Building profits Featured

7:00pm EDT March 27, 2003
For Robert H. Schottenstein, home isn't just where the heart is. It's also where the profits are.

Last year, more than 10,000 building permits were issued in Columbus, representing about 25 percent of all building activity in the state of Ohio. That's good news for Schottenstein's company, M/I Schottenstein Homes, because Ohio represents about 40 percent of its business.

Founded in 1976, M/I is the 19th largest homebuilder in the nation and has notched more than 50,000 homes in its tool belt. According to Standard & Poor's, 50 percent of Columbus home closings were M/I homes. Last year's revenue approached $1 billion from 4,140 home closings at an average price of $238,000. Schottenstein, the company's president, attributes the firm's success to a two-sided business philosophy.

"We care more about the product we build and our customers than any other builder," he says. "And, we are very profit-driven."

The company recorded net income of $15.9 million in the fourth quarter of 2002 and $66.6 million for the year. These record levels represent an 8 percent and 21 percent increase respectively over 2001.

His philosophy sounds simple, but Schottenstein says he and his management staff listened to their customers during the development of several expensive programs designed to enhance the buyer's experience.

"We have an extraordinary number of second- and third-time home buyers," Schottenstein says. "And 95 percent of our customers would recommend us to a friend or family member."

Examples of these buyer-friendly programs are the company's design center and M/I Financial, a wholly owned subsidiary and mortgage lender which finances more than 90 percent of customers' loans.

"M/I Financial is located across the hall from the design center," Schottenstein says. "After the buyer signs the contract, he can apply for a loan and visit the design center."

Schottenstein says that using M/I Financial offers the buyer a competitive rate -- the company's Web site refers to the rates as "below market" -- the ability to finance and close entirely through M/I and the convenience of doing it all in one location.

According to Standard & Poor's, these loans are eventually sold -- a common practice in the mortgage industry -- with the exception of a small servicing portfolio.

Schottenstein says one of M/I's most unique offerings is its Personal Construction Supervisor. Each customer is assigned a single contact person to monitor the construction process and ensure timely delivery and high quality.

Further, M/I encourages buyers to visit the construction site as often as they want, and the company's array of inspections outnumbers those required by city codes.

M/I's efforts to operate conservatively -- such as limiting the number of spec homes it builds -- fuel is ability to maximize revenue and profits.

Schottenstein says the company won't compromise when it comes to profit margins on the houses it sells.

"Other builders are volume driven," he says. "We want to sell houses, but not unless the margin is right."

According to Standard & Poor's, M/I has overall homebuilding gross margins of 24 percent and operating margins of 11 percent.

Schottenstein says M/I's homes are not the cheapest on the market, and stresses that prices are not negotiable.

"All square footage is not created equal," he says. "All of our buyers pay the same prices. But our customers know we'll be there tomorrow if a problem occurs."

Because of the number of homes it builds, M/I has a tremendous amount of purchasing power. Says Schottenstein: "We have relationships with many of the best suppliers in the United States. And we don't employ construction specialists like framers and electricians, we use subcontractors."

Using subcontractors rather than keeping specialists on staff is less expensive, and Schottenstein says the company takes care of its subcontractors by giving them plenty of work.

Sites are supervised by M/I's project managers, who are members of the company's staff of about 1,000 people. Sales associates account for about 20 percent of the work force, and construction workers make up 20 percent to 25 percent of the staff. The remainder are in marketing, design and land development.

An important part of M/I's business model is how it distributes its business across a variety of price points.

"Our goal is to sell 30 to 40 percent of our homes to first-time home buyers, another 30 to 40 percent to move-up buyers and the balance to the luxury buyer," says Schottenstein.

These targets mirror the potential market, which Schottenstein calls a pyramid.

"There are a lot more first-time and move-up buyers than luxury buyers," he says. "And it's a lot harder to sell a second home when the buyer hasn't purchased the first from you."

 

Location is everything
Although Columbus accounts for the largest percentage of M/I's sales, it is not the company's largest market in physical size. In fact, it is the smallest. M/I relies on the Columbus market, but the profit contribution from other markets has been steadily growing.

Growth potential is the primary consideration for Schottenstein when determining both the markets and the neighborhoods in which it will build.

In addition to its hometown of Columbus, M/I builds in Cincinnati, Indianapolis, Charlotte and Raleigh, N.C., the Washington, D.C. area, Tampa, Orlando and Palm Beach, Fla., all strong markets for new home construction.

According to Vincent Squillace, executive vice president of the Ohio Home Builders Association, the state affiliate of the National Association of Home Builders, the South and Southwest are the nation's home building hotspots.

"The south and southwestern states have been the hottest housing markets for at least 10 years," says Squillace. "In Ohio, Columbus and Cincinnati are the two busiest markets."

Following statistics from the U.S. Census Bureau that show the number of building permits issued in metropolitan areas, Schottenstein has opted for markets that represent solid growth potential. But with the exception of Washington, D.C., M/I's markets are not the largest.

By the end of 2002, Atlanta, Phoenix, Riverside, Calif., Houston, Dallas and Washington, D.C. led the nation in building permit activity, with Orlando, Tampa, Charlotte and Raleigh not far behind.

In 2001, M/I stopped building homes in Phoenix, one of the largest homebuilding markets in the country, because the city represented only a small percentage of the company's business. M/I's total home closings dropped by 2 percent in 2002, partly as a result of the closure of the Arizona division, but this was offset by a 6.7 percent increase in overall home price, according to Standard & Poor's.

Schottenstein says the company withdrew from that market to focus on areas where M/I's market share was increasing.

"We are very strong in the Midwest, in Columbus, Indianapolis and Cincinnati," he says. "We are one of the leading builders in Tampa, too."

In addition to growth potential, the company also considers the market and neighborhood's ability to meet its target pyramid sales distribution.

"We look for that in the locations we choose," Schottenstein says. "Identifying and securing new communities is the most important thing we do. We look for the best possible locations for new neighborhoods."

 

Where do we go from here?
Schottenstein says there's no hurry to expand M/I beyond its current markets.

"We feel there are phenomenal growth opportunities where we are right now," he says. "Our business has doubled in Tampa, and we're doing great in Charlotte."

The company's backlog is a healthy 2,321 homes with $567 million in contract value, according to Standard & Poor's.

Schottenstein is also confident the company can increase its Columbus and Cincinnati sales. When it went public in 1993, financial experts advised Schottenstein not to play up its Columbus market, saying it was not a big factor in its growth potential.

"But because of our customer programs, we doubled our business in Columbus since we went public," Schottenstein says.

Going public gave M/I the opportunity to pursue rapid growth without relying on debt to provide needed capital.

"It was a more prudent and safer way to grow the business," Schottenstein says.

The company recently filed a plan with the SEC to restructure itself into a holding company whose operating assets for its regional markets will be owned and operated by five wholly owned limited liability companies. Operations will continue under the same trade names ­ Horizon, M/I Homes and Showcase Homes ­ and the restructuring will provide a framework for future growth. For example, one or more units could raise capital apart from the rest of the company. The plan also protects the company and each of its units from potential liabilities that arise by isolating them to the operating unit they are associated with.

The company's target growth rate is 10 percent a year, and Schottenstein believes that can be achieved simply by doing more business in the cities where M/I is already building homes.

Expansion into other cities, he says, is fraught with more risks than the company cares to take.

"You don't really know a market until you're there," Schottenstein says. "You don't know if you've hired the right people, the right subcontractors, and are in the right areas of the city."

Schottenstein says the company has been in its current markets for years and has overcome those hurdles.

"It's just a more conservative and smarter approach to stay in our current markets," he says.

The biggest challenge M/I faces, especially in the Columbus market, is the dwindling amount of land available for development.

"All of us were justifiably disappointed when America West announced its departure from Columbus," Schottenstein says. "But to me, the moratoriums on building on the west side will hurt this city as much as America West leaving."

The moratorium covers Pickerington and areas of Hilliard and Columbus, and was initiated because of environmental concerns over the Big Darby Creek area, which holds some of the largest tracts of developable land.

Schottenstein agrees that Darby Creek needs to be protected, but also believes the city will die if its ability to grow is suddenly brought to a halt.

"You need to strike a balance," he says. "Slow, controlled growth is good for the city."

Schottenstein is confident the city's leadership will find a way to work out the issues, and has taken an active role himself.

"We intend to get the story out in public," he says. "We -- and other builders -- are stepping up our own advocacy. We want to make certain that two, three or four years from now, there are enough locations for development."

But if the Big Darby Creek situation doesn't change, Schottenstein says it won't affect M/I's plans to continue building on other available tracts of land in the Columbus area.

According to Standard & Poor's, the company maintains a four-year supply of land, which is evenly balanced between lots owned and lots optioned.

Howard Burnett, a research analyst with Salomon Smith Barney in Columbus, says the experience of M/I Homes' executives and the diversity of the homes it sells are among its leading strengths.

"M/I is in its second generation of management, they have a lot of experience," he says, adding that some neighborhoods' resistance to adding new communities is a rising concern that Schottenstein needs to consider.

"Acquiring land is getting to be a big problem," he says, and the home building industry experienced a slowdown in the last year.

"Home builders experienced record years until 2002," says Burnett.

And with economic and political uncertainty still in the air, 2003 is not forecasted to be a record-setting year, despite historical lows in interest rates.

This is something that Schottenstein acknowledges. "There are record low interest rates, but not record-setting sales of new homes," he says.

Schottenstein lays the blame on low job growth in Columbus.

"The single most important factor that affects the housing market is job growth," he says. "Right now, unemployment is on the rise, and there's not a lot of hiring going on."

Still, Schottenstein is confident that business -- and the company's stock value -- will be strong this year.

"A lot of factors are out of our control," he says. "But if we do the right things, the stock value will follow. If we pay attention to our customers and the fundamentals, the stock price will take care of itself."

HOW TO REACH: M/I Schottenstein Homes Inc., (614) 418-8000 or www.mihomes.com.