NVR: Culture Runs Deep
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NVR is one of my favorite companies. We’ve written about it twice (Dan in April 2020 and me in June 2021), which (I believe) is more than any other company.
A glance at NVR’s stock price will alert you that something unusual is going on. Shares trade at nearly $8,000 per share and have appreciated 14,580% over the last 25 years. Berkshire’s A shares are the only higher priced on the NYSE. It’s always good to be in a club with Berkshire.
NVR is unique because of what it doesn’t do rather than what it does. It is an extremely disciplined and focused company. NVR doesn’t:
Hold conference calls
Give guidance
Pay dividends
Split its stock.
NVR famously eschews owning and developing land, which is unique among homebuilders. In fact NVR avoids owning much of anything, preferring to lease its offices, manufacturing facilities, and even employee laptops. All of this adds up to make NVR one of the most capital-efficient businesses out there. The company is truly fanatical about this, and its industry-leading ROE shows.
But that wasn’t always the case. To understand NVR’s culture, it's best to revisit how it was formed. NVR wasn’t always so efficient, capital-light, disciplined, and focused. It was quite the opposite in the early days. NVR’s history is a warning about the dangers of rapid growth and high debt in cyclical and capital intensive industries. It’s a case study worth keeping in mind given the strength of today’s housing market because it shows how quickly fortunes can change.
Origin
Dwight Schar grew up in rural northeast Ohio. He graduated high school in 1960 and left home at 18 to work on a relative’s farm. He married high school sweetheart Janice Winkler at the age of 20 and paid his way through Ohio’s Ashland College working the night shift at a pipe-fitting factory. After graduation he briefly taught science and business in junior high school and sold houses on the weekend.
He quit after one semester and joined Ryan Homes as a land buyer. He headed Ryan's land acquisition and development efforts in Ohio, Kentucky, and Indiana from 1969 to 1973. In 1973 Ryan Homes expanded into Washington D.C. and Schar followed it there.
Schar served as regional manager for Ryan’s Baltimore to Richmond territory for four years and watched the D.C. suburbs expand exponentially. A steady increase in Federal government employment and the companies that do business with it drove demand for housing. Schar's insight was that the region’s highly educated and well-paid population would demand more expensive housing than Ryan’s starter homes offered.
The Rise
At age 35, Schar quit Ryan to go out on his own. In 1977 he founded NVLand with Stephen M. Cumbie. They bought and developed land for local builders, including Ryan, while Schar waited out his three year non-compete. In 1980 William A. Moran joined the duo to form Northern Virginia Homes and started building. Later they shortened the name to NVHomes.
Besides NVLand and NVHomes, Schar and his partners also started NVCommercial, NVProperties, NVRetail, NVIndustrial, etc to target every niche in the real estate industry.
NVHomes grew rapidly by targeting move-up buyers who could not afford a custom home. It doubled its earnings every year, reaching $14 million in 1986 ($40 million today). That year Schar took the company public to get capital for even faster growth.
The other NV companies remained private. Schar divested his stake in NVLand to avoid related party transactions with NVHomes now that it was public. NVLand was renamed Elm Street Development to avoid confusion with NVHomes wholly owned land development subsidiary NVDevelopment. NVDevelopment would ultimately be NVR’s undoing.
Months after the IPO, Schar made a $360 million hostile bid for Ryan Homes, the company he’d quit in 1977. Schar’s bid was audacious, even by the standards of the mid-eighties LBO boom. In 1985 Ryan earned $22.2 million to NVHomes’ $6.1 and built 7,534 homes to NVHome’s 763. Schar sold $218 million of junk bonds to close the deal in 1987. NVHomes changed its name to NVRyan and shortened it to NVR in 1989.
NVR continued to grow rapidly and vertically integrated into every phase of the homebuilding and financing process. NVR controlled nearly 100 subsidiaries that manufactured building products and provided services related to construction, land acquisition, home finance, investment advice, and other real estate development activities. In 1988 NVR even acquired a failed thrift from the government called McLean Federal Savings & Loan Association. The bank was promptly renamed NVR Federal Savings Bank.
NVR expanded geographically, often via acquisition, into Florida, California, Indiana, Kentucky, North Carolina, Ohio, Pennsylvania, and the rest of Virginia.
A nationwide housing boom made NVR’s rapid growth possible. Mortgage rates declined rapidly from their 1981 peak, increasing affordability. The 30-year fixed peaked at 18% in November 1981 and bottomed at 5.9% in September 1986. Deregulation in 1980 allowed thrifts to offer Adjustable Rate Mortgages (ARMs), further increasing affordability.
Reagan’s tax cuts threw fuel on the fire. Reagan increased depreciation charges on real estate, lowered the long-term capital gains rate, and allowed limited partners to write off losses against personal income. This set off a real estate limited partnership investing boom.
The Baby Boomer generation, born between 1946 and 1964, reached their prime homebuying years (25 to 45 years old) in the 1980s. All of these factors combined with a strong economy created a surge in demand for housing.
The Fall
Ten years after starting NVHomes, Schar had become one of the biggest homebuilders in the country. NVR’s rise was the result of Schar’s aggressive tactics and willingness to take big risks.
NVR’s strategy was to borrow money to buy huge tracts of land. Land prices were skyrocketing throughout the eighties, so it must have looked like a no-brainer at the time. Why not buy it before prices rise further? NVR would eventually build a house and capture the gain for itself. Schar wasn’t the only one doing it (and many homebuilders still do).
This strategy worked beautifully during the bull market but faltered when rates rose. The CPI bottomed in 1986 at 1.2% and rose to 4.4% in 1987 and stayed there through 1989. The Fed, targeting zero inflation, tightened monetary policy and pushed borrowing costs into the double digits. Demand for housing fell fast.
Simultaneously, the Tax Reform Act of 1986 phased out the benefits of investing in real estate through limited partnerships. Easy come, easy go.
Although NVR earned $30 million in 1989, the company was in distress. NVR was loaded with loans for land it no longer needed. Land development inventory increased from $400 million in 1988 to $600 million in 1990. Revenue fell from $1,115 million to $900 million. NVR wrote down the value of its land and posted a $260 million loss in 1990.
In August 1990 Iraq invaded Kuwait. Oil rocketed from $17 per barrel in July to $40 in October. The oil shock was a blow to consumer and business confidence and pushed the US into a recession. The housing market dried up.
Bankruptcy
NVR responded by restructuring. It’s here that the company’s modern form began to take shape.
NVR retreated to its core mid-Atlantic markets and simplified its homebuilding product offering. They ditched their speculative land business and pared back ancillary services. Besides the homebuilding operation, NVR kept only its mortgage origination business, title insurance brokerage, and bank.
The restructuring narrowed NVR’s losses, but it was too little too late. Volumes fell 27% in 1991 and prices another 5.5%. Net income remained negative.
On April 6, 1992 NVR filed for Chapter 11 bankruptcy. To add insult to injury Anthony Satariano, CFO of NVR’s finance business, embezzled $763,000 and fled to Malta. Schar’s ex-wife sued him for $1.3 million. When it rains, it pours.
The reorganization swapped $205 million of debt for 90.6% of NVR’s equity. In September 1993 NVR emerged from bankruptcy. The stock price was $9 per share post reorganization (today it’s almost $8,000).
NVR 2.0
The bankruptcy was a painful event which impacted how NVR was run ever since. It allowed NVR to simplify into its current form.
Since the bankruptcy, NVR has been run as conservatively as possible. It is bulletproof and unlikely to ever face bankruptcy or distress, again. While NVR won’t be the best builder to own during an upcycle, it's unquestionably the best to own in the inevitable downcycles. It is the epitome of Howard Mark’s dictum that “You Can't Predict. You Can Prepare.” Memories of the pain are what keeps the culture disciplined and focused.
What changed?
To start, NVR got out of the land ownership business completely. It buys options on its land from developers, like Elm Street Development, and waits to exercise those options until a home is sold. NVR doesn’t build “spec” (speculative) houses anymore either.
This approach has several trade offs, which is why none of the other big builders do it. Lennar and D.R. Horton have moved in this direction, but still own 25% of their land and proudly build spec houses.
NVR sacrifices margins for a higher return on equity. When you buy and develop your own land, you capture that margin for yourself. That ties up a lot of capital though. Land tends to appreciate a few percent per year so owning it unleveraged produces a poor return on equity. Leverage makes the returns more appealing, but carries significant risk, as NVR found out.
Owning land is usually a good bet, until it's not, and then, if you’re leveraged, it's catastrophic. David Flannigan, NVLand’s first hire and partner at Elm Street Development, explains:
“Typically in a ten year period in the land development business two years are so great any idiot can make a lot of money. For six years it's been a fairly normal business. And two are so bad you just can’t make it up.”
A good developer is always preparing to survive the two bad years. A great developer is preparing to take advantage of other people’s difficulties during those two years. That’s antifragility.
NVR went bankrupt because it became illiquid, not insolvent. It was the classic “good business, bad balance sheet” scenario. Its homebuilding and finance operations actually made a small amount of money in 1991 but not enough to pay the interest on its loans. That’s why NVR has become fanatical about reducing risk by reducing capital employed, even at the expense of margins and profit dollars.
Building spec houses sacrifices resilience for growth. Spec houses are easier to sell in a hot market, like the present, because most buyers prefer a turn-key move-in-ready product available instantly. They can't or won’t wait a few months for something to be built. Builders without spec inventory might lose a sale to an existing home or another builder's spec house.
But rapid growth is not always a good thing. It is incredibly difficult to manage, as the pandemic showed. Think about Peloton, which saw a meteoric rise in demand, thought “this is the new normal,” and spent $420 million to panic-acquire additional manufacturing capacity. A year later demand normalized significantly lower, the stock got crushed, and they had to sell their manufacturing facilities. This has happened to a degree to even the most competently led businesses during the pandemic, including Amazon and Dollar General.
Peloton, Amazon, and Dollar General would have been better off if demand had increased slowly, steadily, and predictably. Rapid growth that requires significant capital investment, like land for homebuilding, manufacturing for Pelotons, or warehouses for Amazon, requires management to make a risky bet on the durability and magnitude of the growth. No tree grows to the sky, which means eventually these businesses get burned, just like NVR did.
While building spec houses looks smart today, it didn't look smart in 1991 or 2008. The world is inherently unpredictable, which is why I prefer NVR’s capital-light strategy. They may grow slower in a red hot market, but they’re virtually guaranteed to survive a downturn. NVR was the only publicly traded homebuilder that remained profitable through the 2006-2011 downturn, which demonstrates how far the company has come since its bankruptcy.
In contrast with spec building, NVR will only exercise a land option contract when it has a buyer for the house and that buyer has received mortgage financing. This allows NVR to lock in pricing from its suppliers (using fixed-price contracts) before it locks in a sales price. It also allows NVR to partially finance its balance sheet with customer deposits.
The 10th Man explains that NVR's option contracts allow it to buy a few plots at a time in pods. NVR acquires pods of contiguous lots to maximize efficiencies building them. Sub-contractors can wire or plumb all of the houses on a block in a day. The sub-contractors accept lower margins for this, but make it up in volume. The savings accrue to NVR, who splits it with customers to help keep its housing affordable. NVR has some of the lowest average selling prices among big builders despite focusing on the relatively expensive mid-Atlantic states. Amazon and Costco aren't the only ones implementing scale-economies shared, Mr. Sleep!
NVR is also a leader in a construction technique known as panelization. NVR has eight centralized production facilities around the country which build large sections of homes, like floors, wall panels, roof trusses, and stairs. A crane can assemble all of the panels into a house in about six hours. Panelization is safer, uses less labor and materials, and isn’t subject to weather delays. All the big builders do it to varying degrees and its efficiency gives them a huge advantage over mom-and-pop builders.
NVR is more vertically integrated than the other big builders. While they all panelize to some degree, most focus on assembly and buy components from outside vendors. Builders FirstSource, a manufacturer of engineered wood products, like roof trusses, counts all of the big builders except NVR among its biggest clients.
Panelization and vertical integration are only efficient at scale, which is why NVR prefers to concentrate on dominating a few key geographies. The need for centralized manufacturing facilities operating at scale limits growth to adjacent areas.
Panelization and vertical integration trade customization for efficiency. NVR offers less customization than the other big builders to reap economies of scale. NVR’s customers can pick from a few packages of layouts and themes but cannot mix and match individual elements. Most homebuilders love customization because upgrades carry large incremental margins. NVR always prioritizes a higher return on equity over a higher margin.
NVR’s narrow selection of products allows it to concentrate its buying power with vendors and extract volume discounts it can split with its customers, much like Costco (though less extreme).
Panelization also cuts out the middleman at the lumberyard. NVR’s manufacturing facilities can buy lumber directly from the mill in bulk and have it delivered to one spot.
The 10th Man explains that NVR’s manufacturing facilities also serve as distribution centers. NVR can buy 2,000 sinks in bulk directly from a manufacturer like Masco and have them delivered to their centralized facility. As homes are built, NVR can send them out one at a time. Most builders, even the big ones, rely on their subcontractors to procure materials. The plumber would buy one sink at a time from Fergusson, both taking a margin on it.
NVR’s system is obviously better, but it's difficult and expensive to build an in-house distribution system. NVR’s capability is a legacy of its go-go growth days in the mid eighties when it had over 100 subsidiaries involved in every piece of the real estate industry. NVR’s distribution system isn’t portable, which makes geographic expansion difficult.
NVR’s option contracts slow geographic expansion too. It's not easy to find developers that can operate at the scale NVR requires.NVR’s partnership with Elm Street dates to 1977. The two companies have a symbiotic relationship with a deep trust and understanding of each other and the region. It's impossible to replicate that in a new geography overnight. One of NVR’s competitive advantages has been its ability to build a network of developers that can feed it land.
DR Horton, Lennar, and the other big builders often enter a geography by acquiring a smaller builder in the target area. The acquisition gives them local expertise and land inventory. NVR did this once in 1998 when it acquired Fox Ridge Homes in the Nashville area. It hasn’t since, and I doubt it would again unless prices were distressed.
Incentives
One way to see how management will navigate the growth vs resilience and margin vs ROE trade-offs inherent in any capital intensive business is to look at their incentives.
NVR has one of the best incentive structures out there. Their proxy states: “Our program isn’t structured like most other companies, and we believe that is a significant competitive advantage.” I agree. To get different results you must do something different. NVR’s compensation policy has been consistent for 25 years, a period which has seen the stock climb 14,580%.
Management receives a relatively small (bottom 25% of industry) cash salary. An annual cash bonus is limited to 100% of base salary and 80% contingent on pre-tax profit and 20% new orders, net of cancellations.
The real compensation is stock option grants made every four years. The next issuance will be 2026. The options are struck at the stock’s closing price on the day of issuance and vest 25% in years 3, 4, 5, and 6. The May 2022 grant will vest 25% in 2024, 2025, 2026, and 2027. The May 2018 grant will finish vesting this December. A long vesting period incentivizes retention and allows for significant wealth creation.
50% of the options vest based on continued employment and 50% based on three-year average return on equity. NVR’s ROE must be in the top three of its peer group for a 100% payout.
NVR uses options, as opposed to restricted stock, to tie compensation actually paid to total shareholder return. If management hits the ROE target and their options vest but the stock hasn’t appreciated since the grant date, those options will be worthless. If the options vest and the stock has appreciated significantly (as it has been known to) the options will be worth a lot. Insiders own 7.0% of the company worth $1.7 billion, so they have serious skin in the game.
NVR’s focus on resilience and ROE means there’s minimal capex required and lots of free cash flow. NVR’s annual capex is laughably small. Over the last three years it spent just 1.3% of operating cash flow on capex. Since management’s compensation is tied to NVR’s stock price, they’ve opted to spend NVR’s prodigious free cash flow repurchasing shares.
NVR’s repurchase program began in 1996 and has since retired 76% of shares at a 5.2% annual rate.
The chart above shows that NVR’s repurchases have been consistent but not steady. NVR has reduced shares outstanding every year outside of recessions (2008, 2009, 2020) except 2019.
However, repurchases have not been steady. Management seems to be somewhat opportunistic about repurchases. Heavy stock issuances during periods when the stock has been strong also negated significant amounts of purchases.
On one hand I hate to see dilution. On the other hand, I don’t know of a fairer way to compensate executives than NVR’s approach. If insiders are making money, it's because shareholders are too, and that’s tough to argue with.
The chart also shows that repurchases were most aggressive in the late ‘90s and early 2000’s. In 2001 Norbert Lou of Punch Card Management famously wrote up NVR on VIC, explaining why its business model was superior and that it deserved to trade at a premium. Now it does trade at a premium (17x vs ~10-12x for other large builders).
Nevertheless, NVR will almost assuredly continue to chip away at its share count a few percentage points at a time. Forward returns will be lower than history but likely satisfactory. The business is rock solid and virtually indestructible. Today they have more than $2.2 billion of net cash on their balance sheet. Their debt is $900 million of senior notes due in 2030 and issued in two tranches in 2020 at 3.0% and 2.0%. At today’s interest rates this debt is an asset, not a liability.
Summary
Winston Churchill famously said that you can always trust Americans to do the right thing… after they’ve tried everything else. This quote reminds me of NVR, who tried everything and made every mistake imaginable but eventually saw the light and built an incredible business.
On paper NVR’s model is easy to copy. In practice it has proved impossible. The reason is that no other builder went through the painful bankruptcy NVR did and survived. Without the cultural memories of that pain, it's too easy for other builders to give in to the shorter incentive to pad profits, margins, and growth with spec homes and land. What’s remarkable about NVR is its discipline and focus to stick with its narrow strategy year in and year out.
On a recent Business Breakdowns episode Ed Wachenheim mentioned that Don Horton, founder of DR Horton, “keeps on his desk a model of NVR as a company and the price of their shares and the PE ratios.” NVR is not only an investor’s dream, it is an operator’s dream too. And yet DR Horton cannot (or will not) copy it completely. Just like Berkshire, NVR is often imitated but never copied. A conservative culture of capital allocation is one of the rarest and most valuable assets a company can have. It is impossible to build overnight or copy on demand.
Sources and Further Reading
The Washington Post
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Hope Vistry will have similar success
Great write up. It’s the first time I’ve seen you guys do a more story based one Ala scuttleblurb style. As always, the points are succinct.
As a side note, I’ve been tracking DFH and been trying to identify where/when it is a buy or if like you have mentioned, whether DFH is just an imitator but not a true believer of NVR’s cultural style.