to concentration of land bank ownership, breach of the take-down schedule, and exotic financial vehicles to package land bank deals sold to PE and other types of investors.
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