If you constructed a word cloud for homebuilding today, the biggest words would likely be mortgage rates, tariffs, land, consumer confidence, and land banking.

You can't attend an industry conference without encountering multiple new land bank funds. Yet many builders remain unclear about how this business operates and its implications.

This may be old news for some. Still, reviewing the history, current state, and future direction of land banking seems timely.

A Brief History

Land banking isn't new. It flourished before the Great Financial Crisis, when land bankers could hold builder deposits until deal completion, making deposits substantial relative to remaining takedowns by mid-project. Enron's 2001 bankruptcy, however, prompted FASB to revise GAAP rules for Variable Interest Entities (VIEs) in 2003.

The essence of these complex rules is that deposits cannot reach 20% without likely consolidation. Most land bankers accepted these new rules and continued funding deals with pro-rata deposit releases.

During the Global Financial Crisis, deals were extended, modified, repriced, or resold — often at losses. While specific return data isn't publicly available, anecdotal evidence suggests disappointing full-cycle performance.

NVR's success during the financial crisis, with stellar returns through optioning land rather than owning it, convinced Wall Street that "land light" strategies were safer and more capital efficient. Many public builders saw this as their path to higher PE multiples. Initially, they could option land and lots directly, but as markets recovered and competition intensified, sellers no longer needed to accommodate buyers. Land bankers returned to fill this gap.

Current Deal Structure

Accounting rules have significantly standardized deal structures. With the 20% deposit limit and land bankers accepting only market risk, no cost, approval, or environmental risk, most deals feature rates in the low teens with approximately 15% deposits. These deposits combine upfront cash and potential termination fees if builders terminate their options, though builders remain liable for guarantees and indemnities.

The key underwriting question: Are there multiple large builders in the market who would purchase these lots if a builder were to drop its option? This critical criterion renders land banking unsuitable for creative or unusual product types and lot sizes. It's designed for mainstream development.

The primary variable in risk profile is whether each project stands alone or assets are pooled with cross-collateralization and cross-defaults. Builders willing to pool assets (like Lennar with Millrose) can secure lower rates, since walking away from a mixed-performance portfolio is harder than abandoning select underperforming assets.

Who Uses Land Banking?

While most deals involve public builders, the business extends beyond them. At its core, land banking is a credit product that requires confidence that builders will honor all guarantees and indemnities regardless of market conditions. This typically means well-capitalized public builders and a few large private companies. Some smaller private builders access land banking – at much higher rates and with limited availability.

The Economics

For funds: Simplistically, charging approximately 11%, leveraging at 45% with debt costs of SOFR plus 200 basis points (6-6.5%), and after management fees, funds can achieve mid-teen returns on equity.

For builders: While 11% rates exceed their 4-6% bond costs, they remain below typical ROAs of 12-14%. More importantly, Wall Street rewards this approach, enabling growth without significant cash deployment, which has historically been challenging in homebuilding. In severe downturns, builders can renegotiate (often being logical lot purchasers given existing plans, models, and marketing) or walk away entirely.

Why the Rush Into Land Banking?

Several factors drive investor appetite:

Attractive risk-adjusted returns: If builder default risk is extremely low, rates appear compelling versus other real estate investments or junk bonds.

Operational efficiency: This is a low-overhead, high-throughput business. Reviews are cursory and heavily builder-dependent, unlike private equity deals. Small teams can handle substantial volume.

Limited residential alternatives: As private builder numbers shrink and project returns rarely support double promotes, many investors aren't prepared for entitlement or large land deal risks. Land banking has become the primary game as the industry consolidates.

Consistent results: With capped upside (rate is maximum return) and theoretically unlimited downside, deals perform to proforma until real problems emerge. Like bonds never marked to market absent actual or threatened default, investors enjoy consistent results—until they don't.

Current Market Dynamics

New entrants arrive daily. Everyone watches Millrose's impact on the business. Their 8.5% rate to Lennar (with pooled assets) is exceptionally low. If this forces broader rate compression, leveraging funds becomes uneconomical. After subtracting asset management fees, Millrose returns approximately 7% — a level that could drive participants from the business. Whether this rate proves unique remains unclear.

Public builders show an insatiable appetite. Wall Street rewards land optioning, and with PE ratios around 9-10 while the overall market trades above 25, convincing investors they're less risky and deserve higher multiples far outweighs profit improvements. Previously, falling margins made builders reluctant to use land banking (adding approximately 15% to lot costs and 3-6% to house prices), but I suspect margins would need to become extremely thin before they return significant deals to their balance sheets.

The Fundamental Bet

The core assumption: This time is different. We're so short of lots and land that any problems will be manageable through minor deal modifications, with few projects completely defaulted and resold. This is entirely possible. Most don't expect another GFC. However, I suspect challenges could prove more significant than commonly assumed, though not catastrophic.

Looking Forward

For now, expect more capital entering the space, competitive pressure reducing rates and loosening terms, and public builders enjoying growth without cash deployment. We've already seen "flexibility" in deal sizes and terms, particularly regarding project duration and scale. This creates additional pressure on private builders facing considerably higher capital costs while making it easier for public builders to acquire competitors and immediately transfer assets to land banks.

The land banking boom reflects broader industry consolidation and capital market dynamics. While current conditions favor this approach, the ultimate test will come when market conditions inevitably shift. The question isn't whether land banking works in good times—it's how well it performs when the cycle turns.