June 28, 2018

Homebuilding Warranty Report:

Warranty expenses are rising but so are new home prices, keeping the average amount of money accrued industry-wide after each closing relatively steady, and allowing the accrual rate as a percentage of revenue to actually decline a bit. But many homebuilders continue to raise and reduce their warranty accruals rather impulsively, and sometimes skip them altogether.

New home prices are rising, and their warranty expenses are rising more or less in proportion, keeping the average accrual rate per sale close to $2,650 per unit, and 0.7% of the selling price. After suffering catastrophic sales declines during the recession a decade ago, they've managed to turn in their fifth or sixth consecutive year of both sales growth and increasing warranty expenses.

We began this week's industry analysis with a list of 55 current and former new home builders that have reported their warranty expenses in their financial statements since 2003. Many have gone out of business or have merged with stronger companies in the wake of the last recession, which had a deep and lasting impact upon new home sales.

Those who are still in business and are still reporting their warranty expenses probably account for around 30% of the 612,000 new homes delivered in the U.S. last year. The remaining 70% were built by companies that are either family-owned, privately-held (and do not need to release financial statements), or are publicly-held and are willfully disregarding generally-accepted accounting principles regarding the mandatory disclosure of their liabilities.

Warranty Metrics Collected

From each of the warranty-reporting companies we collected five essential metrics: warranty claims paid, accruals made, and reserves held, as well as the number of homes closed and the dollar amount of revenue raised from home sales (not land sales only or finance/mortgage income). With those metrics in hand, we calculated an additional pair of rates: warranty accruals as a percentage of sales, and warranty accruals made per home sold.

In the nine charts that follow, we will try to detail all of the totals and averages. In Figure 1, we are adding together all of the claims payments reported during each of the last 15 years by all of the builders we track. Last year, they reported spending $589 million on claims, their highest total since 2007 and $46 million more than they spent in 2016.


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

Figure 1


Notice that we're still far below the peak set in 2006, when $968 million was spent on claims. That was the peak year for not only new home sales by this group of companies, but also for home prices in general. Unit sales among this group bottomed-out in 2011, though claims costs hit rock-bottom in 2012.

Among the largest builders, Toll Brothers Inc. saw the biggest jump in claims cost, going from spending $45 million in 2016 to spending $82 million in 2017. D.R. Horton Inc. was close behind, reporting a jump in claims cost from $48 million in 2016 to $66 million in 2017.

Meanwhile, Beazer Homes USA Inc. cut its claims cost in half, from $58 million in 2016 to $29 million in 2017. Hovnanian Enterprises Inc. and William Lyon Homes each managed to chop almost $2 million off their claims totals, and both NVR Inc. and M.D.C. Holdings Inc. made more modest reductions in their claims costs. Most of the others saw increases in their claims costs.

Warranty Accruals

Warranty accruals made by new home builders also hit a post-recession high last year, rising to $533 million, their highest annual total since 2007. It's also the sixth consecutive annual increase, with builders adding $13 million to their 2016 total last year.

Because companies first make their warranty accruals and then spend the money on claims, there is always a lag time between accruals and claims. In Figure 2, in fact, the highs and lows for accruals are exactly a year earlier than they were for claims. The peak for claims was in 2005 for accruals and in 2006 for claims. The bottom of the valley for accruals came in 2011 and in 2012 for claims.


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

Figure 2


Note that unless there is a change in quality, reliability, failure rate or repair cost, accruals should remain more or less proportional to sales. This was approximately the case among the builders we're tracking, with sales revenue growing marginally, and accruals rising by 2.4%.

However, among the top 15 builders, the picture was much more mixed. D.R. Horton boosted accruals by $16 million while PulteGroup Inc. cut its accruals by $17 million. Neither change was even approximately proportional to their respective sales gains.

But then there were several that were almost exactly proportional. For example, Lennar Corp. raised its accruals by 13% as its sales grew by 15%. Toll Brothers boosted accruals by 10% while sales grew by 12%. Meritage Homes Corp. raised accruals by only 2.3%, but then again sales were up by only 6.1%. Even KB Home, which raised its accruals by 28%, was reacting to a 22% increase in sales.

Accruals per Home Sold

In only a few industries, the companies make it possible to track units sold, and therefore to calculate the amount of warranty expense incurred per unit sold. Automobiles is one, and single-family homes is another. We can't think of a third, although readers probably have some suggestions. Please send them in.

What follows is a look at the amount of warranty accruals made per home over the past 15 years. Since warranty accruals are made at the time of sale, while claims are paid months or even years later, it is the best measure of warranty expense per unit sold. Our methodology is simple: find the reported total for accruals, and divide it by the number of homes sold during the same time period.

For this metric, it's important that we count homes actually sold as opposed to merely homes built or homes ordered. Especially during the recession, homes were built but were never sold. And in order to incur warranty costs, they must be sold. However, each homebuilder uses a slightly different word or phrase to refer to homes sold. D.R. Horton, and Meritage call them "homes closed." William Lyon Homes refers to the "number of homes closed." PulteGroup, and Beazer Homes simply call them "closings." Meanwhile, KB Home, Hovnanian, and M/I Homes Inc. call them "homes delivered." Lennar refers to "deliveries." MDC Holdings 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."

As was mentioned, we believe these and the other homebuilders that we're tracking were responsible for constructing about 30% of the new homes closed last year. In Figure 2 we counted $533 million in accruals, and now in Figure 3 we're calculating that amount to represent about $2,650 per home sold, and just over 0.7% of revenue.

In Figure 3, we're tracking these two metrics over the past 15 years. The accruals per home metric uses the left-hand scale, while the accrual rate per dollar of revenue uses the right-hand scale. Long term, the average accrual rates are $2,550 per home and 0.9% of revenue, so at the end of 2017 the industry was above and below those medians, respectively.


Figure 3
Homebuilding Warranties
Average Warranty Accrual Rates
($ per home and % of revenue, 2003-2017)

Figure 3


Many of the top builders were able to bring their accrual rates down significantly in 2017, meaning that there must have been a positive change in quality, reliability, failure rate, or repair cost. For instance, PulteGroup cut its accrual rate from 0.9% to 0.6%. Hovnanian dropped from 1.3% to 1.1%. And NVR dropped from 0.9% to 0.7%.

Among the relatively few accrual rate increases were KB Home (up from 0.8% to 0.9%) and M.D.C. Holdings (up from just under 0.4% to just over 0.4%). The impact of recent crises such as the mold intrusion problem or the odor-emitting drywall seems to have faded, so surprise increases in accrual rates were relatively uncommon last year.

Long-Term Accrual Rates

In Figures 4 through 7, we're going to detail the accruals made per home sold for 15 of the largest builders. Since we're tracking 15 builders, we can split them into three groups of five. The five builders with the highest average accrual rates per home sold are Hovnanian, Lennar, NVR, Toll Brothers, and William Lyon Homes. The five in the middle are M.D.C. Holdings, M/I Homes, Meritage, PulteGroup, and Taylor Morrison. The five builders with the lowest average accrual rates per home sold are Beazer Homes, Standard Pacific Homes, D.R. Horton, KB Home, and Ryland Group.

We should note that Standard Pacific Homes and Ryland Group merged in 2015 to form the CalAtlantic Group. And then CalAtlantic merged with Lennar earlier this year. All four of these companies are included in the chart in Figure 8.

For the other 11, we can't present them in groups based on their average accrual rates being high, low, or average, because if we did the lines for each would be all tanged up on top of each other. So instead, we've selected which ones go on which chart based on how different their patterns are, and therefore how they won't intersect too often.

The thing to watch for in all of these charts is a relatively flat line that rises or falls relatively slowly from one quarter to the next (since each company reports quarterly, there are 60 data points for each over the past 15 years in the charts below). For instance, in Figure 4, the red line for D.R Horton remains relatively close to its $1,200 long-term average -- a sign of its warranty cost management expertise.


Figure 4
Homebuilding Warranties
Warranty Accruals Made per Unit Sold
(in US Dollars, 2003-2017)

Figure 4

In contrast, Taylor Morrison Home Corp., a builder that first went public in 2013, once saw its accrual rate per home sold soar ten-fold, from $550 at the end of one year to $5,500 at the start of the next year. It has yet to settle down into a predictable range, ending 2017 with an accrual rate of $3,750 per home.

In Figure 5, the accrual rate charts for three more builders are hopelessly tanged together. But hopefully, the colors used for each line make it possible to tell them apart. Note that in 2007, just as the recession was taking hold, for one quarter every home built by KB Home was constructed perfectly, requiring $0 in accruals.

PulteGroup also found ways to keep its accruals low during the lean years, and has most recently cut its accrual rate per home back down to $2,200 per unit. MDC did a remarkable job of reducing its warranty expenses per home from 2005 to 2012, before letting its accrual rate slowly creep up again in recent years.


Figure 5
Homebuilding Warranties
Warranty Accruals Made per Unit Sold
(in US Dollars, 2003-2017)

Figure 5

The spikes are even more extreme in Figure 6. At one point in early 2005, Beazer Homes was setting aside nearly $15,000 per home sold to finance warranty costs. In mid-2009, Hovnanian topped that record by $500 per home. Meanwhile, for half of 2006 and again in 2007, every home was perfect at Beazer, requiring $0 in accruals. To its credit, however, the average seems to have stabilized since 2010.


Figure 6
Homebuilding Warranties
Warranty Accruals Made per Unit Sold
(in US Dollars, 2003-2017)

Figure 6

In Figure 7, it's clear that M/I Homes has mastered the art and science of warranty management, keeping its accrual rate close to its $2,200 long-term average. Shea Homes, we should note, has always been a privately-held company, but from 2010 to late 2014 it sold bonds on the open market that required it to file financial statements with the U.S. Securities and Exchange Commission.

The third company on the chart is William Lyon Homes, which we found to have a long-term average accrual rate per home of just over $4,000, but which nevertheless ended 2017 with an accrual rate just over $2,000 per home. Is this a positive sign of good warranty management? Or is it merely the downward extreme of yet another gyration in the company's accrual rate?


Figure 7
Homebuilding Warranties
Warranty Accruals Made per Unit Sold
(in US Dollars, 2003-2017)

Figure 7

As mentioned, all the companies in Figure 8 are now part of Lennar. And, despite some bumps along the way, Lennar is among the companies with the flattest accrual rate chart. However, since 2010 that chart has been flat but rising. But in the final quarter of 2017, it dropped, as it has in the three previous years as well. So obviously, there is a seasonal pattern of some sort at work, which causes warranty accruals to decline in the fourth quarter.


Figure 8
Homebuilding Warranties
Warranty Accruals Made per Unit Sold
(in US Dollars, 2003-2017)

Figure 8

Lennar ended 2017 at $3,500 per home. CalAtlantic, in its final quarter, was just under the $1,600 mark. So it will be interesting to see how these two different companies blend their warranty expense rates over the next few years. In contrast, the accrual rates of Ryland and Standard Pacific had similar ranges before their merger.

Warranty Reserves

Our final warranty metric is the balance in the combined warranty reserve funds of all the builders that report their warranty expenses. In Figure 9, it looks like the industry saw no change in those balances from 2016 to 2017, but in fact there was a $767,000 increase that was too small to be visible.

It was the highest year-ending balance since 2007, and only the fifth year out of the last 15 in which the balance exceeded $1.2 billion. With an industry claims rate close to 0.8% and an accrual rate close to 0.7%, this implies that builders are keeping very close to two years' worth of reserves on hand.


Figure 9
Homebuilding Warranties
Reserves Held by U.S.-based Builders
(in US$ millions, 2003-2017)

Figure 9


CalAtlantic reported having $41.7 million in its warranty reserve fund at the end of September 2017, its last filing before the acquisition. In its financial report for the three months ended February 28, 2018, however, Lennar reported $108 million in acquired warranty reserves. That in turn helped drive Lennar's reserve balance above $270 million.

Others that have seen proportionally large increases in their reserves include D.R. Horton (up $42 million), and KB Home (up $13 million). Two of the largest declines include Toll Brothers (down $42 million) and Beazer Homes (down $16 million). But, as mentioned, the increases and decreases virtually cancelled each other out, leaving the industry's balance up only fractionally.

Worldwide Warranty

This concludes our tour of the U.S.-based product warranty industry, presented in 14 newsletters covering 18 industries. Please go to the online newsletter archives if there are any you've missed.

Next week, we will take a deep dive into the warranty expenses of Toyota and Honda, which just published their annual reports for the year ended March 31, 2018. In the weeks after that, we are going to take all of the U.S. data, and merge it with some additional international warranty data, to help us fashion estimates for the size of the worldwide warranty expense of several industries such as passenger cars, construction equipment, and civilian aircraft. In each of those cases, the known warranty reporters comprise a majority of the industry's market share, so we can add estimates for the remaining few non-reporters to the pie charts and end up with a reasonably accurate measure of the worldwide warranty expense of the entire group.





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