Most land acquired by the average builder in our universe is bought through option contracts, and payment is predominantly made at the options expiration. Especially in areas where available land is relatively scarce or where the entitlement process is comparatively long, option-based purchases can make a lot of sense, based partly on the financial flexibility they provide to the homebuilder. Such contracts require builders to pay only a small fraction of the total lot costs up front, and they tend to have few (if any) performance requirements. These kinds of contracts are often renewable, generally expire on a rolling basis, and have a specified exercise price. During the housing downturn that began in 2006 and continued into 2009, many large homebuilders terminated their land option contracts, thereby losing their cash deposits. Their assumption is that demand in the housing market will not rebound for some time and that they will be able to repurchase land at much lower prices as the economy emerges from recession.
Because the decision whether or not to acquire land is the single most important decision a builder makes, considerable effort is made in this endeavor. Land acquisition experts typically scout the market for recent sales of new homes in search of “comparable” properties. These comparable properties provide the basis for a detailed analysis aimed at determining an estimate of the selling price for homes being considered for construction. Based on a list of no fewer than 20 items, the company contrasts the comparable home’s features to the typical home that it would build, assigning dollar values to the units’ differences. These differences, which try to approximate the value that buyers place on certain features (for example, lot lines and design), are summed and netted against the sales price of the comparable home, in order to arrive at a hypothetical sales price for the builder’s proposed units.