Downsizing the American home

During the housing bubble, KB Home priced out first-time homebuyers by building bigger. Its new, more modest model provides a glimpse of what the return of the housing market may look like.

By Shawn Tully, editor at large

(Fortune Magazine) -- In the history of real estate there are a handful of legendary homebuilders - William Levitt, who created Levittown on Long Island, being one, and then there's Eli Broad, who became a billionaire building tract homes throughout the Midwest and Southern California.

Surrounded by the famous Jasper Johns series "The Seasons" in his office 11 floors above Los Angeles' Wilshire Boulevard, Broad does not miss much. The 75-year-old real estate pioneer has seen bull and bear markets, and in recent years he watched as the company he founded (and cashed out of so he could focus on philanthropy) lost its way. During the bubble, KB Home (KBH, Fortune 500), like many other big builders, blew up its old-line business by going ritzy and building expensive houses. Now KB is among the first homebuilders to recognize the error of its ways, and it is returning to its roots as a purveyor of low-cost, smaller homes. In some cases KB is even using the same façades from the go-go years and then shrinking the house that lurks behind them to be half as deep - and about half as expensive. "If I had to write a headline for housing, it would be back to basics," says Broad. "The right thing to do is just what KB is doing: build starter homes that compete with rentals."

KB's recovery plan is not just a tale of two houses. It is a tale of two CEOs. During the bubble Bruce Karatz, a flamboyant marketer, believed that the public's hunger for McMansions would keep the good times rolling for years to come. It was his successor, Jeff Mezger, a hammer-and-studs operator, who recognized that the world had gone mad and steered KB back to first-time buyers. That strategy shift may prove to be a primer on how the housing market rejuvenates itself after a boom and a bust.

When owning is as cheap as renting
When the real estate market comes back, it will not be with a sonic boom. It is likely to be subtle, below the public's radar. The revival will probably begin in the areas hit hardest by the bust: in Florida, Las Vegas, and the honeycombed tracts that flank the broad freeways east of Los Angeles known as the Inland Empire. (Indeed, home sales in Southern California surged 22% from March to April, hitting their highest levels since August.) Why will housing come back? For a reason as solid as floor joists: The entry-level buyer, for the first time in years, is finding that owning a new house is suddenly just as cheap as renting. "Those first-time buyers got locked out by high prices," says John Karevoll of DataQuick, a research firm that assembles data on the U.S. real estate market. "Now the buying activity that was on hold is starting to come back."

In hindsight, the reason for the current malaise is simple: too few buyers. By 2007 more and more people were frozen out of the market - especially the entry-level buyers, who now account for as much as 30% of new-home sales. They're the twentysomething young professionals who rent until they get married or the first child arrives, and then reach for the American dream of homeownership. From 2005 to 2006 some first-timers rushed to purchase homes they couldn't afford with the help of exotic loans. But another big group of young consumers steered clear and are finally looking to buy. Now that prices of new houses have fallen as much as 30% in areas including the Inland Empire and the outskirts of Phoenix, they are returning- prompting a turning point in the housing cycle. Call it the New Affordability.

Three factors are driving the New Affordability: housing prices, house size, and the government's expanding role in the mortgage market. The experience of Richard Murkey, 28, and his wife, Kayla, 25, epitomizes the trend. The Las Vegas residents started shopping in 2006 but couldn't remotely afford the $300,000-plus prices that modest houses were fetching at the height of the frenzy. "Then, in the middle of 2007, we saw prices dropping, so we started looking again," says Richard, who sells safety products to construction sites. In January the Murkeys went to contract on a four-bedroom, Tuscan-style house at $246,000, more than $50,000 less than that KB model sold for 18 months before. It gets better. KB Home offered a program called "price protection" that guarantees that if the price of your model falls before the closing, KB will lower your price to match it. Result: The Murkeys got a discount that dropped the price from $246,000 to $213,000.

Nor was financing a problem. The Murkeys obtained an FHA-insured loan at under 6%, with a down payment of just 3%. Their mortgage, taxes, and insurance total $1,400 a month, a mere $200 more than the rent they were paying on their three-bedroom apartment. The FHA's role is something that housing bears have mostly overlooked: The FHA, Fannie Mae, and Freddie Mac are now guaranteeing more than 90% of loans to first-time homebuyers. The FHA is providing lending that the private market has stopped making to borrowers with blemishes on their credit records. Both the rates and down payments are extremely low.

Today seven in ten KB customers are getting financing from the FHA. The current rates are below 6%, more than 100 basis points under those on jumbo mortgages not backed by the FHA or Fannie Mae or Freddie Mac. (Fannie and Freddie lend less readily to people with past credit problems and hence aren't as crucial to the entry-level market as FHA financing.) Congress has raised the FHA limit to $729,750 in high-cost areas like Los Angeles through the end of 2008. But even if the limits aren't extended, virtually all the houses KB sells are priced for an FHA loan.

The houses themselves are being radically downsized to meet buyers' budgets. At the peak of the last boom, in 2006, KB's customers craved cathedral ceilings, formal dining and living rooms, and fancy wrought-iron railings on windows and balconies. Today's buyers, KB found, are willing to trade size and amenities for far lower prices. But they're extremely specific about what they want to keep. Buyers welcome houses half as big as the models that reigned at the peak, as long as they offer plenty of bedrooms. They also don't miss the formal living and dining rooms if KB provides a "great room" combining the two in one open space that includes a generous-sized kitchen.

Bargain-hunters are drawn to these small houses, which look just like the behemoths built in 2005 and 2006. In Beaumont, a community of tract homes 70 miles east of Los Angeles, the Seneca Springs community is dotted with 4,000-square-foot, seven-bedroom Mediterranean homes that KB built at the peak. But right next to them the company is erecting new houses with exactly the same 50-foot façades- and a big difference you don't notice from the street: They're about half as deep and roughly 2,000 square feet. Those homes preserve the community's curb appeal by keeping the façades looking similar and sumptuous. But purchasers love that the new homes boast five bedrooms, and they especially appreciate the pricetag: about $220,000, vs. $420,000 for the big neighboring homes built at the peak (and that now sell for around $300,000). Over time this New Affordability may swell the ranks of buyers. "What's been killing the market is people who are waiting to buy or incapable of getting financing," says Jonathan Dienhart of Hanley Wood Market Intelligence, a residential real estate research firm.

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 protégé 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 CNNMoney.com'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."