The Important Geographical Risks in Home Builders

Joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Home builders and developers do much more than stick a few pieces of wood in the ground. From the exploration of a new market to the selling of the last house, homebuilding's a lengthy and involved process. The crucial decision of what market to enter guides a company for years. 

KB Home (NYSE: KBH) has decided to focus on high growth areas like California and Florida. These markets experience bouts of strong growth, but an overreliance on such areas may subject the company to great volatility. In addition to these factors, the macro picture for home builders is mixed over the long run. Other builders offer growth prospects and a greater degree of geographical diversification. 

US Housing Starts data by YCharts

The majority of KB Home's inventory is found in California. This state has high taxes and one of the highest unemployment rates. Based on Q3 2012 data, the central states of Colorado and Texas and the Southeastern states of Florida, Maryland, Virginia, and North Carolina each carry about 17% of land and land development investment. During the recent boom years, California and Florida became infamous for their amount of overbuilding. The changing climate and increasing hurricane activity will be a negative factor in these the Southeast markets. 

Other factors decrease the attractiveness of KB Home. The company has a total debt-to-equity ratio of 4.57, much larger than that of their competitors. This shows that the company has a large amount of debt that could worsen future cash flow issues. On a valuation basis, the company is not a strong buy. It currently trades at a price-to-book ratio around 3.8, which means investors are paying more for KB Home's assets than for those of their competitors. 

What about the competition? 

Brookfield Residential Properties (NYSE: BRP) operates in the U.S. and Canada. It is based in Calgary, Alberta, Canada and offers significant diversification out of the U.S. market. Froth in the Canadian housing bubble is real, but it is critical to recognize the importance of geographical differences.

For years, Vancouver has been outrageously expensive, and it is prudent that Brookfield does not operate in this market. Its Canadian markets are Calgary, Edmonton, and Toronto. The economies of Calgary and Edmonton are built on energy, and the continued growth in the oil sands forms strong underlying support. Toronto and the province of Ontario have not grown as strongly as Alberta, but Toronto has a number of financial and mining firms headquartered in the city that support the local economy. In America, Brookfield focuses on California, Washington D.C., Austin, and Denver. 

Brookfield's total debt-to-equity ratio of 1.45 is healthy, and shows that in addition to greater geographical diversification, its balance sheet carries less risk than KB Home's. On the sales side, the company boasts a gross margin of 27.2% and an EBIT margin of 15.7%. These margins are significantly higher than those of the other two firms mentioned here. This positive news needs to be tempered by Brookfield's relatively low return on investment of 3.1%, which suggests that the company could be using its assets more effectively. Brookfield offers a healthy degree of geographical diversification and is a good long-term investment. 

Lennar (NYSE: LEN) is an interesting company with some encouraging developments. It's experimenting with multigenerational housing. As the number of workers per non-working individual increases, America will have an increasing dependency ratio. In a macro sense, the nation will need to use its resources more effectively, and Lennar's multigenerational homes might make a great fit

Lennar focuses on America's coasts, but it is in a better situation than KB Home. Its total debt-to-equity ratio of 1.35 is on par with Brookfield and does not imply the same risks as KB Home's. Lennar's EBIT margin of 7.7% is half of Brookfield's, but nevertheless, both companies are profitable.

KB Home argues that its  temporary unprofitability is just a period of strong investment. Lennar's ROI of 8.9% shows that some builders are able to remain quite profitable, even while they come out a recession. 

Conclusion
Evaluating risks and uncertainty is a critical part of investing. KB Home's high debt load and concentration in volatile markets gives the company hidden risks. As the market improves, it will be fine -- but what will happen in the next downturn?

Brookfield Residential Properties offers greater diversification throughout Canada and the U.S., along with a more manageable debt load. Lennar offers unique multigenerational housing plans and further diversification with its markets in Chicago, Washington State, and the Northern parts of the East Coast. These two companies are two good investments to consider. 


MrCanadian1 has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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