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Homebuilder funding: A problem of plenty and low leverage

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Sources of funding for homebuilders

Homebuilding is a highly capital-intensive business, and homebuilders are always in need of capital—whether in the form of equity, debt, or hybrid funding. Lack of sufficient capital can make or break any homebuilder’s financial health. The company’s own funds, private investors, private equity, hedge funds, foreign investors, and institutional investors form the equity side of the funding. The debt side comprises government-sponsored entities, insurance companies, commercial banks, and non-bank financial lenders.

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Debt-side funding

On the debt side of funding, banks are the most dominant provider of credit to most homebuilders. However, banks are very selective in their lending and generally favor large homebuilders with stellar balance sheets. Small and medium builders are always at a competitive disadvantage compared to their larger peers because banks look for safety and have become risk-averse after the market crash. Plus, banks have to follow stringent lending standards, which also limit their ability to fund smaller players. Homebuilders have the option to go for other types of debt sources, like mezzanine lenders or insurance companies, but these institutions can’t match banks’ size, and their cost of funding is also higher.

Major homebuilders: Low on leverage

Most homebuilders—like Lennar (LEN), D.R. Horton (DHI), and PulteGroup (PHM)—have low debt on their balance sheets, as the debt-to-equity ratio for many of these companies is lower than one. Some homebuilders, like Beazer Homes and Taylor Morrison Home, have very high debt with a debt-to-equity ratio of 6 and 4, respectively. A high debt-to-equity ratio usually means that a company has been aggressive in financing growth with debt and often results in volatile earnings. On the other hand, a low debt-to-equity ratio indicates lower risk because debt holders have fewer claims on the company’s assets.

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Equity capital: A problem of plenty

Equity financing is the way most homebuilders start their operations. Lot of options are available for homebuilders to raise equity funding apart from their own funds—like private investors, public investors, hedge funds, foreign investors, and pension funds. WCI Communities and William Lyon raised capital by public offering in 2013, while Hovanian Enterprise raised funds by way of joint venture with private equity investors. Most major institutions continuously look to pour a substantial amount of money into the homebuilding industry.

Publicly traded homebuilders like Lennar (LEN), D.R. Horton (DHI), and PulteGroup (PHM) tend to have stronger balance sheets and greater access to low-cost capital than smaller, private builders. That advantage gives larger companies more ability to buy land in good locations. Homebuilder ETFs such as the SPDR S&P Homebuilders ETF (XHB) and the iShares U.S. Home Construction ETF (ITB) are actively buying the equities of these companies.

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