Betting on the Big Easy
Why on earth has KB Home launched a major building project in the wildly uncertain New Orleans real estate market?
(FORTUNE Magazine) - KB Home's CEO Bruce Karatz is placing a big bet on New Orleans' recovery.
Karatz, like many U.S. business leaders, wrote a hefty personal check for the relief efforts following Hurricane Katrina. But that wasn't enough. Says Karatz: "I decided we were going to rebuild New Orleans." (This is an excerpt from a story in the April 3 issue of FORTUNE. To read the complete story, click here.)
KB (Research) has thrived by adhering to the dictates of rigorous market research. Yet in metropolitan New Orleans -- where some 200,000 homes were destroyed by the storm and subsequent flooding -- there were no reliable ways to measure demand. Nine months after the storm, it's still not clear how many displaced residents will return.
As for those who do, says Ivan Miestchovich, director of the University of New Orleans Real Estate Market Data Center, "a lot of these people aren't going to be able to afford a new home."
Nevertheless, last December KB became the first and only national homebuilder to set up shop in New Orleans. Spurred, Karatz says, by moral obligation, KB established a major unit dedicated to the Katrina-ravaged Gulf Coast, pulling a top regional manager, New Orleans native Steven Davis, out of Atlanta and putting him in charge. Davis has already struck three land deals and says he's working on 40 more.
Karatz won't get pinned down on how many homes KB will build in the region -- "I'm not being evasive, I just don't know yet" -- other than to say it will be "in the thousands" per year. "Anything less," he says, "won't impact people's lives. And that's really our goal."
KB's own board of directors voiced reservations about Karatz's plan when he broached it at a board meeting last October. The CEO calmed the objections, says outside director Luis Nogales, by bringing in the Shaw Group, a well-connected engineering firm based in Baton Rouge, as a 50 percent partner in Louisiana.
That not only trims KB's financial exposure but also adds a powerful political ally to help obtain local building permits. "This is a for-profit venture," Karatz stresses, noting that the Gulf Coast unit should have net profit margins in line with KB's 15 percent average.
Certainly New Orleans is a risk Karatz did not need to take. KB started fiscal 2006 with a record backlog of orders -- 27,000 new homes and $6.7 billion in revenue. Yes, the national housing market has been cooling. In Las Vegas, for instance, the number of homebuilding permits issued fell 5 percent last year. KB itself warned in a February filing with the Securities and Exchange Commission that it might be forced to lower revenue guidance for fiscal 2006 "if the current trends do not improve."
But Karatz says concerns about a housing bubble are overblown, and he's hopeful that KB's new Martha Stewart communities, among other building projects, will offset cooling in Vegas and elsewhere. (Designed with the style maven's input, the first Martha Stewart community just opened in Cary, N.C.)
So far, Wall Street has been supportive of KB's New Orleans efforts. Karatz says he isn't expecting a meaningful revenue contribution from the Gulf Coast until 2007, while upfront costs have been substantial. But, says Friedman Billings Ramsey analyst Craig Kucera, "Bruce Karatz isn't going to go in there unless he thinks he's going to make money."
"I think it's okay," echoes fund manager Sam Lieber, who holds 440,000 KB shares in his Alpine U.S. Real Estate Equity fund. Lieber figures that the upside from KB's being on the leading edge of a New Orleans rebuilding boom outweighs the risk that the city won't bounce back: "I'm actually surprised other builders aren't doing it too."
Building on faith
In New Orleans, where housing demand simply can't be measured, KB is building on faith -- a departure for the homebuilders, whose recent success has been built on data. When the Southern California real estate market crashed in the early 1990s. KB acquired San Antonio-based builder Rayco for $105 million and adopted Rayco's scientific approach.
Not only did Rayco use market surveys to set designs and price points (a novelty at the time) but its houses were built to order, not on spec. The upshot: KB got stuck with fewer unsold homes.
Davis feels strongly that New Orleans is on the verge of a renaissance, pointing to school reforms -- post-Katrina New Orleans has become a charter-school haven -- and the sharp drop in New Orleans's crime rate (many once crime-ridden neighborhoods are empty) as evidence that the area is finally poised to participate in the Sunbelt population boom. It's a view shared by Jim Bernhard, CEO of the Shaw Group, KB's local partner.
Between the money spent on rebuilding and the billions more in federal economic assistance, "the economic opportunities are going to be tremendous," Bernhard says. "As one of Louisiana's biggest employers, I can tell you that the No. 1 difficulty we have is finding qualified workers. Everywhere you look, there are HELP WANTED signs."
But just how much demand for new housing will there ultimately be? Many existing homeowners are in a bind, with mortgages that exceed the value of their ruined homes, and no flood insurance to pay for the damage. If state and federal officials don't come up with some sort of homeowner bailout plan -- Shaw's Bernhard says he has "full confidence" they will -- KB could well be gearing up for demand that never materializes.
Of course, it's just as possible that KB is entering the New Orleans market at the forefront of a land boom not unlike the one that Miami -- Dade County experienced in the aftermath of Hurricane Andrew.
"There's just a tremendous amount of ambiguity," says Rick Haase, general manager of Prudential Gardner Realtors, a major New Orleans realty firm. "We can't find anybody -- no economist, no civic leader, no politician -- who claims to know what the future looks like."
This is an excerpt from a story in the April 3 issue of FORTUNE. To read the complete story, click here.