October 12, 2017

New Home Warranty Expense Rates:

Last time there was a recession, the warranty metrics of new home builders flashed danger signals more than a year before it officially started. Currently, there's nothing to worry about, by the looks of the latest industry data.

Just as warranty data gives off an early warning signal in the automotive industry, so too can it become a leading indicator for other lines of business. Back in 2006, the U.S.-based homebuilders began to give off signals that, in hindsight, show that something was going very wrong for their industry, with both sales and warranty expenses peaking and then declining at a precipitous rate. Of course, by 2008, it was obvious to everyone that the home mortgage industry was a wreck, and the Great Recession officially began.

Looking at the latest available metrics now, it seems that nothing like that is happening this year. New home sales continue to rise, warranty expenses are rising proportionally, and there doesn't seem to be any sort of industry-wide downturn. However, that doesn't mean that every builder is prospering equally.

Since 2003, Warranty Week has been collecting five essential metrics from some 55 different U.S.-based homebuilders that report their warranty expenses in their financial statements. We collect the amount of claims paid per quarter, the amount of accruals made per quarter, the balance in their warranty reserve funds at the end of each quarter, their homebuilding revenue, and the number of homes sold.

Taken together, these metrics clearly show the relative health or sickness of the homebuilding industry. We estimate that these warranty-reporting builders account for about a third of the entire industry, with the balance comprised of small, privately-held companies that do not file their financial statements with the U.S. Securities and Exchange Commission.

According to the U.S. Census Bureau, which collects statistics on new home sales in concert with the Department of Housing and Urban Development, sales of new single-family houses in August 2017 were at a seasonally adjusted annual rate of 560,000 units. The companies we track have reported 176,000 homes sold in the year ended June 2017, so we're probably counting around 31% of the current total.

Warranty Expenses

We don't have warranty expense reports for the entire industry, and we wouldn't want to venture a guess knowing exact details for only 31% of the total. But the companies we track have paid $574 million in claims and made $537 million in accruals since June 2016. That's up about 13-to-14% since the previous year, which is right in line with the growth rate for home sales revenue (not including land-only sales, mortgage fees, rentals, etc.). In other words, warranty expenses are growing proportionally with sales.

In Figure 1, we're looking at quarterly claims payments reported by the builders for the past 14-1/2 years. It's plain to see that claims peaked in the second half of 2006, and kept falling until finally bottoming out in 2012.

Figure 1
New Home Warranties
Claims Paid by U.S.-based Homebuilders
(in US$ millions, 2003-2017)

Figure 1

Sales followed a similar pattern, peaking at the end of 2005 and hitting bottom in early 2011, meaning that the recession in new home sales began sooner and lasted longer than it did for most other industries. Claims lagged sales by about a year, which is to be expected given that it takes time for defects to appear, and repairs to be made.

Warranty Accruals

On the other hand, warranty accruals are made at the time a home is sold, and should therefore remain proportional to sales, unless there's been a noticeable change in reliability or repair cost. Over the long term, the builders we've been tracking set aside an average of $2,500 per home sold, meaning that accruals should rise and fall in step with sales, unlike claims.

In Figure 2, in fact, the quarterly peak in accruals is at the end of 2005, and the bottom of the recession is in early 2011, the same as sales. So accruals are probably a better and more current indicator when it comes to the relative health of the industry.

Figure 2
New Home Warranties
Accruals Made by U.S.-based Homebuilders
(in US$ millions, 2003-2017)

Figure 2

In the past four quarters, builders set aside $537 million in accruals, up 14% from $472 million in the previous year. The builders that raised their accruals the most were D.R. Horton Inc., KB Home, M.D.C. Holdings Inc., and William Lyon Homes. But these builders also reported higher-than-average sales growth, so the accrual increases were proportional.

Among the major builders, PulteGroup Inc. and Hovnanian Enterprises Inc. cut their accruals the most. Hovnanian was reacting to a sales decline, but Pulte saw 6% unit sales growth and 12% home sales revenue growth in the second quarter. Yet it reduced accruals by $3.4 million, a 13% reduction.

At the same time, Pulte reported a $12.1 million charge related to estimated costs to complete repairs in a closed-out community in Florida. So the reduction in accruals was more than compensated for by the increase in other adjustments, and the company's warranty reserves rose to a level of $73.5 million by the end of June.

Other builders such as D.R. Horton, M/I Homes Inc., and Lennar Corp. also reported making large adjustments to their warranty reserves. M/I Homes said it was related to stucco repair expenses in Tampa and Orlando. Lennar and Horton weren't as specific, though Horton did say that warranty expenses were rising in Denver, reducing gross profits. In past years, builders have made large adjustments to pay for leaks, mold, and replacements of odor-emitting drywall, but there were no mentions of those problems this year.

None of these builders reported any foreign exchange adjustments, which is to be expected given the site-built nature of their business. Other manufacturers can export. And, in fact, some of the recreational vehicle manufacturers do export, and have to adjust their warranty expenses accordingly. But we'll cover them next week.

Warranty Reserves

The sum of claims, accruals, and adjustments is the balance left in the warranty reserve fund at the end of each financial period. And at the end of June, these builders together reported more than $1.22 billion in warranty reserves.

As the data in Figure 3 illustrates, this is within reach of the industry peak recorded at the end of 2006, when reserves hit a level of $1.33 billion. In fact, it's the one metric that comes closest to surpassing its pre-recession high.

Figure 3
New Home Warranties
Reserves Held by U.S.-based Homebuilders
(in US$ millions, 2003-2017)

Figure 3

We should note, however, that one company -- luxury home builder Toll Brothers Inc. -- accounts for nearly a third of that total. In fact, if we look at the warranty reserve balance as a multiple of claims payments, then Toll Brothers is keeping more than five year's worth of funds in reserve. The industry average is closer to two years.

Other builders with unusually thick cushions in their reserve funds include Hovnanian and KB Home. We wouldn't be surprised if either company someday removes $10 or $20 million from their reserve funds, stating that the adjustment was made because they concluded their balance was unnecessarily high.

At the other extreme, Beazer Homes USA Inc., PulteGroup, and William Lyon Homes have unusually thin cushions in their warranty reserve funds. For instance, Beazer's last reported balance of $19.8 million was equal to what it paid in claims in only seven months. And Beazer just decided to remove $1.3 million from its reserve fund. So it made a thin cushion even thinner.

Warranty Expense Rates

We're not going to include charts of homes sold or sales revenue. Instead, we're going to use those metrics to calculate additional data points by comparing them to claims paid and accruals made.

In Figure 4, we're taking the claims and accrual data from Figures 1 and 2 and dividing it by corresponding sales data, to find the percentage of homebuilding revenue that's going towards warranty expenses. As the chart makes clear, it's always been below two percent, and most of the time is closer to one percent.

Figure 4
U.S.-based Homebuilders
Average Warranty Claims & Accrual Rates
(as a % of selling price, 2003-2017)

Figure 4

The reason for the spike in the claims rate from 2007 to 2011 is simple: to calculate it, we're dividing claims by sales. And in a recession, sales fall but claims don't necessarily follow suit. In fact, the rate at which homebuyers report defects, odors, leaks, and mold might actually increase if they feel their purchase is declining in value. But in looking back to Figure 1, it's clear that claims did in fact decline. It's just that sales declined even faster, driving up the percentage rate.

In contrast, since accruals are always supposed to be made in proportion to sales, the ratio between them should remain the same, even if sales decline precipitously. And it looks like that's the case in the homebuilding industry. In 58 separate measurements taken since 2003, the accrual rate never rises above 1.1% nor falls below 0.6%. The average accrual rate over time is 0.9%, with a standard deviation of only 0.1%.

So let's set aside the claims rate as unreliable because of the impact the recession had on it, and because of the lag time between when a home is sold and when it needs warranty work. But let's keep the accrual rate. And let's add another metric that compares the number of homes sold to the amount of accruals set aside for them.

No two homebuilders are exactly alike. They build in different locations, with different climates, and different levels of prosperity. Some buyers want small starter homes, with simple layouts. Some want huge luxury homes with complex designs and lots of extras. As a result, average selling prices and repair costs will vary widely.

Accrual Rate per Home Sold

Long term, the average accrual per home is just over $2,500. And, as was just mentioned, this represents a little less than one percent of the average purchase price of a new home. But, of course, prices change, and so does the cost of warranty work. In recent years, the accrual rate per home sold has been slowly climbing upwards, hitting $2,850 at the end of 2016 before falling back in 2017.

In the chart below, the blue line represents the accrual rate per home sold, in dollars, using the left-hand scale, while the green line represents the accrual rate per dollar of revenue, in percent, using the right-hand scale. Both lines show some seasonality, but over time they remain within a relatively tight range.

Figure 5
U.S.-based Homebuilders
Average Warranty Accrual Rates
($ per home and % of revenue, 2003-2017)

Figure 5

The accrual rate per home has been as high as $3,500 and as low as $2,100. Its long-term average has been $2,500, with a standard deviation of $281. But there has been quite a bit of variation among the companies themselves.

The homebuilders that have historically accrued the most per home sold include Hovnanian, Toll Brothers, NVR, and William Lyon Homes. Those that have accrued the least include D.R. Horton, KB Home, Meritage Homes Corp., and CalAtlantic Group Inc.

The companies that have kept their accrual rates per home the most consistent over time, as measured by the standard deviation of their quarterly averages, are D.R. Horton, Meritage, and M/I Homes. In other words, they typically set aside the same amount of funds every time they sell a home, with little variation. At the other extreme, Hovnanian and Beazer Homes have changed their accrual rates per home sold the most, allowing them to rise and fall by thousands of dollars or more from one quarter to the next.

Definition of a Sale

For this metric, it's important that we count homes actually sold as opposed to homes built or homes ordered. Orders can be cancelled, and homes can be built but go unsold. So we must measure actual closings whenever possible. However, each homebuilder uses a slightly different word or phrase to refer to this status. D.R. Horton and Meritage call them "homes closed." William Lyon Homes refers to the "number of homes closed." PulteGroup, Beazer Homes simply calls them "closings." Meanwhile, KB Home, Hovnanian, and M/I Homes call them "homes delivered." Lennar refers to "deliveries." MDC now calls them "new home deliveries," though it used to refer to "homes closed" until it switched to the new term in 2011. And NVR simply calls them "settlements." Standard Pacific Corp. used to count "new homes delivered." The Ryland Group Inc. called them "closings." When they merged and formed CalAtlantic Homes, they called them "new homes delivered."

In the second quarter of 2017, these and other homebuilders that we track reported just over 47,000 closings, up approximately 10% from unit sales levels during the second quarter of 2016. As was mentioned, sales revenue in dollars was up by 13% over the same interval, so the average selling price per home is also rising.

The accrual rate per home, however, actually fell slightly, from $2,670 in June 2016 to $2,650 in June 2017. it's a negligible change, but it reflects the prevailing belief among homebuilders that neither reliability nor repair costs are changing much.

And that's the general conclusion we reach after looking over these metrics: things aren't really changing much. Warranty reserves have been higher than usual for the past nine months, but only because a few companies are keeping more funds on hand than is necessary. All the other metrics are stable or changing slowly. Both accrual rates and even the claims rate are relatively stable, although they all show seasonal fluctuations. But there are no signs of the pre-recession peaks we saw in 2005 and 2006.

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