EXCLUSIVE: Interview with Martin Connor, CFO of Toll Brothers

Welcome to Zing Talk, where Benzinga brings you the biggest names and brightest minds from Silicon Valley to New York City.

Direct Download Subscribe in iTunes

I'm your host, Jason Raznick; today our guest is Marty Connor, CFO of Toll Brothers TOL, a residential and commercial real estate development company. Connor came to Toll Brothers with more than 20 years of experience. He previously worked at Ernst & Young. He also founded and operated a successful accounting and consulting practice. Marty, how are you doing today?

Marty Connor: I'm doing great Jason. Thanks for calling me up.

We're glad to have you on. You replaced Joel Rassman, who passed away last September. What is it like to follow in the footsteps of a man with such a brilliant career?

Marty Connor: Well, Joel was certainly irreplaceable and invaluable, while he was here at toll brothers and certainly in the legacy that he left, not only with me, who worked side by side with him for his last two years here, but the entire finance team and operations team that has been here at Toll. It was a joy to have the two years to work with Joel and it's been a little bittersweet ever since. I joke that I always look forward to him being in the back seat as he handed the reins over to me and unfortunately, he's not there right now.

I'm sure he would be proud of what you're doing with the company and your stewardship.

Marty Connor: Well, he did a great job of positioning the company through the downturn and to emerge stronger than ever out of the downturn. Under Joel's stewardship we have one of the strongest if not the strongest balance sheets in the industry. And we maintain investment grade ratings from two of the three ratings agencies, despite our business being off 75% from the top of the market.

That is nothing short of an impressive feat to be able to do that in the market we've been in the last couple years.

Marty Connor: Absolutely. The homebuilders, all of them have done a pretty good job of surviving that kind of volume drop. The business model is such that when you start shrinking, you generate cash. So long as your bond maturities are appropriately laddered or re-financeable, you can survive because you're collecting money from the disposition of your land, improvements, and homes, while not making reinvestments in land and improvements.

Now, we're starting to see some signs of recovery, but the real estate market still seems like it is suffering. Do you expect to see any improvements in the coming months?

Marty Connor: Well, we're optimistic that we may see some improvement, but we're also cautious. I would say we are emphasizing the word 'cautious'. It is a great time to buy a home, but our home purchase decision by our buyers is very confidence-sensitive, and confidence has not returned to the extent that we'd like to see it returned to the consumer. I think they aren't as concerned as they were 18-24 months ago about job loss. I think if they've survived this long with the job they have, they're comfortable, but it is a sizable investment that we're asking them to make into a new home, and despite all time highs in affordability and near all time lows in mortgage rates, they still have a little hesitancy at this point.

Do you expect the spring shopping season to be better than last year's?

Marty Connor: I think through the first three weeks of February, which is kind of the first three weeks of the spring selling season, as we announced at our earnings release January 31, 2011 for our first quarter, we had a 9% increase in deposits, which is the second step behind traffic in moving to the third step, which is an agreement, and that was actually up 15% on a gross basis and 9% on a per-community basis. So we are increasing the number of communities that we are offering homes for sale out of and we are encouraged by that uptick and encouraged even more so that it's truly organic. There is not any benefit coming from a tax credit like there was in the comparable period a year ago.

One thing in our local market, which is Michigan, we've seen a lot of pent up demand here, where people put off buying for several months, looking to this season as the season where they are going to get the best deal and hopefully the most availability comes on the market. So hopefully, supply and demand starts meeting where it should be.

Marty Connor: I think one of the reasons we have some optimism is the pent up demand that has to be accumulating. It is widely expected that households will form each year for the next ten years, pursuant to the Harvard Study at 1.6 million households. Homes are torn down in America, about three to four-hundred-thousand per year. Right now, the industry is only building about 250,000 to 400,000 per year, so we'll have a supply/demand imbalance at some point. In some markets, we may be seeing the beginnings of that. Real estate is a micro-market base, so if there are excess homes in a place where people don't want to live, that's not really relevant to a shortage of homes where people do want to live.

You said right now industry is building 250k to 400k homes. What were they building closer to the highs?

Marty Connor: At the height of the market, it was closer to 2 million units per year. The average for the last 40 years has been 1.5 to 1.6 million units.

So with household formation and the number of houses being torn down today, there's going to be a point where the supply doesn't meet the demand.

Marty Connor: That is correct. Right now, there is pent up demand. Kids live with their parents a little longer. They room three to an apartment rather than two or one. You can only live with mom and dad for so long before you want to move out or they want you to move out. The same often happens with roommate situations.

Do you or Toll have a viewpoint on where things in the real estate market are going to be going in the next 2-4 years?

Marty Connor: We're pretty confident that we've hit the bottom in most markets and now it is a question of "do we continue to bounce along the bottom or do things start to tick upward?" I think the demographic stats I cited earlier are indicative that is has got to get better sometime. The question is when that time is. We're positioned to take advantage of whenever that time is, with the lot holdings we have, and the balance sheet we have, but we're not in the forecasting game to say when it's going to be.

What do you think some of the keys are to revitalizing the housing market? Do you think the government should be doing more to help the recovery?

Marty Connor: I think confidence is a key driver of the recovery of the housing market. We could all use the housing market to recover, because it is so tied to personal worth, personal net wealth, as well as just jobs. When the industry was building one million to a million and a half more homes than they're building now, that's a lot of people who are at work, either pounding nails, laying carpet, selling drapes, building furniture, and whatever. Part of the unemployment problem in this country is a result of fewer homes being constructed. I think we need confidence to tick up before we see more people in the market. I think slowly but surely we're getting there. The general economic news has been relatively positive the past three or four months. The unemployment rate is coming down a little bit and I think everybody feels a little bit better about that. In terms of what the government can do and shouldn't do, I think right now, there is a lot of focus on mortgage reform, mortgage finance reform, and that takes a number of different shapes. What's going to happen with the government-sponsored entities Fannie Mae and Freddy Mac.? What's the deductibility of the mortgage going to be, going forward? What is the minimum down payment that might be necessary? When we look at all those different questions that are currently overhanging the housing industry, we say this is not the time to evaluate those changes. We need to let housing heal, on its own, based on the old rules. When it is healthy, it might be an appropriate time to consider making changes to the historical rules. We're not looking for a tax credit. We're not sure that the tax credit from a year ago accomplished what it was supposed to; it did not apply to new homes, so in many cases, it did not create additional jobs. Actually was just money going to people who were going to buy a home anyway.

One of the things my sources are seeing is that people with good credit, especially those who are self-employed, are having a difficult time getting approved for loans where they have a decent down payment. Do you think the government will end up letting the free market settle itself, where a lender comes in and helps these people that have phenomenal credit, significant down payments, but need a little bit of help with the mortgage when currently, Fannie Mae and Freddy do not have products like that any more?

Marty Connor: We're fortunate in that 18% of our buyers pay cash. Of the other 82%, the average down payment we're seeing is 30% down. We have an average FICA score from our buyers of 750-760. We're able, through our mortgage company, to find financing for them, whether they're self employed or doctors or lawyers. There's a lot more paperwork they have to go through. There's not as much money available for situations where the income is not as easy to prove, since you're vouching for yourself but we haven't had some of the problems that you're referring to.

Do you think there should be other entities? You briefly mentioned FHA. Do you feel that program is useful, or should it be modified?

Marty Connor: The FHA has programs where you can get a home for 3-and-1/2% down. There's an extra interest rate fee that comes along with that, but that's an attractive program for entry-level buyers or people who are just begging to try accumulating some down payment money or equity in a home. For the right buyer, it makes a lot of sense. We sell very few homes under that program, so it's not that big of a deal for us directly. Most of our buyers have a home to sell; anything that benefits the low end of the market trickles up and helps us at the luxury end. I think the lessons that we need to have learned over the last 4-5 years are that, if we're going to issue those mortgages in this country, we need to have the right underwriting standards behind them. I think at this point, many of those standards have been refined.

What are some of the things Toll did to persevere during these hard times? Your predecessor preserved cash; is there anything else you did?

Marty Connor: On the proactive front, we stopped buying land. We walked away from some option contracts where we had the option to buy land. We were conservative in our spending of cash. more painfully, we went from 7500 employees down to 2500 employees, so you can imagine that's a tough environment to ask your team to put up with, but it was necessary as part of this downturn. We generally look for opportunities in our operations to save cost in the components and in the subcontracts and in the way we operate, all with no negative impact on our quality. In some select occasions, we disposed of some large parcels of land in strategic transactions where we thought it was more advantageous to dispose of the land, take the cash, rather than to hold it, even though the costs of holding it are relatively nominal.

Have you seen any drastic changes, positive or negative, in any of the areas that you operate in?

Marty Connor: New York urban is our best market right now. It's a market where we have some limited pricing power and we can raise prices on occasion and reduce incentives. We have certain communities around the country where we have the right product at the right price in the right location, and they move pretty well. In Philadelphia urban, we have a community in Naval Square that has sold more than 50 units in the last 12 months. We have another community that we opened 6 months ago and have sold nearly 30 units already. That gives us optimism that if we have the right product at the right price in the right location, that product will move regardless of the level of confidence or economic times we find ourselves in. Overall, 60% of our business is between Boston and northern Virginia, and that is a market that can get super hot at the height of it and then get super cool in the retreat. Right now, it's doing fine. Between Houston and Dallas, we have another 10% of our business and that market has held up as well. Some of the western state markets, with the exception of California, where we are really just coastal and around the bay, we're comfortable with that market. But Arizona, Las Vegas, and Nevada, and the Midwest, they have a long way to come back from.

You used to be big buyers of land. Are you starting to buy more land again and if so, is it already titled and ready for building?

Marty Connor: We've spent approximately $550 million on land in the last 15 months. We had gone two or three years before that without purchasing any. That's kind of our perspective that the value of land had reached a low point. We continue to look for opportunities to buy land. We generally only buy entitled land. If land is un-entitled, we may put it under an options contract, but we generally only buy land once it is approved and entitled, particularly in today's market. It was always in our best interest to do an option contract. Our historical operating model would be to find a piece of ground, go to the owner and say look, your ground is currently zoned, say, agricultural and is worth $3000 an acre. I'll give you a deposit and say, if I get it approved for residential in the next 5-7 years, I will pay you $50,000 an acre for it. And if for some reason, it does not get approved or rezoned, I either get my deposit back or in some cases let you keep the deposit for giving me that option. Ideally, if I did get it approved, it was no longer worth $50,000 an acre, which is what I paid the seller for it, but was now worth $100,000 an acre. We kept some of the appreciation that other builders, who were not as much a land developer as we are would not keep and that helped our growth. Those opportunities are just not there to the extent they were before.

It seems like the whole land-buying, land-acquisitions market has completely changed over the last 5 years.

Marty Connor: In the early 90s, when the RTC was out there, that was your one-stop shopping for land. Many real estate companies, including Toll Brothers, took advantage of that and made great land purchases at very attractive pricing. As the market heated up, the concept of optioning land became more prevalent and we took advantage of that. As land values declined, when you optioned land, you lost less money than if you had owned it. Now we're in another situation where the predominant disposers of land are people who are just trying to wash their hands of it. They're not interested in giving an option or they just don't have the time.

Final two questions. First, you founded and operated a successful finance accounting consulting practice. Tell us about this and how you came to Toll Brothers.

Marty Connor: When I was at Ernst & Young, I ran the real estate practice in the Philadelphia area. I left Ernst & Young for a position with a large regional developer and I was the CFO and Director of Operations there. I learned a lot and had a great time and decided to branch out on my own and become a consultant to many of my former clients. Then Joel called me up when he discovered he had leukemia, and asked me if I wanted to sign on with Toll Brothers. I left that consultancy by the wayside for the great opportunity to work alongside and ultimately succeed Joel. It's been great and I've really enjoyed it.

Last question. You're very active in community organizations. Tell us about your involvement.

Marty Connor: My personality is such that I can work pretty hard for the day job, but I need a little bit of an outlet to diversify my interests. Whether that is coaching my kids in baseball or basketball or serve on some boards. I look at the break from the day-to-day grind as an opportunity to recharge my battery and refocus my attention in some great directions, meet new people with new perspectives, and bring some of those perspectives back into my work environment. It's important to contribute to the community and to give back and it is a great opportunity to grow yourself as a person and grow your networks and contribute some great positives.

We want to thank Marty Connor for joining us today on the Benzinga podcast. You can download us on iTunes. Thanks again Marty.

Marty Connor: Thanks Jason. It was my pleasure.