Rewriting the Homebuilding Handbook

There’s an interesting article in the Arizona Republic about Meritage Homes and its attempts to revamp its business model. Aside from being a relatively impressive retooling, the article and Meritage’s efforts probably represent a good model of what home building is likely to be all about for the next few years. It’s also a bit of a cautionary tale about the overall housing market.

Meritage’s new strategy focuses on reducing land, construction, selling and overhead expenses, building smaller homes with fewer amenities and targeting their product to buyers that can afford them. Along the way, they’ve also revamped the way they market the homes to buyers.

Controlling costs is a pretty self-evident strategy. The market has helped them in this regard since material and labor costs have declined significantly due to the state of the overall market. As a survivor, they have been able to pick up lots for a fraction of what they sold for a few years ago. The company has also wrung a lot of fluff out of its advertising budget — down from $31 million in 2007 to $15 million in 2008.

What’s more interesting is the decrease in the size of their product. Their smallest offering is now 1100 square feet down from 1800 square feet and their largest is 3100 square feet down from 4000 square feet. The objective is to drive down the price by reducing the size. The smallest house now sells for under $100,000 which is competitive with foreclosure homes.

Metitage is after the first time homebuyer or the homebuyer that is going to base their decision about buying or renting strictly on monthly payment. They have a pretty unique marketing plan. The cheapest model is a bare bones product, no upgrades. They prominently display the monthly payment for the house on the garage of the model. At the sales center prospective buyers can view designs and upgrades. Each change to the basic model includes a calculation of what the incremental cost will be in terms of a monthly payment.

Meritage is revamping its building program in Arizona, California, Nevada and Florida to conform to this low-cost strategy. Low-cost also means low margin. The profits that Meritage and its competitors have traditionally taken out of the industry are obviously going to be much lower for some significant period of time. If they can build volume with this strategy, then profitability may be acceptable but as a group, this would indicate that even with recovery the homebuilders are unlikely to generate profits in line with historical norms.

Their strategy also has implications for the middle and upper tiers of the housing market. A lot of observers feel that sector of the market is the next domino to fall. Between the recession and homeowner that stretched too far, they expect a wave of foreclosures in the upper end. In fact, that already appears to be occurring. If Meritage is right that most of the action in home buying is going to be at the lower end then the prospects for the mid and upper tiers would appear to be poor.

I think that Meritage’s strategic decisions give some credibility to an eventual recovery in the housing market. Unfortunately, it might be a recovery that’s concentrated in one segment of the industry which means that the organic health of the overall market might be poor for some time to come.

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