Part 1.
Land, the Double Edged Sword
If the real estate recession has taught us anything, it’s that owning land is a double edged sword. Companies that prospered by owning land when it was scarce were the same companies that got hammered when the market turned. The land that had previously provided an asset base and predictability about a company’s future expansion quickly their cement boots sinking them into bankruptcy and dissolution.
For some of these companies, the time frame between land rich developer and bankruptcy court was shockingly fast. How could this happen and, how could this happen so quickly?
Land Banking
In the home building industry, the idea of land banking is a common one. Land banking means buying and holding land ahead of demand. The term has a nice ring to it. The image is of your land sitting safely, steadily increasing in value, all the while protected from the vagaries of the market. Nice image but far from the truth.
Land and Hedging Strategy
Whatever you want to call it, buying land ahead of demand is a hedge. You can hedge anything -- airlines hedge aviation fuel, trucking company’s hedge gas, food companies hedge grain and corn. The idea behind a hedge is simple. If you believe the price of something will rise, you buy it when it’s cheaper, locking in your prices and protecting profit margins.
Land Speculators vs. Hedgers, Subtle but Significant
Hedgers are primarily interested in minimizing risk by protecting themselves against price changes that undercut profits. Speculators, on the other hand, are in a market purely to make money -- essentially, betting on a price increase. The difference is subtle but significant.
As builders and developers saw the increase in land and lot prices, land originally held as a hedge was sold. In essence, by profitably selling land they already owned, builders and developers became accidental speculators. Now, seeing the profit in land, builders and developers were no longer just interested in buying land ahead of demand. Instead, they got heavily into the land market, buying land like it was free hotdog day at the lumber yard. Lenders facilitated this process through generous valuations and low LTV’s on land purchases.
Live by the Sword, Die by the Sword
While there is nothing wrong with speculators, accidently becoming one creates huge functional problems. Unlike true commodities, fuel, grain, etc., there is no national commodities market for land. Also, the price of land is set locally, not nationally. Compared to standard commodities, the combination of no national clearing mechanism, combined with local pricing and demand, means that from a practical standpoint, there are times when land is illiquid.
When prices and demand were rising this was a not an issue. However when the market turned, it became a big problem. Selling anything -- oil, lumber, pork bellies or building lots -- into a declining market further lowers the price and locks in your losses.
These factors make speculating (err, excuse me, land banking) risky. The value of any asset is only the price that someone is willing to pay. If you’re a builder trying to liquidate your land holdings and the market is frozen (no buyers, no financing available, etc.), then the effective value of the asset is zero.
By changing from hedgers to speculators, builders and developers participated in their own undoing. The sudden freezing of the credit market for land acquisition and high builder debt levels also explains the suddenness of their demise.
So… does this mean you stop buying land? No, but the approach needs to be more strategic.
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