December 14, 2015
Interviewed by: Privcap
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Extended RE Cycle Seen on the Horizon

With housing starts and completions significantly below long-term averages, Connor expects Toll Brothers’ profit margins to continue to rise in 2016. However, he advises all real estate players to take heed of the lessons learned in 2008.

With housing starts and completions significantly below long-term averages, Connor expects Toll Brothers’ profit margins to continue to rise in 2016. However, he advises all real estate players to take heed of the lessons learned in 2008.

Extended RE Cycle Seen on the Horizon
With Marty Connor of Toll Brothers

Zoe Hughes, PrivcapRE: I’m joined here today by Marty Connor, CFO of Toll Brothers. Marty, thank you so much for joining me.

Marty Connor, Toll Brothers: It’s my pleasure, thanks for having me.

Hughes: At Privcap, we particularly focus on the institutional, commercial real estate investment sector. However, when it comes to actually understanding cycles and the fundamentals within the real estate business, I think it’s exceptionally insightful to look to the residential for sale business. Obviously, as CFO of the U.S.’s largest luxury home builder, you have a very clear view of what’s happening in terms of fundamentals. Where are we in the cycle?

Connor: I think the safest way to say it is the cycle has been much more extended in terms of the recovery than we thought and most people thought. We went down to 250,000 to 300,000 units a year from a long-term average of 105 million. Right now, we’re about one million. So, we have a long way to go. We’ve got some catching up to do for the deferred-household formations and deferred purchases out there. I’d say we’re in the fourth or fifth inning, if I can use a baseball analogy.

Hughes: It’s very interesting, because when we look to the commercial real estate, many people always cite the sixth or seventh inning. One thing I always find interesting—does it matter what inning we’re in? Surely, it’s the length of the game, because the last cycle—the buildup was 14 to 15 years. Do you think we’re actually going to match that on the residential side?

Connor: Most cycles have been seven or eight. The last one was 15 good years and four really rough years, and we’re four years removed from those really rough years. So, we’re already, one might argue, eight years in, four years from the lowest point. I think it’s going to be pretty extended. I don’t know that we’ll get to 14 or 15 years again, but it’s not going to be the normal seven or eight.

Hughes: Looking back from the last crisis, what triggers are you actually looking for and keeping a very close eye on this time around?

Connor: We’re looking at total volume and we’re still below what we think is a long-term average. I think we’re looking at land prices. Is it really heated? I think we’re looking at credit availability. We should have been smarter back the mid2000s, when every bartender in Las Vegas owned five houses. That’s not right. That’s not healthy. We don’t see that right now, so we’re confident that we have quite a ways to go.

Hughes: When it comes to Toll Brothers, fourthquarter preliminary earnings came out and your average sale price is now $790,000 for a unit. What are the expectations on future growth in terms of sales prices?

Connor: Our average delivered price is $790,000. That really relates to sales we did about a year ago, because it takes us that long to actually construct and complete the home.

Hughes: So, what are your expectations?

Connor: Our average sales prices right now are actually in the mid$800s, in terms of what we’ll deliver next year. We have seen an increase around the country in sales prices, but a lot of the impactful change in our average is a function of the mix shift with more in California and more in New York City.

Hughes: I do want to ask about that concentration risk. First, in terms of profit margins, what’s that looking like?

Connor: Across the industry, we’ve seen margins compress a bit. Labor has gotten more challenging in terms of both cost and availability. We’re feeling that a little bit, but we’re proud that we’ll have improved margins in 2015. Our guidance isn’t fully-baked for 2016, but we’ve been saying for a while now that our margins will be up again in 2016. And those two factors—‘15 improved margins and ‘16 improved margins—are unique in the industry.

Hughes: Let’s go back to that concentration risk. Obviously, Toll Brothers’ portfolio is quite concentrated on New York and California. Talk to me in terms of the risk. How do you overcome that risk of concentration?

Connor: We look at California as two separate and distinct markets—not just California, but Northern California and Southern California. And New York. While we do have significant investments in there, they’re also the biggest markets in the country, right? We have upwards of 20 million people in both New York City and Southern California, and maybe half that many in Northern California.

When we look at the health of each of those economies, the New York economy’s been remarkably resilient. It is not entirely dependent upon Wall Street. There’s a significant tourism and hospitality business here. The tech business is pretty strong here. The tech business in Northern California is remarkably strong. These are real companies, as opposed to 15 years ago where they weren’t quite as real. There’s probably a few that are not going to make it. But I don’t think Google and Apple and those guys are going away anytime soon. You heard it here first.

Then, in Southern California, we have 20 million people living, so you need that many doctors, that many lawyers and that much in terms of healthcare, education, media and telecommunications. And tech is pretty solid in Southern California. It’s something we were focused on: what do these people do that are spending $2 million for our houses? And we get comfortable on it.

Hughes: Now, I know it’s not just forsale housing. Obviously, you’re also doing condo in New York City and expanding into multifamily. Talk to me about the strategy and how that growth is going, particularly for the condo.

Connor: We’re thrilled with our results in the condo product we’re building in New York City and Hoboken. We’d love to take that business to certain other markets around the country. We’ve just struggled to find the right opportunity. But we’re in our 24th or 25th building up here and we learned some lessons along the way. We plowed through the recession. But New York was the quickest market to rebound, even after the financial crisis, and having some product available to serve those people has been great.

Hughes: Talk to me about land valuations and getting the right prices for the product for your own revenues.

Connor: Land up here in New York is very expensive and it’s a different risk profile to do a condominium building. We’re building those all on spec. Generally, we do not do spec out in the farm fields—we customize the home. It’s tough to put a bonus sunroom on the back of the eighthfloor condo unit. So, these buildings—we buy the land. It takes us about a year to design and bid out to the subs the building. It takes us another year and a half to two years to sell it, and then we start delivering. So, we’re three or four years into a spec building before we’re having our first dollar of revenue. We have contracts in advance of that, but the closings can’t happen until you’re done and the HVAC unit’s on the roof and the certificate of occupancies are received.

Hughes: We should look out to that market. In three to four years’ time, with things you’re actually doing now, what are your expectations for continued growth in the condo sector?

Connor: We have seen rapid appreciation in house prices and condo prices in New York over the previous three years. We’re benefiting from that now as we deliver units, but we don’t project that to continue. It’d be great if it did, but we don’t underwrite projecting that it will. So, for these buildings, because they are higher risk, because you can’t stop in the middle—we can stop in the farm fields, but in the condos we can’t stop—we demand a higher return. We underwrite to roughly mid30s gross margin. The buildings we’re delivering now are mid-40s gross margin. Mid-40s only happens again if appreciation continues.

Hughes: You expect some tail off in terms of the rev—

Connor: Absolutely. We’re underwriting a piece of ground that we buy today to delivery mid-30s. We will take mid-40s if it happens, but so far we’ve seen a bit of a stabilizing in New York. It’s not rapidly appreciating as much as it had been, which is healthy.

Hughes: Talk to me about the multifamily side. Where are you particularly focused when you’re looking for multifamily? Because, again, valuations always come into the story for multifamily. It’s priced to perfection. That’s one of the comments you always hear. What’s the story? What are the strategies you like, particularly over the next three to five years?

Connor: We built two buildings back in the late ‘90s to early 2000s—rental buildings. We’ve got four or five under construction right now as we kind of put the band back together coming out of the downturn. All of those buildings are in the northeast. Our sweet spot is Boston to D.C. We look to get this expanded beyond that, but we want to get a few things completed with the team we have in place. We have a great team, but when you start diluting them on a plane to California or Texas or whatever, you run some risks that we’re not willing to do right now.

Hughes: What’s the hold period in terms of multifamily? Are you looking for long-term hold or will you actually build to core?

Connor: We’re going to do a bit of both. As we develop these buildings, they don’t generate a lot of GAAP net income because of depreciation expense. The REITs have the FFO metric that they use. The homebuilders don’t. We may have some education to do with our shareholder base to teach them about that, so the longterm holds don’t generate a lot of current income. It’s great cash flow and it’s great value appreciation, so we’ll hold some. But we’re also going to sell some so we can recognize the gain.

Hughes: What risks are you really looking out for today, and actually, have they changed since the last crisis? Has your understanding of risk or your appreciation of risk actually changed?

Connor: As an organization, not just as a CFO, we are constantly reminding ourselves of the challenges that the industry and the economy went through in the mid-2000s. So, we don’t want to overpay for land. We don’t want to have too much land. While our land holds it value pretty good because it’s in great locations, it’s not that liquid because you have to find somebody else to buy it from you. In a tough time, that line is pretty short. We don’t want to be too extended in our land. We want to make sure our balance sheet is positioned to take advantage of opportunities, both going up the cycle and even down the cycle. Because, when things get tough, if you’ve got a lot of cash, you can pick up some opportunities at a significant discount.

In addition to the amount of land we have, we got hurt in some pretty complicated, big partnerships as things went down. So, a partner or two—two or three banks—is fine. But we had some deals with five or six different partners and 10 to 12 different banks, and it’s tough to get everybody thinking the same way.

Hughes: Simplicity is key, then.

Connor: It’s important. It’s really important.

Hughes: Also, this mixing up of the portfolio so it’s not just obviously for sale housing, but you’re also doing the condos, the multifamily. Is that a deliberate strategy as well—to almost balance out to ride you through some of the cycles?

Connor: Absolutely. We’re looking at the rental business as a bit of a counter-cyclical hedge. It’s going to take a while for us to grab enough real estate to be an effective counterbalance to our $4 or $5-billion worth of revenue on the forsale side. But it would have been great to have 25,000 apartment units in 2008.

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