BRUCE KARATZ OF KB HOME: Gimme shelter

After years of being shunned by tech-crazy investors, the venerable homebuilder was recapturing Wall Street’s fancy.

After years of being shunned by tech-crazy investors, the venerable homebuilder was recapturing Wall Street’s fancy. Now a faltering economy threatens the relationship.

Like many Old Economy chief executives, Bruce Karatz, 54, had a hard time getting investors to pay attention to his company during the technology-stock boom of the late 1990s. That changed after the tech bubble burst last year. Since July shares of Los Angeles-based homebuilder KB Home, formerly known as Kaufman & Broad Home Corp., have reversed a two-year, 50 percent decline, briefly reaching an all-time high of $38.31 in mid-December. The renewed enthusiasm for the stock reflected a strong economy, low interest rates and a booming housing market, which led to an increase in sales from $1.79 billion to $3.93 billion over the past five years, and helped turn a $61 million net loss into earnings of $210 million ($5.24 per share) during the same period.

But lately, concerns about a weakening economy have clouded the company’s prospects. KB Home shares, at a recent price of $27, still trade at a paltry seven times projected 12-month earnings, despite revamping operations in recent years to make the company less of a cyclical play. For example, after decades of building on spec - without having buyers lined up - the company now sells homes before building and has a six-month backlog of orders.

Karatz, a 29-year veteran of KB Home who became chief executive in 1986, has made a series of acquisitions, taking the company into new regional markets in the U.S. and thereby diversifying its exposure to local economies.

KB Home also has a thriving business in France. The overseas initiative was launched by co-founder Eli Broad in the late 1960s, even though suburban development pioneer William Levitt had already tried, unsuccessfully, to export his Levittown model to Europe. The French unit generates 11 percent of the company’s revenues. Karatz ran it from 1974 to 1981. KB Home also lists its shares on the ParisBourse. “We’re better known in Paris than we are in Los Angeles,” quips the CEO.

Still, international expansion remains difficult because of underdeveloped global mortgage finance markets. At home Karatz hopes to boost growth through a joint venture formed last year with American CityVista, a development company headed by Henry Cisneros, former U.S. secretary of Housing and Urban Development, to build developments in aging city centers.

Karatz recently discussed his company’s outlook with Institutional Investor Staff Writer Justin Schack.

Institutional Investor: How much of the decline in your stock price during the past few years was attributable to investors obsessed with technology at the expense of other industries?

Karatz: I think almost all of it. Our industry essentially was overlooked during the technology bubble. Homebuilders have made a nice recovery over the past several months, but I think there’s still room for improvement.

How do you get there?

We have to continue to make people aware that our business is flourishing and that we’ve changed our operating model so that the risk profile is lower now. Analysts, for the most part, have recognized that a company in our sector, with our kind of record and historical price-earnings ratio, should not be trading this cheaply. But most investors still are not listening.

Are you considering acquisitions to broaden KB Home’s geographic reach?

We see continued growth opportunities in Texas, Arizona, Colorado and, to a smaller extent, in California. You’ll probably see us in some new geographies. I just can’t tell you when. What’s more important than where we go is to find the right company that we can acquire at a fair price. I’m more motivated by those factors than by, say, Virginia versus Florida. We can standardize the business across different regions, but if the biggest employers in a local market for some reason go away, we can’t help that. Housing demand will diminish and we will suffer, which is the reason why we diversify.

France seems like an odd place for suburban subdivisions.

French families have just as strong a desire to move into a single-family home, with a backyard, a garage and a walk-in closet, as a family in New Jersey. What is different is that planners there would rather see midrise buildings, grouped around a village core, surrounded by fields, than single-family neighborhoods á la Southern California, stretched out for miles. That has pushed us to build condominiums. The split for us in Paris is about two thirds condominiums and one third single-family homes.

Will you expand in Europe?

Probably not. In past years we were a significant builder in Germany and in Belgium. But during the early 1980s, I made the decision to get out. Particularly in Germany, as property was passed on from generation to generation, families split it equally. To piece together a parcel for development, you often needed 20 or 30 landowners to come together, which was a discouraging factor.

What about other parts of the world?

That can be tricky. We’ve experimented with Mexico City, for example. The demand for housing there is phenomenal, but it lacks a secondary mortgage market. For a housing market to be vibrant, you need to be able to provide longer-term, fixed-rate mortgages that cover a substantial majority of the price of the product. As soon as you require people to put up 50-plus percent of the price of real estate, your market shrinks dramatically. We don’t appreciate how lucky we are in the U.S. to have this large secondary mortgage market, the Fannie Mae-Freddie Mac combo, that has really allowed us to keep rates down and have funds available at all times.

Isn’t that also a problem in France?

That’s a unique situation. There are national banks that put mortgages in their portfolios. They require the borrowers to open up bank accounts that they will automatically withdraw payments from, and into which the borrower’s payroll checks are directly deposited. There’s no secondary market, but there are big financial institutions that compete to create opportunities for homebuyers.

What public policy issues affecting KBH are you most concerned with?

One is the very restrictive building environment in California. Cities get a far larger percentage of sales tax revenues than they do of property taxes. So mayors and city councils love a new Chevrolet dealership, as opposed to a new town-house development, even though they desperately need more housing. California’s population is expected to grow by something like 15 to 20 million people in the next 20 years. We need to eliminate that disincentive to development.

Have you seen a backlash against the kinds of developments you build from opponents of suburban sprawl?

For the most part, “sprawl” is a word invented by antidevelopment forces who idealize certain living standards that we all should aspire to and be wary of losing. But the real issue is that we need to create, in certain communities, adequate housing for the population in the least intrusive manner. If you don’t do that, over time you will depreciate the environment for everyone. We’ve seen this in parts of California, where multiple families live in single units and motels are converted to housing units charging by the night. In Silicon Valley people are paying per night to sleep in someone else’s living room.

Does KBH try to mitigate some of the negative effects of sprawl, such as traffic and environmental damage?

We support the development of new infrastructure. Look at the BART system in the Bay Area. People laughed at it when it was built, and now it’s very successful. If we had built something similar in Southern California 20 years ago, people there wouldn’t be feeling the pinch of congestion as much now. We also support higher-density development, closer to the city core. A good example is the joint venture we created last year with Henry Cisneros.

Are these kinds of high-density, city-core communities also good business?

Yes. We now have more than 500 families on our waiting list to purchase homes in the first American CityVista development. This is in an area of San Antonio, Texas, where there has been no new construction in 40 years. Everybody assumed there was no demand. But there are many people who have lived there for many years, want a new home and don’t want to move away to get one.

How concerned are you about an economic downturn?

I think we benefit from the combination of concern about a downturn and the [U.S. Federal Reserve Board] aggressively reducing rates. With unemployment still very low, falling rates allow our customers to afford a home or buy a more expensive home. I think we’re in an environment where things will fall off modestly. The good operators - and I believe we are one of them - will make up for that modest drop by eating the lunches of the smaller players that are not operating as well.

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