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Chris McFarland

Lennar (NYSE: LEN) is the second largest homebuilder in the United States, based on homes closed in 2007. In 2007, Lennar delivered 33,283 homes and had total revenues of $10.1 billion, of which $9.7 billion came from its homebuilding division, and $456 million came from its financial services division which offers mortgage financing, title insurance, and closing services.^[1]

Lennar is heavily exposed to fluctuations in the housing and credit markets. Due to this exposure, Lennar has been hit particularly hard by the rapid decline of prices in the U.S. housing market and the subsequent subprime lending crisis in 2007 and early 2008. Like most homebuilders, it finances most of its operations through large lines of credit with major financial institutions. The volatility in the housing market has made assessing risk very difficult and consequently, financial institutions are unwilling to lend as freely. However, Lennar has set itself apart from other homebuilders by selling assets, paying off debts, and increasing its cash reserves, all of which help protect its long-term outlook from short-term drops in demand for residential housing.^[2]

Business Overview

The core of Lennar's business model is the mass-production and sale of single-family attached and detached homes. Lennar buys the land, outsources the construction^[3], and then markets and helps finance the sale of its homes. Based in Miami, Lennar has extensive operations in Florida, Virginia, Arizona, Colorado, Texas, California, and New York. Although most of these states have some of the fastest-growing housing markets, they are also the ones that have been hit hardest by the decline in real estate prices and credit crisis in 2007 and 2008. In California and Florida, housing prices fell 36% and 30%, respectively, against a nationwide average decline of 20%^[4].

In order to differentiate their homes from those of other vendors, Lennar employs a wide variety of marketing techniques. First and foremost, they include many luxury items as standard features in all of their homes. By streamlining the land acquisition, construction, selling, and financing process, they are able to lower costs and offer homes at lower prices in more competitive regions. In addition, they also have a wide range of prices in their housing portfolio. This allows them to target a large group of customers^[5]. The deterioration of market conditions, however, has lead to a sharp decline in revenue for FY 2007, despite strong and increasing earnings for two years prior.

Lennar also offers mortgage financing services. Traditionally, they have helped secure regular, jumbo, and subprime loans for their customers, with 73% of them using mortgage financing in 2007. Due to the recent credit crisis, however, mortgage interest rates have risen dramatically, the market for subprime loans is virtually nonexistent, and larger down-payments for homes are required. These effects have greatly reduced the number of customers who are financially able to buy a home^[6]. Although the percentage of customers using mortgages (known as the mortgage capture rate) has increased this past year, the quantity and total value of the mortgages, as well as the number of titles issued, has dropped significantly^[7].

Trends and Forces

• Lennar will have trouble financing future operations: Operating earnings were negative during FY2007. Furthermore, its stock price has declined by 61% from a year earlier. Its weak financial position means that Lennar can raise relatively little cash through either stock or bond offerings. This, coupled with large financial institutions' unwillingness to finance the large revolving debt associated with homebuilding, means that Lennar may have trouble financing future operations as traditional vehicles for borrowing money are closed to the firm.

• Regulations on the secondary mortgage market increase Lennar's risk: Lennar sells most of the loans it originates in the form of mortgage-backed securities. Regulations on the secondary mortgage market, as well as the decline in demand for mortgage-backed securities could force Lennar to pay its borrowers from its own reserves. This will lower its cash reserves and increase its exposure to defaulting risk.^[8] In particular, the Mortgage Reform and Anti-Predatory Lending Act would make loan originators, and to a certain extent, companies creating mortgage securities, liable if loans are made to unqualified people.^[9]

• Real estate prices must stabilize before Lennar can continue large-scale operations: Since Lennar buys the property on which it builds, unstable prices may force it to sell its houses at a loss. Lennar has already been forced to do this once before due to weakeness in the housing market - in November 2007, it sold 11,000 homes at a 60% discount to Morgan Stanley^[10]. The real estate market will have to stabilize before Lennar commits to purchasing large tracts of land for residential development^[11].

• Overproduction by the housing industry may hurt Lennar's sales: During the housing boom, many homebuilders began overproducing homes. For example, the Greater Phoenix area usually has a yearly demand of 40,000 new homes. However, in mid-2007, the region had an estimated 35,000 excess new homes^[12]. Now that the housing market is in decline, many of these companies are selling houses at significant discounts or even at a loss. If Lennar does not want to sell its houses at a loss, it may be forced to keep the debt associated with it in its balance sheet, which in turn will affect its ability to borrow money.

• Lennar's operations are highly susceptible to natural disasters: Two of Lennar's most important states (Florida and California) are exposed to natural disasters. Such an event would damage Lennar's properties and construction material, resulting in a smaller inventory turnover ratio. Furthermore, its insurance policy may not cover all damages caused by natural disasters^[13].

Competition

Lennar faces competition from other homebuilders as well as from the used housing market. The market share of the top three firms is about 12%, with Lennar at 4.31%^[14]. This helps illustrate the magnitude and importance of the used housing market.

Homebuilders

Lennar competes against other national homebuilders, as well as homebuilders in the regional and local levels. In some locations, this may force Lennar to lower the profit margin on its homes.

D.R. Horton (DHI) is the largest homebuilder in the United States based on homes closed. They operate in all of the same regions and offer the same services as Lennar.

Pulte Homes (PHM) is the third largest homebuilder in the United States. Although they offer the same services as Lennar, they sell more expensive and exclusive homes, which limits its threat to Lennar in lower-income markets.

Used housing market

Lennar also faces competition from the used housing market. Customers may decide on buying a house from an individual instead of one that is new. The people who do this are bypassing Lennar's entire product mix.

References

1. ↑ FY2007 SEC Filing - Selected Financial Data p19
2. ↑ MarketWatch - Investors Greet Lennar
3. ↑ FY2007 SEC Filing - Homebuilding Operations p3
4. ↑ Financial Times - Recession looming in US housing-boom states
5. ↑ FY2007 SEC Filing - Marketing p4
6. ↑ Baltimore Sun - Home loans harder to get
7. ↑ FY2007 SEC Filing - Financial Services Operations p6
8. ↑ FY2007 SEC Filing - Regulatory Risk p14
9. ↑ Mortgage Reform and Anti-Predatory Lending Act - Section 204
10. ↑ Financial Times - Vultures circle US real estate
11. ↑ FY2007 SEC Filing - Homebuilding Market and Economic Risk p10
12. ↑ Knowledge@W.P.Carey - In an Uncertain Economy, the Worst May Not Be Over Yet
13. ↑ FY2007 SEC Filing - Operational Risk p11
14. ↑ Builder Magazine - 2006 Builder 100