: ‘We only want to start a home that we know will get paid for when it’s completed.’ KB Home CEO Jeffrey Mezger on his approach to the home-building boom

Housing inventory is circling record lows as the pandemic has kept many sellers from listing their properties. As a result, more people are turning to the market for newly-constructed properties instead.

That’s been a boon to home builders, including KB Home KBH, -1.52%, one of the country’s largest home-construction companies. The company reported quarterly earnings of 83 cents per share for the third quarter earlier this week — an increase of roughly 14% from a year ago, owing to improving housing profit margins. And the company’s net orders were up 27% from 2019, with growth across all the company’s regions.

MarketWatch spoke with KB HomePresident and CEO Jeffrey Mezger to get his perspective on how to sell homes in today’s market and what buyers are looking for. The following conversation has been edited for length and clarity.

MarketWatch: As evidenced by the most recent new home sales report, the market for newly-constructed properties is booming. In your view, what’s driving this growth?

Mezger: So if you go back to the after the financial crash in 2007-2008, we dropped as low as 300,000 starts a year at the bottom. So in a 12-month period, we under-built by 600,000 homes just in one year. And this went on for a decade, and we were slowly increasing production as an industry but the household formation actually accelerated. I’ve seen reports that estimate there’s as much as a shortfall of as much as 4.5 million homes needed right now around the country.

So you have a lack of supply on the new home side. And you now have a lack of supply on the resale side. Because of COVID, people didn’t want to list their home or didn’t want to move right now. And so you have a restriction on the resale supply as well. On a national basis, the new home or the resale inventory is about three months. In many of the markets we operate in, it’s a month. So there’s literally one month’s worth of home sales on the ground.

And you’ve had this building demographic demand as the millennials hit their home-buying years, and you’ve got the Gen Zs now that are right behind them hitting their home-buying years. Between those two cohorts, it’s 170 million people. So you have this wave of demographics coming. And then interest rates hit the floor, all at the same time. And interest rates are incredibly compelling right now for mortgages. And that’s what’s fueling the strength in new home sales right now.

MarketWatch: Some economists have expressed concerns that the rebound in the labor market has slowed — does that color your outlook for the housing market?

Mezger: I think in our view, you’ll see this strong demand run for a while, because of all those dynamics. People go ‘Well, there’s 20 million people unemployed these days.’ And as we’ve looked at the unemployment side of things today, most of the unemployed are at income levels below what our home buyers are at. And those people that have a job today and have good incomes are compelled to be a homeowner. So you have everything aligned for an incredible run on new home sales right now.

MarketWatch: The rising costs associated with lumber and labor have been raised as potential headwinds for home-building sector. Do you agree with that assessment?

Mezger: It’s an interesting give and take. I always observe I would much rather have to worry about controlling cost than worry about whether we can sell a home. And I say that because normally costs go up when demand is very good. And you typically can cover any cost increases with pricing. If demand is not strong, and you don’t have price or you don’t have a lot of volume, typically costs go down at the same time. So they move together.

You’ve heard a lot of the headline noise on labor is tight and lumber costs went through the roof, no pun intended. But for our deliveries in the third quarter, our total cost of build was up 1.5% versus the third quarter of last year. So costs really haven’t moved as much as the news and we are mindful of it and managing to it.

With the lumber cost, that big spike did happen, it was triggered by lack of supply and not that demand was so strong. A lot of the mills shut down when COVID first hit, and are just now getting back online. And if you look at lumber futures, they got as high as $900 a board-foot — they’re actually already back down to $600 and are projected to drop below that. So over the next 60 days, you’ll see lumber rationalized pretty quickly from an extraordinary peak that hit in August. So we monitor that we partner with our contractors and our suppliers and and you just work through it. We actually were able to expand margins in the third quarter and guided on our call, we’re going to expand them again in the fourth quarter.

MarketWatch: The coronavirus pandemic has led some people to move out of cities and into the suburbs. At the same time, you see people leaving markets like California because of high costs or the threat of wildfires. Has this changed where and what you choose to build?

Mezger: The U.S. population has been pretty fluid for four decades in terms of migration and determining where they want to live. We’re seeing a lot of in-migration in Nevada, Arizona, Florida and Texas. It’s the states that are a little more affordable, lower cost of living, and may have a different tax structure than a coastal state. And so those trends have been going on for quite some time. And we take advantage of that.

But we also see within states, for instance, in California, the commuter corridors inland, in northern California that head towards Sacramento, or head down toward Stockton, are very strong right now. And in Southern California the Inland Empire as it’s called — Riverside, San Bernardino — the market is very strong right now. People are moving and in a lot of cases are leaving an expensive apartment near the urban core, lowering their monthly payment and now owning a very attractive home in the suburbs. And that is a trend that we’re seeing in a lot of the cities we operate in.

In the Bay Area, Google GOOGL, +1.21% or Apple AAPL, +3.44%, they’ve announced that “OK, this department is now going to work from home permanently.” And if you’re renting an apartment in San Jose, and you’re one of the employees that can now work from home permanently, you’re probably not going to stay in San Jose. What we don’t know yet is whether they move to Phoenix, Austin Vegas, Orlando, or do they move just inland a little bit to Sacramento?

Those are the trends that we’re trying to understand right now and be able to track. We really haven’t changed our location investment strategy in that we typically operate in the more desirable suburbs of a city. We don’t build in the urban core too much. That’s not our business model. But what we will focus on is what I call suburban-urban, where you’re near large job clusters, but it’s out in the suburbs more. And people want that a lot. They want a little space today. It’s what we’ve done for quite some time. And it’s working very well right now to stay out in that area.

The wildfires are an issue in this state. But they’re in areas that are not densely populated at all right. It’s not threatening large areas where a lot of new home construction is occurring today. It’s more rural, but it is something people think about no different than the hurricane that just flooded Houston.

MarketWatch: Low interest rates aside, affordability remains a concern for many home buyers in the market today. How do you approach building homes from an affordability perspective?

Mezger: We’re a little different than a lot of our peers in that we’re at 80-85% pre-sold, meaning we don’t build a bunch of homes and then sell them. We let the buyer pick their lot, pick the floor plan, personalize their home in the studio, and then we build it. So we move with where the market demand is pretty quickly. What we try to do is the strategy I call “bracketing the median income.” We will identify a sub-market in Stockton. And, OK, the median income is $70,000. We have to have homes available in that community that are attainable by the median income.

And that typically puts you at a high end first-time product, or a lower-priced first move-up product, which is where the biggest demand chunks are in every sub-market of every city. So we position our product there. And then we let the buyer tell us what size home they want and what features they want in the home.

So when the market turned down back in 2007 to 2009, we have product series that will range from 1,500 to 3,500-square-feet. So when the when the market gets tough, you’ll position the product at the smaller footage band because of affordability pressures and whatnot. And then when the market is running, you may move up to the 2,000 to 3,500-square-foot band, and you let the buyer pick, ‘Do I want the four bedroom at 2,000 square feet or do I want the five-bedroom at 3,500 square feet. And the incomes really drive where the demand goes in that sub-market.

In fall of 2018, new home sales slowed in a hurry. Even through spring of 2018 and summer of 2018, the market was very good. And then interest rates went up. And when interest rates went up, that’s what really slowed sales down and it moved pretty quickly. And as strong as the market is today, we’re not looking to push prices really hard because you can quickly push past what the consumer can afford, especially if interest rates were to tick back up. So if interest rates go up, we’ll go move to a little bit smaller home and still continue to target the median income, but the buyer is the buyer and they can only afford so much payment on it. We stay sensitive to that balance.

Our mantra in our business is we only want to start a home that we know will get paid for when it’s completed. And if you’re starting a bunch of inventory where you don’t know if you’re going to get paid when it’s completed and you don’t know what the final margin will be, prices start to drop or incentives and concessions show up. Then you have to compromise margin to sell the home. And in the downturn we weren’t stuck with a lot of standing inventory homes that we had to go liquidate. Because we were building to our sales pace, it’s a much lower risk profile.

MarketWatch: In terms of the design and layout of the homes you build, have Americans’ preferences changed as a result of the pandemic?

Mezger: On a daily basis, we’re a read on what the consumers’ preferences are. Normally on our earnings call, we talk about deliveries and revenue. And I thought it would be helpful for the investment community to hear what’s what went on with our consumers that are buying today post-pandemic, because there was a pretty significant shift between our deliveries and our orders in the third quarter.

I think it’s too early to gauge whether working from home really accelerates. It has been accelerating for years, but it’s still 7% to 9% of people work from home. We actually now offer home-office packages in our communities where you can take a bedroom or an area of the home and actually convert it to an office with built-in desks and built-in shelves, high speed Wi Fi, charging ports and lighting. We have some homes that have bathrooms and we have doors to the outside. We did all that so we can see how the consumer responds, and we think it can be pretty compelling because it’s very affordable.

At the same time, people were actually spending more in the third quarter incrementally than they were in the first or second quarter.

People are buying these homes because they intend to live there and live there for some time. So they’re making it their home. We’ve introduced the office and the office is an affordable option. What we’re seeing in the buyer preferences, the square footage of the home didn’t change and hasn’t changed much in a few years. In our case, as a company, it’s roughly at 2,100 square foot house is the average we’re seeing.

And that didn’t change in the third quarter, they’re spending more in the studio. And what they’re spending it on is what I would call value options. It’s not, instead of the level-three granite, I want level-seven, or some of the sizzle things that people can put in their homes. It’s more I want the extra island cabinets, I want to convert this room to a den. I want to add a bathroom in the home, I need a third bathroom because of extended family that’s going to be living with me. It’s those type of things right now.

It’s a financially strong first-time buyer that is putting a lot of thought into, “I’m going to live in this home for a while and I want to make it my own.”