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…
