As new home prices enter uncharted territory in months to come – in a scenario range that spans slow-growth, no-growth, modest-decline, to potentially steep decline – one of real estate's biggest questions lurks.

UBS equity research associate Spencer Kaufman took a cue, during Toll Brothers' late August Q3 earnings call, to give the question oxygen, although most homebuilding strategists – public and private – would rather it didn't come up at all right now, if they could help it.

Kaufman followed on Credit Suisse equity research director Dan Oppenheim's query for Toll ceo Doug Yearley and cfo Marty Connor, on whether challenges in the operating environment might impact Toll's schedule of new community openings, and, for that matter, new lot acquisition. Oppenheim asked:

Wondering how you're thinking about allocating capital given the discount to to book ... relative to this environment, where you're ... reassessing ... putting more into land?"

Toll finance chief Connor jumped in with a response, essentially affirming that apart from securing shareholder value, Toll would continue "to pursue new land deals ... many ... from old land contracts, which still work," adding,

It is increasingly difficult for new land deals to meet our underwriting standards."

Kaufman's turn came next in line among participating Wall Street company equity research analysts. He asked, as a follow to Oppenheim's question whether Yearley and Connor would give greater color to where pace and price weaknesses were showing up, and which customer segments appear to be showing more or less exposure to risk. Doug Yearley offered that Toll's less mortgage-rate-sensitive higher end move-up and active adult customer segments show greater resilience to date, versus buyers who are more monthly-payment focused. Too, he said, geographical markets that had been the "hottest" in the wake of the pandemic, where price appreciation had steeper trajectories, were ones Toll was seeing the most weakness, because, he said, "the prices being higher than the affordability."

At which point, Kaufman shot back with the question he couldn't help but ask, although it's too early innings to get an answer that's likely to stick.

Maybe can you just talk a little bit as to what would need to happen in order for you guys to see widespread impairments?"

Toll's Marty Connor graced the question with a respectful financial come-back, given that nobody knows right now the ultimate duration and trajectory of the new home market's correction. Soft landings to a "normalized" and "balanced" equilibrium are the predominant narrative, and executives are sticking to it.

Land impairments – should they occur – would show up downstream of price weakness no builder is yet modeling, given a broad backdrop of demographic demand and, in many locales, significant underbuilding. Further, impairments would likely come in isolation – i.e. some land deals in select submarkets or markets that don't any longer pencil for an acceptable internal rate of return versus their home's selling price.

"Widespread impairments," as Kaufman asked about, would not only retrace to eat up homebuilders' best gross and net margins in years, but further than that, would signal a much worse market than any strategic executive has publicly acknowledged could lie ahead. In such a scenario, it would take a deflationary reset to re-boot new home sales at a sustainable pace of production, completions, and closings to keep cash flow in line with front loaded investment.

At the same time, Connor's mention that it has become "increasingly difficult" to pencil new land deals creates a classic crossroads tipping point, one that allows counter-cyclical and counter-trend players to pounce at a moment fewer would-be bidders are trolling for the same parcels.

Fact is, 12 to 24 months ago, an everything-goes gold rush on residential land meant that A, B, C, and D lots all could attract multiple viable bidders – from strategics, financials, hybrid land bankers, developers, etc – because a demand use-case could fly for all of them. Now things are different.

Builders are slowing starts. They're shoring up their balance sheets for turbulence. They're keen to gauge what it takes – price incentives, rate locks, upgrades, down payment assistance, and a host of other selling tools – to establish visibility on their absorption pace versus price versus location. In some cases, like Connor mentions above, they "continue to look" but are hesitant now to pull the trigger to pencil new land acquisitions before national and local prices find a floor.

Some of them are even walking away from land parcel deals they had under contract, but now believe that the cost of carrying them is higher than the benefit they might get from keeping them in the stable. The types of deals homebuilders might walk from first might be the land purchases that might have been attractive when practically any transaction could work, but had either land entitlement risk or some other challenge – environmental, topography, access roads, community push-back, etc. – that would likely escalate timing and cost barriers.

So, as others exit the land buying dance floor for each of their own business reasons, certain players detect a stronger opportunity to gain an upper hand on pricing.

Our Encore Capital Management group is buying land, particularly larger parcels that others have shown a lot more caution about in this environment," says Tony Avila, managing principal and co-founder with Art Falcone. "Encore does not use debt when we buy land, so unleveraged, the opportunity – especially in tracts that have some 'hair' on them – has less risk, and we can use that lower risk profile to create better alignments with builders when we sell to them."

Avila and Falcone founded their capital investment venture in 2008, as an "encore" to extremely well-timed mergers and acquisitions transactions that date back to the Great Recession. The market challenges of the moment make for prime opportunities for homebuilders – D.R. Horton, Lennar, LGI, Dream Finders, and Meritage, to name some of Encore's builder client roster – to make calculated moves on land both to respond to near-term portfolio management opportunities to push volume, or get pipelines ready for a market reboot in early 2024 or there abouts. Recently, Encore has worked with Northern California-based DeNova Homes and Hayden Homes in the Pacific Northwest on off-balance sheet land ventures.

We've seen a marked increase in willing sellers as the slowdown started in midyear," says Avila. "Other buyers are falling out, bank financing is tightening up, hard money lenders are going away, which makes our model – with its track record of 20% annualized internal rate of return on our land deals – stand out. We're willing to take the land risk, which allows builders to reduce theirs because the venture doesn't hit their balance sheet. That's a good business right now."

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