Last Updated: June 4, 2008: 7:34 AM EDT
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Downsizing the American home (page 2)

By Shawn Tully, editor at large

During the bubble KB lost its way. Building big, pricey homes wasn't a mistake- that's what the public wanted. The real problem was that management misread the future: It bought the illusion that the frenzy would last, and gorged on overpriced land. Management's grandiose thinking also pushed KB into splashy new businesses far from its traditions. KB began in 1957, when Broad, then 23, recognized that he could lure legions of first-time buyers from their Detroit garden apartments if he could build houses more cheaply than his competitors. His rivals were erecting classic houses with basements. Broad saw basements as an anachronism: Homeowners no longer needed cellars for storing coal. So his new company, Kaufman & Broad, erected houses on a concrete slab and used part of the savings to offer his suburban commuters a popular new feature, the carport. Broad's $13,700, three-bedroom starter homes carried the same monthly cost as a two-bedroom rental. "It was all about affordability," says Broad, "just like it is again today." By the early 1960s Broad had moved Kaufman & Broad to California and expanded into the thriving Sunbelt markets that, along with the Golden State, are still KB's main turf, chiefly Arizona, Nevada, North Carolina, and Florida. Then as now, KB built not only starter homes but also their cousins, inexpensive houses for customers moving up.

Market forces were partly to blame for KB's detour in 2005 and 2006. Builders could sell all the $400,000 homes they wanted, and the margins on those McMansions were a lot fatter than on small houses, chiefly because they could build them on virtually the same small lots as the old-fashioned starter houses. Still, some of the blame for KB's losing its way belongs to the CEO who succeeded Broad, his protg Bruce Karatz.

Karatz led a high-profile life. He was married to the Food Network's Sandra Lee, was a regular in a skybox at L.A. Lakers games, and earned more than $40 million in fiscal 2005, ranking among America's highest-paid CEOs. Karatz launched a division to build high-priced urban condos and hotels in downtown L.A. Martha Stewart designed a special line of premium homes for KB: Her clapboard Katonah model, featuring colonial columns, dormers, oval windows, and transoms, sold for an un-KB price of $500,000 at the peak in Houston.

In Karatz's defense, KB was profiting wildly from the expensive houses it was building, and in 2005 the CEO predicted sales would double to $18 billion by 2008 (we'll get to the actual number in a minute). But a year later Karatz was forced to resign, the victim of a stock-options backdating scandal. (Karatz declined to comment for this story.) To calm investors, KB's board brought in Stephen Bollenbach as the new chairman. Bollenbach (who's a board member of Time Warner (TWX, Fortune 500), Fortune and's parent company) arrived from a tenure at Hilton Hotels that culminated last year in his selling the company to the Blackstone Group for an astounding $26 billion.

In November 2006, KB also promoted its longtime COO, Jeff Mezger, to CEO. In contrast to the flashy Karatz, Mezger is a brick-and-mortar operator. At 10 years of age, Mezger was attending planning-board meetings with his father, a Chicago homebuilder. His obsession is to make homes affordable but still offer features that sharply distinguish KB houses from the competition's. Jon Georgio, a landscaping contractor, recalls working with Mezger in the depressed market of the early 1990s in Antelope Valley, 40 miles north of L.A. "All the other developers were seeding front lawns, so the lots looked messy and unfinished while the lawn was growing," recalls Georgio. "Jeff insisted on sodding all the lawns to get a lush green look." By giving the landscaper lots of lawns to fill, Mezger persuaded Georgio to supply sod for close to the same price as seed. The gambit worked. "Jeff found a way to sell dozens of houses when few other builders were selling," says Georgio. The landscaper is quick to caution that Mezger can be a hoot outside the office: He's the proud owner of a 1963 Corvette and hosts Georgio for karaoke duels at his Bel Air home.

A strong balance sheet

It was Mezger who shifted KB's focus back to the customer who built the franchise, the first-time homebuyer. His coup was making the turn to affordability before such competitors as Centex (CTX, Fortune 500) and Ryland Homes (RYL). "By late 2005 we could see credit was tightening and investors were no longer buying," says Mezger. So he pitched his strategy toward producing the old KB product. "We needed to build houses priced for the median incomes of our communities," says Mezger. "We got away from that in 2004 to 2006." He also strove to build big financial reserves to provide KB with the staying power to weather the stricken market, for several years if needed. Hence, KB sold off huge landholdings and thousands of homes at a loss. In the fiscal year that ended in November, it posted a deficit of $929 million on $6.4 billion in sales, about a third of what Karatz predicted just three years ago.

KB is booking those losses because it's been selling homes and lots at well below the amount it spent to build or buy them. But it put out that cash years ago. Now Mezger is building fewer homes and acquiring less land than in the past. So despite the accounting losses, KB is taking in far more cash than it's putting out. As a result, it has increased its cash hoard from $700 million to $1.3 billion and has reduced debt by almost $1 billion, or 33%, in the past 18 months. "KB has one of the strongest balance sheets of any homebuilder, and the resources to get through the downturn," says Jay McCanless, an analyst with brokerage firm FTN Midwest Securities. Gone, too, are the noncore projects of the Karatz years. The new boss has dumped the corporate jet, and the annual report is a stapled SEC filing. "Who needs fancy pictures in this kind of a housing market?" he asks.

Mezger's back-to-basics approach depends on two variables beyond his control: land prices and labor costs. In Jacksonville, for example, the price for finished lots with roads and utilities in place tripled from $25,000 to $75,000 between 2002 and 2006. KB couldn't make money building its old staple and had to build big. By 2006 KB's median price in Florida had jumped from $180,000 to $270,000, and the size of its houses had ballooned from 1,800 to more than 3,000 square feet.

Today both land and construction costs are falling rapidly. In California's Inland Empire, the price per finished lot has collapsed, plunging from $150,000 at the peak to about $50,000. Labor costs, the single biggest expense after land, are also dropping as construction trades look for work. In Florida, construction costs for a 2,000-square-foot home have dropped to $80,000, vs. $100,000 at the peak, a 20% reduction. The result is that the average sales price there has fallen from $275,000 to $215,000. In the inland areas of Southern California it has dropped from $350,000 to $260,000. Additionally, KB is cutting costs by assembling homes from prefabricated 12- and 16-foot panels that are hoisted into place with cranes. That wasn't possible when buyers coveted fancier houses with custom elements.

So if those first-timers who sat out the era of the McMansions and the McMortgages start buying these modest homes, Mezger may go down in the annals of real estate as the man who saved The House That Eli Broad Built. He'll also need to expand his crooning repertoire. On karaoke nights, he usually caps the evening by singing "Unforgettable." Since his music collection harks back to the 1930s, investors are hoping that he may soon be singing another classic: "We're in the Money."  To top of page

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