Poway Seller,

I don’t think he’s including land price appreciation into his increase in construction costs.

In addition to astronomical land prices, soaring builder insurance costs and accelerating governmental exactions, this price-shaving strategy also faces the headwind of sharply rising construction costs due to the China effect, Hurricane Katrina and other macro-economic factors.

I think he’s clearly separating the land cost from the construction cost. Certainly the price of building materials is up due to increased demand. The same is true of the skilled labor needed. For his number of 40%, you need ~18% per year increases. I don’t think that’s unrealistic in today’s building environment.

Have you tried to hire a contractor lately?

In addition to …

That means he including the land and other costs.

You’re right Dougie, it does include the land but he’s not saying the price of the land is going up. Let’s parse it again with an eye toward change and rate of change. Remember, the context of the quote is about affordable housing.

In addition to astronomical land prices, soaring builder insurance costs and accelerating governmental exactions, this price-shaving strategy also faces the headwind of sharply rising construction costs…

Let’s face it, land costs have been astronomical in So. Cal. for a while. He’s saying nothing about them becoming more astronomical. It’s a static term in this context.

For all of his other costs, he makes it abundantly clear that they are rising very quickly. If the land prices were also rising, I think he would have been more explicit in saying so.

In 8 years, your construction cost went up 2x, while your land cost went up 5x. Did construction costs increase at a constant 9% annually, due to tight labor markets, or was there a sudden jump in the last year due to hurricane demand effects?

Any permanent rise in cost of construction cost would lead to a permanent rise in the value of housing. The speculative element, and the artificially high price of land, which has risen despite any change in fundamentals (population, wages), will be eliminated.

So when the bubble bursts, perhaps we’ll be at a higher plateau? Or will construction costs decrease as the labor market weakens and the temporary hurricane effects dampen?

This is in response to the many excellent posts by powayseller, whereby I felt compelled to clarify some issues raised:

I am a land subdivider (I secure the entitlements or the rights to build on a piece of land) and have been doing that for more than 30 years. Once I secure the entitlements, I then sell the land to merchant home builders, who complete the process of entitlement by improving the lots and building houses. I sell the land in essentially the same condition as I purchased it except that it has been subdivided (on paper). I move no dirt and perform no construction. What I do is basically a political process. It is capital intensive and very risky because you may be denied approvals after several years of hard and incredibly frustrating design and planning work.

Land costs have increased in large part due to overly burdensome processing and subdivision regulations, especially environmental constraints (some needed and some absolutely ridiculous). I recently sold 180 acres of subdivided land to a public builder and it took me 16 years to put that land in a condition whereby I could sell it (in the old days — read that 20 years ago — I could have done it in two or three years). That extra time involved adds a lot to the cost of subdividing the land and to the retail cost of a home.

During that time (1988-2004) I saw certain fees increase astronomically (and all sorts of new fee categories sprung up as various municipalities got more creative in ways to generate new revenue). I invested five times the cost of my most recent project just to bring the land to the point where it could be subdivided. That “added value” comes at great capital risk and those costs are passed through to the ultimate home buyer.

So again, a large part of the increase in homes prices is due to increases in costs in land entitlement, not to mention large increases in the costs of lot improvements and home building (construction). The hotter a market gets, the more prices of materials increase (everyone wants them – basic supply and demand) and when a market gets hot after being cold for a long time (which happened in San Diego), labor is in high demand and in short supply and contractors can charge more.

It used to be in a “normal” market, land (a buildable, finished lot) represented 1/3 of the retail price of a home; the cost to construct the house was 1/3 of the retail price of the home; and profit and overhead was 1/3 of the retail price of the home. Most builders worked off margins varying from 8%-12% (more or less, depending on the efficiency of their operation and location of the project) and in tough times, many builders would work off virtually no margin, just to keep their operations going and their doors open.

Land costs have skyrocketed in the last five years due to intense over regulation, especially in San Diego, which environmentally is incredibly bio diverse. In some more recent transactions I have seen the land component (as finished lots) representing 40%, 50% and sometimes even 60% of the total delivered (retail) cost of the home. That’s why a national builder like Toll Bros. can deliver the same house in Virginia for maybe half the price of that house in California. The difference is in the cost of the land, which is not used in determining the “cost per square foot” of the home.

So, to clarify, when a builder talks about cost per square foot, he is almost always talking hard construction costs in the home and those costs have increased dramatically over the last few years, with certain components of construction jumping 40%-60%.

Finish lot costs (excluding costs of the subdivided land) are costs for infrastructure — grading, streets, sidewalks, sewers, water, utilities, etc., which have also increased dramatically over the last five or so years, especially fees.

Now, sometimes a builder buys lots finished (ready to be built upon — less risk) but oftentimes a builder purchases paper lots, finishes the final engineering, constructs the lot improvements and then builds houses. Stated very simply there are three phases to a completed house: land entitlement/subdivision, land development (getting the lots ready to be built upon) and home construction (sticks and bricks).

True, over the last five or six years builders have made larger profit margins because of an incredibly hot market but believe me, it evens out during the lean years (which are just around the corner). There is an old saying in the building business that if you stay in it long enough, you will go broke.

There are a lot better businesses with a lot less risk than building homes. Residential building has a very long lead time. Profits are almost always commensurate with the risks, spread out over both up and down markets. (Condo conversions are a whole different matter but thats a whole different discussion).

Look at it this way — you are a builder holding millions of dollars in lot inventory and the market starts to tank and tank quickly. You bought those lots based on what you perceived would be a viable retail value of the homes. If you are working on a 12% margin and the market tanks 15% before you can get to market, you will lose money on that subdivision.

Multiply that by hundreds or even thousands of lots in standing inventory and then a lot of the profit you made over the last five years starts to evaporate through holding costs, interest carry, etc.

It is very difficult to determine where a market will be in two years, let alone ten years or more, which in many cases is the lead time of a large building project. Again, I think the market determines the profit margins of any business based on what the perceived risk is at any particular point in time.

Lastly, I did want to clarify something else: I believe the question was asked how a builder can deliver a home at $ 90/sq foot, his cost. Economies of scale are responsible for that. If you are building 150 or 200 homes, your per unit cost on everything (from toilets to trees) is a lot cheaper than if you are building one home. If you are a national builder delivering thousands of homes per year in hundreds of different markets, your savings can be quite substantial over the purchase of any one item individually.

Believe me, I have seen some absolutely beautiful homes built by merchant builders for $ 58 – $ 65 per square foot (home construction costs only) and that has been within the last five years but now costs have increased up to the $ 85 – $ 90 level for a nice merchant built home, and in many cases even more, with the increases due to material costs, not necessarily land costs, which are starting to plane out and in some cases actually fall a bit.

The bottom line is this: Some of the homes being delivered in an upscale subdivision of many luxury houses couldn’t be duplicated on an individual basis at twice the price of the semi-custom tract built home. Forgetting that the market is nuts, when you compare apples to apples, at any given time, a nice tract built home beats the pants off a custom built home (at the same spec level) when you compare cost, value and overall cost per square foot (to the consumer, then the land is included in the cost per square foot, and in some coastal areas that can push beyond $ 1,000 per foot).

Lastly, some custom builders work off 30% – 50% margins (especially in the very high end — say $ 5 Million to $ 30 Million), so if you are looking for a home in that range, you’re probably better off building it yourself (assuming you have the talent to do so and believe me, it isn’t easy).

Recently, a spectacular home in La Jolla that originally listed at $ 42 Million sold at $ 17.8 million after several price adjustments and about three years on the market (so that gives you some idea of how much room is in some of those houses, but that particular home was built on land held for more than 15 years too). Another coastal home in La Jolla, originally listed at $ 23 Million, recently sold for about $ 18 Million. I did some simple math and figured the builder’s profit margin was about 33%. But again, look at the risk he (and especially his construction lender) took in that deal. That’s a big roll of the dice in a very small universe of buyers.

Again, I believe profit is commensurate with risk and is determined by an efficient marketplace at any given point in time. As the saying goes “When you’re hot, you’re hot, and when you’re not, you’re not.” And in my opinion we are headed for a new ice age in the real estate market…

You’re welcome.

I’ll try to address each question as briefly as possible but the issues in this real estate market are pretty complicated.

Builders are still looking for land but in Southern California it is real tough to find entitled land that makes sense and almost impossible to find raw land to entitle. And even if I could find large swaths of acreage to subdivide, I would not take on the risk, because I believe the market will be contracting and the regulations are so burdensome, it’s just not worth the brain damage (I’m 58 and pretty much retired off my last deal).

I think you are going to see lots more infill (smaller projects of maybe 25-50 units) and more attached product (even though there is a condo glut) as well as more creative ways to get more houses on less land (zero lot line stuff and clustering). We really are running out of land in San Diego and the entitlement processes are so long and risky no one really wants to take them on anymore. You can still get land entitled in Arizona or Texas in a few years but in San Diego, it sometimes takes decades, depending on the size and complexity of the project. Most of the stuff being built in San Diego had its planning initiated years ago, especially the master planned communities.

As far as your question about Lennar goes, yes, to some extent highly profitable sales in other regions will offset not so good profits in others. I also believe Lennar had some relatively strong profits booked on land sales (large builders like Lennar hold lots of land in inventory and also act as land developers). For instance, Lennar sold about 25 lots to Barratt at the Bressi Ranch and will be building out the other lots themselves. They also acted as master developer. That particular project has been in planning for years! I remember looking at it in the early nineties. Incidently, if you haven’t seen the Barratt Homes called Magnolia Estates at Bressi Ranch, you are missing a really high quality product and at what I percieve to be a fair price (even in this frothy market). I have seen comparable custom homes at three times the price.

What really made land expensive was the environmental regulations enacted years ago. In order for me to be able to subdivide my land, I had to agree to give up about half (90 acres) to the Resource Agencies. It is a subtle condemnation action and it’s called exactions. So, half my land (retail value subdivided is about $ 30 Million) was given to the wildlife agencies for FREE so that I could develop the other half.

This is very common and believe me, it adds huge amounts of cost and risk to the entitlement business and subsequently to the building of homes. This is where a lot of the cost of a new home shows up. There is a move afoot to reverse this process but it will take years. I, as well as any other subdivider or land developer, can tell you tons of horror stories of having to deal with Environmental Agencies (US Fish and Wilflife Service and the California Department of Fish and Game). I don’t want to get distracted but I will say this: I call them Terra Firma Terrorists due to the way they operate. Totally unethical, no integrity and very covert.

Last question: The majority of land cost is due to exactions, environmental regulations and city and county fees. Anyone who speculates on land is an absolute fool. Gone are the days of buying and holding land…if you do that without moving forward with some sort of plan to add value through a rezone or subdivision plan, your land will become a park.

There are thousands of ownerships in San Diego that are less than 10 acres that will never be able to develop their property because they have been placed into a Multiple Species Conservation Plan or a Habitat Planning Area or some other such designation and they won’t know it until they go in to get a building permit. If you don’t stay proactive with your land holdings, you will never be able to build, let alone walk on your property because of it’s “sensitive resources.” But you will get to continue to pay property taxes!

Quite frankly, the main reason I am finished subdividing land in San Diego is because of the extreme difficulty and risk inherent in the business due to the over regulation of the governmental agencies. Private property rights have been compromised well beyond what is necessary. But I digress.

I’m not one for making predictions but I can feel the chill in the air. There are so many variables (just like global warming) no one can say for sure what will act as a catalyst and accelerate the demise of this market…One thing that no one has really addressed is the massive exodus I see from the baby boomers (who have driven this market excessively for years) into smaller homes as they retire and downsize. 75-80 Million of us in our peak earning years and heading towards retirement and that is going to impact a whole host of areas, not to mention real estate.

I’m in cash and short term treasuries and hold no stocks or real estate, except my free and clear home, recently valued at $ 2 Million (I bought it for half that three years ago with 20% down and just recently paid it off). Do I think it’s going to fall in value -Absolutely. How much? I haven’t a clue. But then, I bought my house to live in and will proably die in it too. So, I’m not selling it to capture any gain because I honestly believe I couldn’t replace it (lot orientation and view) for twice it’s most recent appraisal.

Since there are lots of questions in each paragraph, I will address each paragraph:

Paragraph 1: It’s hard to say how much environmental regulations add to the cost of subdivided land to a builder because you invest not only capital but lots of time (I negotiated with the Resource Agencies for more than nine years and still ended up where they wanted me to because they have ALL the power). And half of my processing costs were towards environmental issues. So, what does that equate to down the road? My WAG (wild ass guess) based on experience is probably 25% of the finished cost of the home. Any premium on a lot is already reflected in the price. And a lot of land in San Diego has become LESS valuable due to the environmental restrictions placed upon it. If housing prices fall (on existing homes) it will be a purely market phenomenon because the land value has already been factored in. If new home prices fall (all other factors such as square footage and spec level the same), then yes it would be due to the cost of the land. Speculation in Arizona recently and Las Vegas a few years ago was driven in large part by California speculators who got priced out of the California market. How much was due to “investor” activity I have no clue but again my WAG is up to 25% in some markets.

Paragraph 2: I can remember selling land to homebuilders in the early nineties that were using construction costs of $ 35 – $ 40 per square foot on a pretty nice home. So using simple math, construction costs have probably doubled in the last 15 years. Again, building one house as opposed to several can easily double the construction costs, assuming the same level of spec. My brother, who is a contractor, just did a beautiful remodel on a large home in Point Loma and the cost per square foot was in excess of $ 400 (but that includes demo work and all sorts of other things that you don’t deal with in a new home). Remember, you have to compare apples to apples when talking cost per square foot and the spec level is what determines that as well as the economies of scale (if you are a tract builder). A single home builder has to make a much larger profit margin than a tract builder. As far as building your home in five years, just using real inflation (which I think is about 5.5% as opposed to what’s being advertised) that $ 168 per foot would be about $ 220 per foot, not taking into account any increases in certain materials that may experience shortages (like concrete or lumber). As far as what your house cost to build if you got at least three bids and they were all pretty close, you probably got a fair deal from your contractor. Something else you have to consider is the quality of the work that your contractor delivered. My brother can oftentimes charge up to 20% more for his work because he works with people who are very particular and want high quality. Merchant builders are absolute pros are keeping quality up and costs down. They know to the penny what it costs to build a house, especially if they are building the same home in several different markets. A single homebuilder simply can’t compete with that.

Paragraph 3: There was an article in today’s paper addressing the boomers appetite for second homes. I think the boomers will want to start trading down in a big way within five years or so but the question is will there be buyers to take those homes. And if there isn’t a large market for that, it will depress prices in that range or the boomers just won’t sell. I think you will see a lot of boomers moving to cheaper, warmer climates (Arizona, Nevada, New Mexico and Texas) but not necessarily California as it is still way too expensive for most retirees. I think family size will shrink and the next generation will marry later but they will still want the large home. That’s pretty engrained in our psyches (unless there is a huge fundamental shift like everyone wants to go green, which may be absolutely necessary if things continue along the lines they have been for the last fifty years).

Paragraph 4: Yes, I am blessed to be able to own my home free and clear. However, had your house been paid off, you say you wouldn’t have sold. I thought you sold to make a profit, so it wouldn’t matter if the home was paid off or not. I’m just a little confused here. Did you sell to reduce your payments then?

Paragraph 5: I am in short term treasuries and laddered bonds. I want to stay liquid until I see a clear direction in either the stock market or the real estate market. Making predictions, especially with your cash, is very dangerous. Check out http://www.treasurydirect.com where you can buy treasuries without the normal fees. I also like well diversified index funds. There is an absolutely excellent website at http://www.ifa.com Read everything on that site as well as the e-book and it will totally change the way you look at investing. Another great resource for index funds is a very bright guy in Monterey named Dr. Steven Evanson. His website can be found at http://www.evansonasset.com Both sites use Dimensional Fund Advisor products, the best funds on the market, bar none. I have researched the subject of investing for several years (I’m real conservative when it comes to my capital) and am convinced that for the regular guy on the street (read that pretty much everyone), a well diversified portfolio of index funds is the best way to go. Lastly, if you have a bit of a risk gene, commodities may be a good balance to your portfolio but I would only invest in the Jim Rogers International Commodity Index Fund or with a competent CTA (lots of information can be found on CTAs at http://www.trendfollowing.com (read Michael Covey’s book “Trend Following”) and there is an excellent white paper on the commodities market at http://www.trendfollowing.com/whitepaper/commodity-investing2.pdf#search=’Rogers%20Commodity%20Index%20Fund’

Paragraph 6: I have no idea how much housing prices will fall because each market is so different and localized. You can always tell when a market is topping because prices continue to increase but volume starts to fall off (that means the last lemmings are getting into the market). I believe it was Warren Buffett who said, and I paraphrase “Be greedy when others are fearful and fearful when others are greedy.” When everyone is scared to death that real estate is in the toilet, that’s when you should start buying. No one has a crystal ball and predictions are always temporary. Real estate will fall (it always has) and at some point it will recover (it always has). This market is particularly scary because in my lifetime there is no precedent for it. So it’s anyone’s guess what will happen. Stay liquid and keep reading Rich’s excellent postings as well as those of the members and bloggers. Most of those people know more than the “experts”. Be cautious and trust yourself to make the right investment decisions (after careful study and analysis).