With housing sales soaring, homebuilders are the toast of this year's FORTUNE 500--and none is riding higher than luxury specialist Toll Brothers. But what happens when there's a slowdown?

(FORTUNE Magazine) – No. 477

On a recent Monday evening in suburban Philadelphia, two dozen sober-suited executives huddle around a giant conference table for the weekly "ops" meeting inside the nerve center of Toll Brothers, the hottest homebuilder in America. As another half-dozen division heads join the conversation by satellite, the group begins wrestling with brick-and-mortar matters such as how many digits to include in the codes for custom options that distinguish, for example, butterfly staircases from Palladian kitchens. Suddenly co-founder and CEO Bob Toll bursts in and starts firing questions at his brain trust: Are local managers doing enough to deter the buy-and-flip crowd? Are rival builders throwing up houses without signing up buyers first? His lieutenants reassure the boss that their customers are bona fide primary- and vacation-home owners who just keep coming, and that speculative building isn't widespread. Finally, with his paranoia assuaged, Toll allows himself to do what he loves best: ratchet up prices.

Over the past half-decade this veteran builder's weekly strategy session has evolved into a kind of ritualistic celebration of the boom going on in the U.S. housing market. Every Sunday, his company's divisions e-mail Toll, his top brass, and other managers the sales figures for each of his 220 developments around the country. After digesting the data, Toll himself makes the final decision on whether to raise home costs. On this night he's so confident that people will keep buying that he lifts the prices on projects in Florida, Las Vegas, and other markets by 1%. That amounts to about $10,000 for each house over the list price from the previous week. It's nothing new; he's been hiking prices Monday after Monday. At Toll's Frenchman's Reserve community in Palm Beach Gardens, the price of a Florida rococo confection called the Signature has jumped $200,000 just since January, to $1.4 million. That's an average increase of $15,000 a week. "People just keep buying anyway," Toll marvels. "I've never seen anything like this in almost 40 years in the business."

This year Toll Brothers is one of four homebuilders--Hovnanian, MDC, and Beazer are the others--joining the FORTUNE 500 list, a testament to the industry's historic growth. And the prosperity has been passed along to shareholders. Indeed, judging solely from the arc of their stock charts, today's homebuilders are reminiscent of the tech stars of the 1990s. In the past five years, the 11 builders in the FORTUNE 500--including national powerhouses like D.R. Horton, Lennar, and Pulte--have multiplied their share prices eightfold. In this year's FORTUNE 500, homebuilders rank first among all industries in five-year return to investors, handing their shareholders a stunning average annual gain of 51% since 1999.

But the homebuilders are very different from yesterday's technology highfliers. While Internet and telecom companies with tiny profits were rewarded with astronomical price/earnings multiples, the homebuilders are getting exactly the opposite treatment. They're posting huge profits, yet based on this year's projected earnings, they have a puny average P/E of just eight, or less than half the S&P average. That's not a new development. A high degree of skepticism has kept the homebuilders trading at discounted valuations throughout their run over the past few years. Investors who have been burned in past housing booms keep expressing disbelief that the industry can continue to scale new heights. Meanwhile profits keep swelling.

Perhaps no single operator has benefited more from the real estate mania than Bob Toll. In a decade he has transformed an obscure regional builder anchored in the Northeast snowbelt into a national player with revenues running at $6 billion a year and a powerful presence everywhere from South Florida to Las Vegas. Today Toll, who owns over 13% of his company's stock, is worth more than $1 billion in shares and in-the-money options. An outspoken, frequently abrasive leader who, with his cacophonous wardrobe and mustache bears a striking resemblance to Groucho Marx, Toll is, in the words of an industry insider, "a strange duck who antagonizes as many people as he charms." He's also probably the cagiest operator in the housing game. Even rivals acknowledge the masterful touch behind Toll Brothers' rise. "In two years Toll Brothers went from nowhere to being the top player in the top end of our market," says Perry Di Loreto, a competitor in Reno. "They've done the same thing in a lot of places. In no time, they've developed tremendous name recognition."

Toll has built its reputation by mass-producing the most expensive houses of any major builder in America: Right now Toll Brothers' offerings are selling for an average of $664,000, more than twice the $250,000 that big rivals charge for their homes. Though Toll Brothers ranks 11th among the fraternity in total sales, it now stands shoulder to shoulder with NVR, another luxury homebuilder based in Virginia, as the most profitable player in the business. Its return on sales runs at more than 11%, leagues ahead of the industry average of 8%. Small wonder, then, that since the beginning of 2004, Toll Brothers has been the hottest stock of any builder in the FORTUNE 500, jumping over 90% to $77 per share. The good times are bound to keep rolling--at least for a while. In its fiscal 2005, which ends in October, Toll is predicting a 60% jump in profits to around $640 million. Since it's selling houses today for delivery in 9 to 12 months, that number's in the bag.

But can this magical market really defy gravity much longer?

Shockingly, despite his paranoid questions and years of hardscrabble experience, Bob Toll's answer to that question is a resounding yes. For Toll, what looks to many people like pure craziness is perfectly normal, a reflection of a new supply-and-demand equation that will last a long time. He's an outspoken believer that, yes, the world really has changed this time. That the traditional boom-to-bust housing cycle is now a smooth upward climb. That housing prices will keep rocking practically, well, forever. "We'll reach the point Europe reached 20 years ago, where families pay 45% of their income on housing and married couples have to live with their parents for years before they can afford houses," he says. "Prices will keep going up in double digits for years." Toll is a bit worried about overheating in Las Vegas and Phoenix and predicts a near-term correction before those markets surge higher.

What convinced this hardened veteran that the real estate cycle is mostly dead? "Look at what happened in San Francisco in 2001 and 2002, when the area lost 100,000 jobs," says Toll. "Prices fell, yet 12 months later, they hit new record highs. Today a down cycle means that only two people want to buy your house instead of ten." Toll believes that even when demand ebbs somewhat--and he doesn't think it will fall much--housing will stay strong because of a fundamental structural change in the market, what he calls a tremendous restraint on supply. "Towns don't want anything built," says Toll. He says that they're obsessed with what he calls NIMBY, or "not in my back yard," politics. In other words, suburban homeowners want the farm fields across the street left in soybeans, not chock-a-block with Colonials on cul-de-sacs. "The towns and counties are running an oligopoly for us!" exults Toll. "If the builders could get together and do what NIMBY politics is doing for us, we'd be prosecuted for antitrust violations!"

Toll argues that even with increased construction in some markets, the flow of new houses won't keep up with the ferocious demand that is a natural outgrowth of demographics. He points to the 80 million baby-boomers who are reaching the prime age for moving up to fancier homes and securing their havens for retirement. Over a ten- or 20-year period, the demographics do indeed favor the homebuilders, especially ones like Toll, whose sweet spot is the kind of splashy house the well-heeled boomers covet.

But how to reconcile the cautious attitude of many industry experts with Toll's brash predictions? And what happens to his company if his analysis turns out to be wrong? Fortunately for investors, Toll doesn't act the way he talks. The colorful character is a conservative manager at heart. And while no homebuilder is doing more to squeeze profits from the boom, no company is likely to navigate a downturn with greater skill. The reason is that Toll has constructed an organization with a level of specialization and efficiency that is unmatched in the business.

Bob Toll, 64, grew up in suburban Philadelphia and graduated from the University of Pennsylvania law school in 1966. He founded Toll Brothers on a shoestring in 1967 with his brother Bruce, who served as COO until seven years ago. On the company's first project, Bob busied himself by gathering discarded nails and lumber from all over the job site, then carrying the materials back to the framers to save money. These days Toll, a passionate opera fan, adorns the walls of his 18th-century farmhouse with art by Hopper, Monet, and Picasso. But he has never forgotten that his father, a real estate investor, lost everything in the Depression. "Somehow he thinks he could still lose it," says Steve Solms, a retired developer who's a close friend.

Toll has built his business on three strong pillars, and the first, not surprisingly, is financial discipline. He will buy land only if a development will prove profitable at today's home prices; he doesn't bake any appreciation into his analysis. He also hasn't lost his instinct for chopping expenses in tough markets. Toll promises that if the market turns, he'll lay off most of the 200 MBAs, lawyers, and other aspiring homebuilders in his training program and eliminate many of his construction managers. Their bosses, executives who now supervise several projects, would move down a notch; they'd leave their offices and go to work in construction trailers, building houses. All told, Toll reckons, he could quickly erase $450 million in expenses--about 15% of total costs.

Nevertheless, Toll isn't a slash-and-burn leader. He manages to combine being a demanding, intimidating boss with an ability to keep a loyal team in place for years. His style could be described as Columbo with an edge. He's famous for questioning lieutenants on their land deals with the persistence of a trial attorney. "He says, 'I don't understand, and neither do you. Come back when you figure it out,'" says Walter Meranze, a financial advisor who's a close friend. Toll's top ten managers have been with him an average of almost 20 years. One reason he keeps people is that even if he pushes them into more menial jobs in a tough market, he won't cut their pay. "Once you're at a senior level," he says, "we do everything we can to give you more money. No one has ever gone backwards."

The second key to the company's success is that it remains the best in the business at a process Toll pioneered in the mid-1980s: building luxury houses with the same efficient mass-production techniques that rivals use on low-cost starter homes. He's still the only national builder specializing in that niche. Toll Brothers keeps costs down by designing its homes with as many common components as possible, just as carmakers seek to use the same chassis in multiple models. In framing a house, the key elements are the trusses that support the roof and the panels, a lattice of two-by-fours that forms the walls. Toll manufactures both trusses and panels at two plants in Pennsylvania and a third in Virginia. Its computers custom-cut the panels to place doors and windows in the right spot for its wide range of floor plans. The system doesn't give Toll Brothers the huge scale of a builder of starter homes punching out the same box, but it makes costs far lower than those of custom builders who assemble all the panels on site with a hammer and nails and buy doors or windows in far smaller quantities.

It's the efficient assembly-line building that enables Toll to pocket those sumptuous margins. It doesn't cost too much more per square foot to produce a fancy brick Colonial with a cupola than a ranch-style starter house, about $52 versus $45. Yet America is so in love with luxury that Toll is now charging twice as much per square foot for the completed house.

Do the production houses that Toll's well-heeled buyers snap up really resemble custom homes? Not entirely: The Toll communities, despite their golf courses, parks, and gated entrances that open onto wide boulevards, typically pack houses cheek by jowl into regimented rows. Still, Toll gets a semicustom look by offering an astounding variety of façades, interior finishes, and amenities. In each city, Toll sells at least four different sizes of homes that range from 2,500 to 5,500 square feet. At the Aviano development outside Phoenix, for example, the top-of-the-line houses are called Mesquite and come in no fewer than five floor plans, each of which in turn comes in one of three or four façades. So buyers have a choice of no less than 15 different homes. The list price for the biggest, the Mesquite Mirador, Tuscan-style, is $820,000 and rising.

But the base price is seldom the full ticket. Toll also cleans up offering myriad options, not to mention what it calls "lot premiums," markups for special locations. While Toll himself says he can't understand the appeal of living next to a golf course, he knows that plenty of his customers are willing to pay for the privilege. Golf courses are at the center of 50 Toll developments. Bill Guibor, a retired executive with Williams-Sonoma, paid an extra $200,000 for a spot on the fairway at Toll Brothers' Red Rock Country Club in Las Vegas. Guibor also feasted on high-end options, including cherry floors in the dining and living rooms, marble in the hallways and foyer, and granite countertops in the kitchen and bathrooms. The price for all the upgrades: $400,000.

Toll Brothers' strongest suit, however, and the third pillar of the business, is its skill in buying and managing the basic raw material in homebuilding: land. In the mid-1980s, Bob Toll decided that land was vastly overpriced, so he stopped buying and hoarded cash. When the market collapsed a few years later, he vacuumed up parcels on the cheap, paving the way for Toll Brothers' expansion. Toll prides itself on buying farmland that's zoned for relatively dense development but is completely unimproved and still needs the county or township's approval for everything from environmental regulations to the specifications for streets before a developer can erect the first house. The approval process is getting tougher and tougher. In the late 1980s it took three years on average to get a building plan approved in New Jersey; today it takes six. In Florida the process has expanded since 2001 from one year to 2½.

The tougher the approval process gets, the more Toll Brothers benefits. Bob Toll started off in the most restrictive, antigrowth markets in America--New Jersey and Pennsylvania--and learned how to shepherd projects through years of expensive, exhausting, often contentious review by local governments. Toll relishes the process, because very few parcels are zoned for development in markets like New Jersey and California. When a project does get approved, customers line up to buy the houses--at enormous prices. Toll Brothers is often selling the only new houses in the entire area. "We pride ourselves on buying our lots wholesale," says CFO Joel Rassman. "We have such high margins because we take the land through the whole process. The profit can be the biggest source of earnings."

Other national builders, notably Pulte and Hovnanian, are also expert at getting raw land approved for development. But they're often seeking different parcels than Toll Brothers. In general Toll Brothers wants ground that's near employment centers, in prime locations that can command million-dollar-plus prices for new homes. The other national builders tend to buy land that's cheaper and requires a longer commute, but where $250,000 houses are extremely profitable. For the premium parcels, Toll Brothers' biggest competitors are often local and regional players that also build luxury houses. But Toll Brothers has a major edge over the smaller guys in buying land. "The difficulty of getting land approved is the biggest factor pushing the smaller builders out of the market," says Toll. Indeed, the top 11 homebuilders have gone from a 12% to a 23% market share in just the past seven years. As the land game gets tougher, the giants continue to gain.

When the potential prize is large enough, Bob Toll will go to amazing lengths to secure the rights to build. Case in point: West Windsor, N.J., a town near Princeton, where Toll Brothers bought a 300-acre parcel years ago and is only now selling houses. On paper the piece was a prize when Toll Brothers first saw it. The corn and soybean farm was one of the few tracts in the entire region zoned for dense development. But the town was fighting to keep the land undeveloped. It had already defeated the former owner, who went bankrupt after eight years of battling the town fathers. But Bob Toll thought he saw a gold mine. In 1992 he bought the land for $7 million.

The township didn't exactly warm up to Toll Brothers right away. A new mayor won a landslide victory running on a one-issue platform: "Stop Toll." The day after the election, Toll Brothers sued. The case took almost ten years. But in 2002 the New Jersey State Supreme Court decided that Toll had the right to build 1,165 homes and apartments on the site. And The Estates at Princeton Junction became virtually the only place for people in the booming Princeton area to buy a new single-family house. The project is within biking distance of the Princeton Junction train station, where commuters wait up to four years to get a reserved parking space. When the project opened for sale in late 2002, 5,000 people went on the waiting list. FORTUNE reckons that Toll Brothers is building the houses in West Windsor for an average cost of about $350,000, including land, and each house is generating a profit of around $200,000. That's a margin of more than 50%. Total profits should top $100 million.

Toll has rewarded himself for such spectacular returns with an extremely generous pay package. His bonus is calculated on a complicated formula based on both pretax profits and the stock's performance. For fiscal 2004, Toll pocketed a bonus of $30 million--and it would have been $50 million if he hadn't requested that the board adjust the over-the-top formula to something more reasonable. This year his bonus, with the formula adjusted downward again, is likely to hit $29 million. Does Toll think it's fair that he's making more than Jeffrey Immelt of GE or Michael Eisner of Walt Disney? "I deserve it," says Toll. "Look at all the value I've created for shareholders!"

Amazingly, for a manager who usually watches every detail, Toll doesn't seem to know exactly how he's being paid. "If I don't raise profits at least 10%, I get no bonus," he told FORTUNE. "See if Eisner would take that!" When this reporter suggested that isn't what his plan says, Toll said he had to confirm the details and immediately got CFO Rassman on the line for a conference call. Rassman said that the boss was incorrect about the 10% requirement. In fact, if earnings don't rise at all this year and the stock price tanks, Toll will receive a bonus of $14 million. "That kind of pay bothers me," says analyst Greg Gieber of AG Edwards. "See if he doubles market share in a down cycle, then give him a big bonus."

Toll, of course, is not anticipating a downturn. But even with his prime property holdings in restricted markets, Toll is vulnerable to a slowdown because of a basic weakness in his bullish argument: The pace of today's buying is so crazy, so far above any sustainable long-term trend, that it can't last. This year housing starts are running at an annual rate of 2.2 million, and all the houses are selling. That's a buying rate that's 34% above the already heady pace set back in 1999. A pair of special, one-time factors are pushing Americans to acquire houses far faster than they normally do. First, people are rushing to buy before fixed mortgage rates rise sharply, which seems inevitable now that the Fed is raising short-term rates. Second, Americans simply think that real estate is a better investment than stocks, bonds, or just about anything else--and for the past few years, it has been. So they're putting more of their nest eggs in houses. "A lot of the demand is coming from this portfolio shifting," says Gieber. "Say a homeowner buys a much bigger house, so that the percentage of assets they have in real estate goes from 40% to 60%. That's a one-time increase. It won't go from 60% to 80%. If the family gets pessimistic about housing, they will stop trading up."

Contrary to what Toll says, the best bet is that within the next couple of years, today's galloping demand will fall back to a more normal trot. Toll Brothers won't be immune from that downturn. "We know from past cycles that tough markets hit everyone, including high-end builders like Toll," says Ken Rosen, an economist at the University of California at Berkeley. The best bet is that Toll Brothers' volumes and margins will drop starting late next year or in 2007. Still, it's probable that the company will fare better than its competitors. And the outlook across the deep valley that looms ahead is excellent.

Meanwhile Toll continues to look for every angle that might give him a competitive advantage--or allow him to charge extra for the houses he sells. It turns out that the West Windsor project near Princeton is popular with a lot of Asian-American buyers who work in the area's high-tech corridor. And Toll Brothers has found that one of their main concerns is buying homes with façades that face east or south so that the house will have the best possible feng shui, or good luck brought by the spirits. Does that mean Toll Brothers will soon be charging special lot premiums for eastward facing homes? "Why not, if that's what tickles your bippy!" bellows Toll. "One man's feng shui is another man's golf course. I think feng shui is worth a lot more."