Will Custom Building Survive the Crash?

CB: How is the housing crash affecting your business?

Stephen Hann: I've become more involved with my clients and their lenders over the last two years, whereas for 14 or 15 years I didn't really get involved in that. And I think most custom builders are going to be more involved in the financial side of it than ever before, because many lenders don't understand raw schedules, and they certainly don't understand cost-plus contracts.

I often refer my clients to lenders that do understand construction financing. The need for that will become more acute because there's going to be a domino effect of people that shouldn't be in the construction lending market.

Paul Magleby: At least not on the high end.

Hann: Right. So that's one component. The other is that appraisals are a real problem right now.

Magleby: They're a disaster. They have no merit.

Hann: A banker recently told me about a deal where he had gotten an appraisal. The bank's internal policy is that any appraisal over $250,000 requires an independent certification. The independent certifier says he can't use the appraisal because the appraiser didn't find a comparable home within a five-mile radius that sold within the last six to nine months. So we've got the appraiser working under one set of rules and the certification agent working under another. They can't find any sales that are within that geographic area. No lender that I'm dealing with will move forward unless all the boxes are checked off and the file is pristine.

Magleby: Steve and I know full well that if we start a project, if we've got a plan, we can budget that project. We know what the permit costs — the sticks, the bricks, the trade contractors — and it equals X, and we put on a little bit for our overhead and a little bit for our profit, and it becomes X dollars.

The appraisers don't even give any credence to that. They go out to some market value that's already skewed because of low prices and whatever other factors that they use in their equation that doesn't equal what it even costs us to build the structure. So automatically our clients are at a disadvantage because they have to come up with exponentially more money to put into the deal to even get it to our costs.

Hann: Then you have people in those markets that have second or third homes, and when things get tight, they want to get out from under them, so they're accepting artificially low values. That creates a negative spiral in the comp realm.

I have a contract right now to build a house at $2.6 million, just sticks and bricks, and the appraiser can't even look at what the cost to assemble is. He has to look at comparable homes. And it's a one-of-a-kind lot; the client paid $1 million for it. But again, you can't get a comp just for the lot and for the type of home he wants to put in there.

Paul Magleby, PresidentMagleby Cos., Orem, UtahPaul Magelby was NAHB's first Custom Home Builder of the Year (2006-2007). Magleby Cos., which he founded in 1974, builds luxury custom homes on the outskirts of Salt Lake City.Stephen Hann, PresidentHann Builders, Stafford, TexasNAHB's Custom Home Builder of the Year for 2007-2008, Hann started Hann Builders, a design/build firm, in 1993 and gained a reputation in Houston as a leading high-end remodeler and custom builder. CB: Have you detected any shift in client expectations? Is there more emphasis on seeing everything and being kept in the loop?

Magleby: Our business model is that they see everything anyway, but I'll tell you what they are doing. Generally these folks have a lot of investments that they manage or have someone else manage for them. One of our clients, who is doing a multimillion dollar project, said to me, “Why should I take these millions and stick them in basically a static asset — something that isn't going to appreciate — when I can take the same millions and stick them over here in a depressed stock or some other kind of investment and see it appreciate significantly in the next six to eight months?” That really kills a builder who's on a production schedule with employees, trade contractors and materials that have been ordered. How do you stop all that stuff and, when the clients decide they're ready to go again, start it back up? There's a slowdown time frame and a ramp-up time frame, and it all costs money. Sometimes I'm not sure they factor in those costs.

Hann: I agree. But wasn't your client also thinking about rebidding portions of the project?

Magleby: Yes. This particular client runs an investment firm and buys commodities and futures. She said, “That's all down 30 percent. I'm positive that's going to hit the retail side at some point in time at some margin. I'm just going to wait because I don't want to pay the higher price [for products and materials] now when I know I can get them later at a better rate.” Our other clients are doing the same thing.

We brought in all of our trade contractors on one project and said, “We need to find some way to save about 15 percent or this job's going to shut down.” There's a sense of a savings there that makes the client feel OK about moving forward. A lot of these things were budgeted three, four, five, six months ago and the prices have dropped. The trade contractor's willing to do the work for less and the supply house is willing to sell it for less. It's a lot more work for us, but we need the job.

Hann: I just poured the slab on a home and the client sent me an e-mail saying, “I'm really looking forward to all the savings we're going to have on this project,” because he's in the international chemical business and his costs are dropping. I'm not going to argue with him, but it's a fixed-price contract, and if costs had gone the other way he wouldn't be open to spending more money to get the same product.

CB: So what's the short-term outlook? If production builders aren't going to be building as many houses, will they start going after a piece of the custom market?

Magleby: Not the national production builders, but local production builders that need the work might do that. Whether they can get their foot in the door remains to be seen, because I don't think the discriminating client will go there unless the builder has a proven track record. But it will put pressure on the custom builder.

CB: And will there be trade contractors left to build these houses when things do turn around?

Magleby: That is a real fear for me. Some trade contractors are just hanging on by their fingernails right now. We instituted a new policy the first of October that we do not disperse the entire check to the trade contractor without a conditional lien release from their supply house on any materials that they've purchased for our project. We'll either cut a check to the supply house for that amount or issue dual checks to the supplier and contractor. We feel like we need to start managing their business as well as protect our clients, so that the vendors don't come to us wanting to be paid for materials they've delivered when we already paid the trade contractor and he used the funds to meet other financial obligations. We just can't take that liability.

Hann: I would agree. I feel very fortunate that we've got work and we're signing on for more work and have a pretty good backlog. But I think you're going to see a lot of builders and trade contractors who won't survive because they don't have enough powder in the kegs to keep dry as we go through this cycle. There are going to be people out there making dumb moves, such as not having enough backlog or taking work at lower margins than they should …

Magleby: Below cost.

Hann: They're already in a cash-flow crunch. If they take a job and haven't figured it properly, or they were production builders and think they can go into custom, their cost basis will be incorrect. They'll realize they're in over their heads and won't be able to finish the job. They may even leave a client with obligations for work in place because they've funneled the money somewhere else.

Magleby: Or just flat out under-budgeted and didn't end up with enough to cover it. Then they start calling Steve and I to bail them out!