December 18, 2014

New Home Warranty Accruals:

While the average homebuilder sets aside about one percent of revenue to cover warranty costs, the average new home is expected to cost around $2,500 over the life of its warranty. Luxury homes will cost more, but even some average-priced units have high warranty costs. It all depends on the builder.

New home sales are rising in the U.S., but they're still far below the levels they reached eight or nine years ago. Their warranty expenses are rising too, but the expense rate per home sold has remained about the same. Still, some homebuilders are finding ways to reduce warranty costs, or at least keep them steady and consistent.

In an industry as unstable as new home building has been in recent years, we would think that stability and longevity would be welcome attributes. In warranty terms, what we'd be looking for is a builder who knows how much their warranties are going to cost per unit, and who sets aside a consistent and accurate amount every time they sell a new home.

This can best be tracked through the measurement of warranty accruals reported by each builder in their financial reports, and the comparison of those totals to the number of homes sold and the amount of revenue derived from those sales. And what we have found is that while some builders are steady and predictable, others follow an unpredictable path with their warranty expense rates.

Value and Quality

However, some whose expense rates have gyrated in years past seem to have stabilized in recent years. Some have even managed to remain below the industry averages. And some have found the perfect pairing of low product prices coupled with low warranty expense rates, which are surrogates for value and quality.

We began with a list of 49 current and former builders of single-family and multi-family homes. All of them are U.S.-based public companies that have reported their warranty expenses at some time between 2003 and now. However, 15 of them have gone out of business at some point during the last decade.

The list does not include the recreational vehicle makers that we usually include with the truck and bus manufacturers -- companies like Thor Industries Inc.; Winnebago Industries Inc.; and Spartan Motors Inc. that nobody would think of as "homebuilders." But it does include a few manufacturers of prefabricated homes, such as Cavco Industries Inc.; Skyline Corp.; and Nobility Homes Inc. So it's not exclusively a list of site-built home construction companies.

This group was extremely hard-hit by the recession, which is obvious from just a glance at any of the industry's warranty metrics. But unlike the passenger car business, which recovered after 2009, the homebuilders are still waiting for the good old days to return.

Declining Claims Cost

In Figure 1, we're tracking claims paid per quarter for the 47 quarters between the beginning of 2003 and the third quarter of 2014. One can see a rapid decline from 2006 to 2009, but then the totals get lower in 2001, and again in 2012 and 2013. Things are looking up in 2014, but the industry still hasn't topped the $100 million mark since 2010.

Figure 1
New Home Builders
Quarterly Claims Paid, 2003 to 2014
(in Millions of U.S. Dollars)

Figure 1

Maybe that's a good thing? Maybe the houses are so good that there's no need for warranty work? If only that were true. The reality is that repairs are less frequent because sales are still depressed. For the top 14 homebuilders that we track in detail, unit sales of homes are up significantly from the depths of 2009-2012, but they're still not back to 2008 levels, and are less than half the size they were during the peak years of 2005 and 2006.

There is growth, however. These top 14 homebuilders have closed on 91,000 homes so far this year, up 6% from 86,000 units sold in the first nine months of 2013. And their claims payments are actually rising a bit faster. For the first nine months of 2014, all the builders paid $278 million in claims, up 18% from 2013 levels.

Accruals Proportional to Sales

Warranty accruals, however, are rising at more or less the same pace as sales, as they should. For the first nine months of 2014, homebuilders set aside $248 million in warranty accruals, up about 8% from the same period in 2013. However, as we can see from a quick glance at Figure 2, it remains to be seen whether the accrual total for the fourth quarter of 2014 will be large enough to surpass 2013 levels.

Figure 2
New Home Builders
Quarterly Accruals Made, 2003 to 2014
(in Millions of U.S. Dollars)

Figure 2

Again with this warranty metric, it's clear that there was a massive contraction from 2005 to 2009. And again, there's been a slight recovery in the last year or two. But the industry is still far below its peak years of 2005 or 2006.

Fortunately, all the homebuilders report not only their warranty claims and accruals, but also the number of homes they have sold. Typically, there are a few months at least of lag time between when a home is sold and when it needs some warranty work. But there should be no delay between the time a home is sold and the moment the seller sets aside enough accruals to pay for the expected amount of warranty work.

In other words, there should be no difference between the time a home is sold and the moment an accrual is made. So accruals and sales should rise and fall in proportion to each other, unless something else changes, such as the predicted cost or frequency of repair work.

And that is about what we see happening in the homebuilding market. Unit sales are up 6% and accruals are up 8%, which means slightly more accruals per unit this year than last. As we shall see in Figure 5, that is exactly the case.

Warranty Reserve Totals

But first, let's finish out the charting of the reported warranty expenses. The accruals go into a warranty reserve fund, where they remain until they're spent on warranty claims. In Figure 3, we've charted the end-of-quarter balance in the reserve funds of all the homebuilders on our list.

Again, the peak came in 2006, as expected, but the trough is much later than one would have predicted. From mid-2012 to early 2013, the balance sat around $625 to $630 million, before staging a mini-recovery to its most recent level of $719 million. And that brings it back to where it was in early 2011.

Figure 3
New Home Builders
Quarterly Reserves Held, 2003 to 2014
(in Millions of U.S. Dollars)

Figure 3

In pictures, these three charts illustrate what's happened to the U.S. housing market. It started declining before the recession officially began and it kept declining after it was allegedly over. And in what were supposed to be years of recovery, it just sat there at depressed levels. Sure, the totals are now rising again, but let's not get carried away and call it a boom.

In Figure 4, we've taken the claims and accruals from Figures 1 and 2 and divided them by home sales revenue totals. It is important to note that we did not include any finance revenue, nor did we include any sales of land only. So it's really a comparison of new home claims and accruals to new home revenue.

Mold & Drywall Expenses

The most noticeable feature of the chart is the rise in the claims rate from 2007 to 2010, followed by its decline from 2010 to 2012. There are two reasons for it: First, because of the lag time between sales and claims, the builders were fixing last year's sales with this year's money, and there was far less money because of plummeting sales figures. Second, there were some genuine and unexpected repair expense increases related to mold and drywall odors that had to be handled in that time period.

But also notice how the accrual rate, in green, remained within that range of 0.8% to 1.1% for almost the entire period. That's because the builders set their accrual rates based upon the expenses they expect, leaving the unexpected to be dealt with through changes of estimate that aren't included here. And their accruals are based upon the homes they sell, so the rate should remain the same even if unit sales fall.

Figure 4
New Home Builders
Claims Paid & Accruals Made as a
Percentage of Product Revenue, 2003 to 2014

Figure 4

The good news is that the 0.7% claims rate and 0.6% accrual rate calculated for the third quarter of 2014 are the lowest ever, edging out the previous low marks set during the third quarter of 2013. So even if sales aren't swift, at least expense rates are low, which means that the homes that are being sold aren't costing as much as they used to.

There are only two industries where both the unit sales data and the warranty expense reports are detailed enough to allow us to calculate the amount of warranty expense predicted for each product sold. And those are the passenger car industry and the homebuilding industry. We covered the car industry in the July 17 newsletter and followed it up a week later in the July 24 newsletter with a look at the homebuilders.

We'd now like to add six months of data to the latter report. In July we had only the first quarter's totals; now we have the nine-month figures. And what we've found is that the top homebuilders are sticking very close to a level of $2,500 in warranty accruals per new home sold, though new home prices are actually rising a bit.

Definition of a Sale

Figure 5 takes the accrual totals from Figure 2 and divides them by the number of homes sold per quarter. However, each builder uses slightly different wording to describe this metric in its financial statements. D.R. Horton, Shea Homes, William Lyon Homes, and Meritage Homes call them "homes closed." KB Home, Hovnanian Enterprises, and M/I Homes call them "homes delivered." Toll Brothers uses multiple terms, including "settlements," "closings," and "units delivered." Lennar Corp. calls them "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. PulteGroup Inc., Beazer Homes, and the Ryland Group Inc. simply call them "closings." NVR Inc. simply calls them "settlements."

In Figure 5, the accrual rate per home sold is in blue and follows the left-hand axis, while the accrual rate per dollar of revenue is in green and follows the right-hand axis. The latter is the same as the accrual data in Figure 4. But the per-home data is new.

Figure 5
New Home Builders
Accruals Made per Home Sold, and as a
Percentage of Sales Revenue, 2003 to 2014

Figure 5

Note that while the average accrual rate per home sold has oscillated around $2,500 from 2007 to 2013, it has remained right on that line for the first three quarters of 2014. Perhaps what we used to think was seasonality was instead merely bad aim? And perhaps what we're seeing now is more precision and better predictions? In other words, perhaps the homebuilders now have enough data about repair rates and cost in hand that they can make precise estimates of how much each home's warranty coverage will cost them?

Only time will tell. There have been other periods where the accrual rate per home sold remained about the same for multiple consecutive quarters, but then the oscillations returned. Even last year, the average accrual rate fell to $2,200 per home before it shot up to $3,400 per home. So let's wait and see if the recent flatness is the beginning of a trend, or merely a reprieve between spikes.

Precision & Consistency

There are reasons to believe that some of these builders are becoming more precise as they gain more experience with warranty management, but there is also some evidence that not every builder is constantly reducing and stabilizing its warranty expenses. It just so happens that D.R. Horton and Beazer Homes are the only two of the top 14 homebuilders that end their fiscal years in September, so in Figure 6 we've charted them both. And this chart supports the argument that some homebuilders are getting more precise about choosing the right level of accruals.

Figure 6
D.R. Horton & Beazer Homes
Accruals Made per Home Sold, 2003 to 2014

Figure 6

Once upon a time, way back in 2005, Beazer Homes set aside almost $15,000 in accruals for every home it sold. Sales were normal enough, with 3,600 homes closed during the first quarter of 2005. But for some reason the company accrued nearly $54 million that quarter, which was about $40 million more than it usually did. The result was that tremendous spike you see in Figure 6.

During two quarters in 2006 and one more quarter in 2007, Beazer made absolutely no accruals, while at certain points during 2008 and 2009, it set aside only a few hundred dollars per home sold. But then beginning in 2010, it suddenly achieved serenity and wisdom, and for five years running its accrual rate per home sold has been somewhat stable.

Compare and contrast that record with D.R. Horton, the ultimate in composure when it comes to warranty expenses. For 12 years running, the company's accrual rate per home has never been much above $1,200 nor much below $900, except during 2006, when it rose all the way to $1,700.

It just so happens that Beazer and D.R. Horton now accrue almost the same amount per home. As of September, Horton was at $1,250 while Beazer was at $1,400. At one point in 2013, they were within $20 of each other. But the main point is, Beazer seems to have now learned how to keep its accruals stable, while Horton always knew how to do it.

Rising and Falling Accrual Rates

Meanwhile, of the dozen other major builders, we selected to include MDC Holdings and KB Home in Figure 7 for one reason: they're seeing the greatest recent changes in their accrual rates per home. MDC Holdings has reduced its accrual rate dramatically, while KB Home is now seeing a slow but steady rise in its accrual rate.

Figure 7
MDC Holdings & KB Home
Accruals Made per Home Sold, 2003 to 2014

Figure 7

As the chart illustrates, MDC Holdings let its accrual rate per home climb as high as $5,700 back in late 2005, but it has been all downhill ever since. Its accruals passed the $2,000 level in 2010 and briefly dropped below $1,000 per home in 2010 and again in 2012. So far this year, its accrual rate per home has remained within a tight range of $1,050 to $1,150 per home.

Meanwhile, KB Home has seen its accrual rate per home climb as high as $4,900 (in 2006) and as low as $0 (in 2007). After another spike in 2009, though, it managed to keep its accruals per home relatively stable, around the $900 level, for most of 2010 and 2011.

Then in 2012, its accrual rate per home began to rise. And it hasn't stopped rising. It rose above $1,000 at the start of 2012, and passed $2,000 in 2013. In the quarter ended August 31, 2014, KB Home's accrual rate per home was $2,535, based on 1,793 home sales and $4.5 million in accruals. It's not a worrisome level, but it is above the industry average.

Of the top 14 builders, six were below and eight were above the industry average of $2,470 per home in the third quarter of 2014. In the second quarter, it was seven and seven, with KB Home below the line. So it is significant that KB Home has seen its accrual rates rise above the industry average.

Warranty Expense vs. Average Selling Price

Of course, what we haven't mentioned is the average selling price of the homes. Some of these companies are selling luxury homes priced at $750,000 and up, so three or four thousand dollars in warranty expenses is still a relatively small amount. Then again, some of these companies are selling $300,000 homes that accrue $5,000 in warranty expenses, and that is not a good combination.

Among the luxury-priced home builders, Ryland has below-average accruals while Toll Brothers, Shea Homes and William Lyon Homes have above-average accruals per home sold. And then among the ten builders whose homes are priced close to $300,000 per unit, five have below-average accruals (MDC; Horton; Beazer; M/I Homes; and Meritage) and five have above-average accruals (KB Home; PulteGroup; Lennar; NVR; and Hovnanian) per home sold.

There are multiple factors contributing to this outcome, but what we're saying is this: Take ten builders selling $300,000 homes. Five expect to spend between $1,100 and $2,000 on their new home warranties, while five expect to spend between $2,500 and $5,300 per home on warranty work.

That's their own estimates, based upon how many homes they sold and how much they set aside in accruals. We're just reverse-engineering their own math, calculating how much they set aside in accruals every time they sell a new home. If their estimates are too high or too low given their actual costs, well, that's their problem.

And then take the four luxury builders. Ryland is setting aside only $1,800 per luxury home sold, while Toll Brothers, Shea Homes, and William Lyon Homes are setting aside between $3,700 and $5,600 per home. And ironically, the one with the highest average sale price per home (that would be William Lyon Homes) is not accruing the most money per unit sold. Instead, that distinction goes to Shea Homes, which typically sets aside $5,600 in accruals for each half-million-dollar home it sells.

In diplomatic language, what we're saying is that while the luxury homes do require more accruals than the typical $300,000 unit, there is quite a spread even within those two categories. For instance, MDC, NVR and Meritage sell similarly-priced homes. But MDC sets aside only $1,100 in accruals per unit sold, while Meritage sets aside $2,000 and NVR sets aside $3,700.

And that implies that there is a quality difference, or perhaps a difference in regional labor rates, weather conditions, the cost of materials, or the frequency of repair. Two units priced the same can have very different predicted repair costs over the lives of their warranties. And that information won't be in the sales brochures.

Happy Holidays!

Next Thursday is Christmas Day and the Thursday afterwards is New Year's Day, so Warranty Week will be taking a two-week break, returning with our next newsletter on January 8, 2015.

Incredibly, this is the thirteenth holiday break we've taken since the publication was launched in November 2002. And even more incredibly, there are still about a hundred subscribers among our 7,800 that have been there from the first few months until this, the 577th weekly installment in the ongoing series of weekly newsletters.

And so, for the thirteenth time, on behalf of our editor, our webmaster, and our photo editor, we'd like to take this opportunity to thank all of you for subscribing. We'll be back for another series of newsletters focused on product warranties and service contracts on January 8. Until then, we wish all our readers a happy holiday and a healthy, safe, and prosperous new year!

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