Builder Incentives and Profits

I saw this interesting note from Lance Lambert. One of his readers noted that they recently bought some homes from Lennar at a steep cash discount. Lennar sold the units for $310,000-$320,000, then gave them $50,000-$60,000 in cash discounts.

This is tricky because it really creates a fake menu price. Though, of course, other buyers are getting incentives, too. Mortgaged buyers pay the menu price, then Lennar’s lending arm gives them a mortgage with a deeply discounted interest rate. If they sell that mortgage to an investor, they are going to get $260,000 for it instead of $310,000.

It’s not so easy to force builders to put a firm dollar value on things like interest rate buy downs. Where those mortgages trade, one could assign a market price to the rate buydown, but it is based on a number of abstractions and expectations, unlike the cash discount. But, basically the same thing is going on. They could just sell the house for $260,000 with a 7% mortgage. The rate buydown inflates the menu price.

The all-cash buyer, which is the most clear and quantifiable example of menu price padding, will be fine. If they sell the houses for $260,000, they won’t be taking a loss. The mortgaged buyer, on the other hand, would be in a tough spot. I wonder if those discounted rate mortgages are generally assignable.

On the other hand, the lender only valued or paid $260,000 for the mortgage, so if the buyer defaults or sells short, the lender doesn’t actually face an unusual loss. (I’m ignoring down payments for brevity’s sake.)

Anyway, this sort of thing is problematic in a market that is about to take a deep turn south, because it adds more losses as defaults and foreclosures pile up.

Add another point to the pile of reasons not to purposefully create a massive housing bust. And it’s another thing that looks like it was a cause of the 2008 crisis, when really the choice of having a crisis in 2008 had many facets that are all predictable things that happen when you choose to have a crisis.

When you create a massive cliff in prices and output, the riskiest actors at, or just after, the peak are always going to look the fool, and look like they caused the cliff, if you’re so inclined to believe it.

In 2006, the Fed was actually trying to reduce residential investment. Then, by the end of 2007, federal regulators started the unprecedented pull back in mortgage access.

The growing use of incentives then was a result of those choices, not the cause of them.

The Fed isn’t interested in slowing down housing construction today and we couldn’t repeat the mortgage crackdown if we wanted to. We aren’t going to have a crisis.

So, what’s going on with these incentives?

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