Lennar Corp /New/ Q3 FY2022 Earnings Call

Welcome to Lennar’s Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the presentation, we will conduct a question-and-answer session. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Alexandra Lumpkin for the reading of the forward-looking statement.

Thank you, and good morning. Today’s conference call may include forward-looking statements, including statements regarding Lennar’s business, financial condition, results of operations, cash flows, strategies, and prospects. Forward-looking statements represent only Lennar’s estimates on the date of this conference call and are not intended to give any assurance as to actual future results. Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties. Many factors could affect future results and may cause Lennar’s actual activities or results to differ materially from the activities and results anticipated in forward-looking statements. These factors include those described in yesterday’s press release and our SEC filings, including those under the caption Risk Factors contained in Lennar’s Annual Report on Form 10-K most recently filed with the SEC. Please note that Lennar assumes no obligation to update any forward-looking statements.

I would like to introduce your host, Mr. Stuart Miller, Executive Chairman. Sir, you may begin.

Very good. Good morning, everyone. Thanks for joining us. This morning, I'm here in Miami, joined by Diane Bessette, our Chief Financial Officer; David Collins, our Controller and Vice President; and of course, Alex, who you just heard from; Jon Jaffe and Rick Beckwitt, our Co-CEOs and Co-Presidents are on the line also, but they will be participating remotely for the Q&A. As usual, I'm going to give a macro overview and strategic Lennar plan. After my introductory remarks, Rick is going to talk about our markets around the country. Jon will update on supply chain, construction costs, land strategy, and as usual, Diane will give a detailed financial highlight and will give some rough boundaries for the fourth quarter to assist in go-forward thinking and modeling. And then, we'll answer as many questions as we can. And as usual, please limit to one question, one follow-up. So, let me begin and start by saying that once again, the Lennar team has turned in an excellent third quarter result, which continues to enhance our positioning for the evolving market conditions. Throughout our third quarter, we continued to manage the still constrained supply chain and workforce and delivered over 17,200 homes with a gross margin of 29.2%, and the net margin of 23.5%. These deliveries continued to drive very strong cash flow and bottom-line earnings as we continued to refine our already efficient operation with SG&A of 5.8% for a 120 basis-point improvement over last year. With strong bottom-line earnings of $1.47 billion or $5.03 per diluted share, driving strong cash flow, we've continued to fortify our balance sheet. After paying down $575 million of maturing senior debt without replacement, we ended the quarter with $1.3 billion of cash, nothing drawn on our revolver, and a 15% debt to total capitalization ratio as compared to 21.2% last year. As a matter of careful capital allocation this quarter, given current market conditions, we chose not to repurchase stock in favor of early retirement of debt. As we continue to drive strong closings and performance, we are well-prepared to handle the current market conditions. In addition to the well-documented supply chain constraints and limited workforce slowing production, housing has now been considerably impacted by the more than doubling of mortgage rates over the past months and therefore, the doubling of monthly payment costs and reduction of housing affordability. The housing market has continued to weaken, as expected, in response to the Fed’s too late, but now very rapid and aggressive reaction to inflation. Home building finds itself once again at the forefront of all that is happening in the economy, and the Fed's use of its interest rate tool to curtail inflation is certainly having the desired effect on the for-sale housing market. The market is now adjusting. The interest rate movements were very sudden and adjusted very quickly, and that suddenness has always led to a pullback in housing demand. Part of the pullback is driven by simple affordability, and part of the pullback is driven by the psychology of the sudden and aggressive interest rate hike, causing either monthly payment sticker shock or a sense of having missed the boat. The Fed chair's additional increase of 75 basis points of the Fed funds rate yesterday together with an articulated determination to do more suggests that even more challenges lie ahead. While demand has cooled at once high pricing levels, demand for shelter still exists, where price intersects with current interest rates to produce an affordable monthly payment. There is still a housing shortage across the country, especially workforce housing, and household formation has continued to rise. There's still very limited inventory and there's very little exposure to traditional inventory overhangs like foreclosures and speculators. Additionally, buyers are still seeking shelter from inflationary pressures on rentals as scarce rentals and increased demand from those who would otherwise purchase drive and keep rents higher. As we bring prices down and incentives up, demand is still there. And these fundamentals give us assurance that while there is short and medium-term reconciliation, the long-term prospects for housing continue to be strong. Demand remains reasonably strong at adjusted prices as buyers still have jobs as well as down-payments, have attractive credit scores, and can qualify. With higher rates, prices must be adjusted downward, and incentives used to find the market or sales just drop off. Accordingly, we have carefully managed sales price and our pace through the third quarter, exactly as we said we would last quarter. Although our sales are down 12% from last year's levels, we have focused our management's attention on finding pricing levels that attract demand. Each market is different, and as much as it is an art and not a science, our efforts have slightly lagged our goal of matching our sales pace with our start pace, but we feel certain that we will find pricing and accelerate that pace in the near future. In a few minutes, Rick is going to give a more detailed overall market review that will give a more comprehensive snapshot of what we've seen in our markets across the country. Along with bringing home sales prices down, we are also laser-focused on bringing down production costs as well. We are working with our vast network of trade partners to recognize that the world has changed and we all have to work together to keep the machine working. In fact, last night I returned from a two-day extraordinary supply chain conference that was hosted by our purchasing leadership group led by Kemp Gillis, trade partners and Lennar division leaders convened to work together to attack costs, find efficiencies, and adjust to current market conditions. Rick and Jon will drive continued and focused attention on this critical initiative. And as the market recalibrates, land costs will have to adjust as well. Accordingly, we are reviewing and re-underwriting every land deal in our pipeline to the current market conditions. In time, new land deals will have different pricing that will be properly sized to the home sales prices. Overall, these are the trends as we see them. And while we can choose to fight against the trends, the reality is that the market has been changing and we are getting ahead of it by making all necessary adjustments. Last quarter, we laid out our simple strategy playbook going forward. Let me review and add a few items. We're going to keep it simple and focused and here to this core strategy. First, as I said last quarter, we're going to continue to sell homes, adjust pricing to market conditions, and maintain reasonable volume. We have discussed over the past years that we have a strong housing shortage across the country. We will continue to build even as prices adjust in order to fill that shortfall and provide much-needed workforce housing. As we have noted many times in the past, whether the market is improving or declining, we employ our dynamic pricing model week-by-week to price product to current market conditions in order to maximize pricing and margin while we maintain a very carefully and limited inventory level. As the market moves, that is how we will continue to be responsive. Second, we are going to work with our trade partners, as I've said, to right-size our cost structure to current market conditions as well. Third, we will and have sharpened our attention on land acquisitions. We are being extremely selective on new land acquisitions and new communities. We have re-reviewed and re-underwritten every land deal in our pipeline, and we are re-underwriting to current market conditions. Capital allocation is being micromanaged as every dollar invested in land must compete against repurchasing our own stock as we seek to maximize total shareholder value and return. In sync with selling homes, we will continue to improve our cost of doing business by focusing on and reducing SG&A. We have seen quarter-over-quarter improvement in our SG&A over the past years, and we expect to drive efficiencies through technology and process improvement to offset market adjustments where possible while we leverage our extraordinary management team across the country. Next, we will maintain tight inventory control. We are aware that our inventory levels are up 20% year-over-year. This increase is mostly a function of growth, supply chain dysfunction, and expanded cycle time. As our growth rate is reduced to zero and our cycle times revert to normal, our inventory should shrink and should generate sizable cash flow in the future. Our commitment to sales pace will ensure that we will not create standing inventory in its place. Next, we'll continue to focus on cash flow and bottom line to protect and enhance our already extraordinary balance sheet. And finally, we will conclude our long-planned and awaited spin-off by year-end. Recent back-and-forth questions with the SEC could push the final date by a month or so, but Quarterra will be listed very soon. Of course, prior to the spin, we will have a comprehensive company overview and conference call to introduce the new management team and to further detail the financial elements of the company. Stay tuned. As we have continued to refine and finalize the three verticals of our spin company, we will spin a mature asset management company into the public market along with billions of dollars of assets under management that we previously held on Lennar's books. Lennar will be a pure-play homebuilding company with a simple mandate to build and sell homes that delight our customers while we drive and maximize shareholder value. The final spin of our new company, Quarterra, will trade under the stock symbol Q and will have, as noted before, an asset-light asset management business that will have a limited balance sheet. We are very excited about the prospects for Quarterra as this is our second spin in our history, and we have great confidence in its prospects for the future. So, let me conclude by saying that while the market is shifting and adjusting to a new higher interest rate environment, we at Lennar are prepared. We have been here before, and we have navigated adversity. We have a seasoned team that knows exactly what to do and how to do it. Every member of the Lennar management team is fully aligned and working in a coordinated way. We are extremely well positioned financially, organizationally, and technologically to thrive and succeed in these conditions. We recognize that interest rates are rising, inflation continues to be a legitimate threat, and important parts of the economy are slowing. We know that the Fed is determined to curtail inflation, and this will take some time. But we also know how to adjust to these market changes, and we are making those adjustments. As we look to the remainder of 2022, we recognize there are challenges in the market that we must carefully regard, expect that we will meet the challenges and that we will continue to adjust to maximize opportunity and drive Lennar into an even better future. With that, let me turn over to Rick.

Thanks, Stuart. As you can tell from Stuart's opening comments, the overall housing market has been reacting to significant increases in mortgage rates, continued inflation, and a volatile stock market, all of which has impacted affordability and homebuyer confidence. While we continue to have some strong markets, in our more challenging areas, we've had to adjust prices and increase incentives to regain sales momentum. Our sales strategy has been to find the market clearing price for each of our homes on a community-by-community basis as quickly as possible and price our homes accordingly. This has required a detailed understanding of traffic trends, inventory levels, community and product-specific pricing, financing programs, and buyer sentiment. During the third quarter, our new sales orders declined by 12% from the prior year on a 1% lower year-over-year community count. While our cancellation rate and sales incentives picked up during the quarter, our sales orders and sales pace per community increased sequentially each month as we successfully executed our pricing strategy in more and more markets. To put some color on this, our sales pace per community in June, July, and August was 3.7, 3.9, and 4.5, respectively. To achieve this, we lowered our base new order sales price and increased sales incentives in many communities. On a company-wide basis, new sales order incentives increased during the quarter from 2.3% in June to 6% in August and varied significantly by market and community. Based on these combined adjustments, our new net order sales price declined 9% sequentially from the second quarter but was up 1% from the prior year. This pricing strategy produced enough new gross sales to offset cancellations company-wide as our third quarter cancellation rate was 21%, which is slightly above our historical average. Our pricing strategy has continued to work successfully in September. It gives us confidence in our new sales orders guidance for the fourth quarter. We fundamentally believe that this price to market strategy reflects our balance sheet first focus, where we can maintain starts in sales, generate cash flow, and keep our homebuilding machine going. I'd now like to give you an update on our markets across the country. They really fall into three categories: one, markets that have continued to perform well; two, markets where we have adjusted pricing and incentives, found the market price, and have successfully regained sales momentum; and three, markets that may require some additional pricing adjustments to regain our targeted absorption base. During the third quarter and so far in September, we have had 9 markets that continue to perform well. These are Southwest Florida, Southeast Florida, Palm Atlantic, New Jersey, Maryland, Virginia, Charlotte, Indianapolis, and San Diego. These markets are benefiting from extremely low inventory, and many are benefiting from a strong local economy, employment growth, and in-migration. While these markets have continued to be strong, we have had to offer mortgage buydown programs and normalized incentives to maintain sales momentum. Some communities in these markets have required targeted price adjustments on a limited basis. Our category two markets, which reflect markets where we have made more significant adjustments to regain sales momentum, include 22 markets. These are Tampa, Orlando, and Jacksonville, Coastal Carolinas, Atlanta, Chicago and Nashville, Raleigh, Dallas, Houston, San Antonio, Phoenix, Tucson, Las Vegas, Colorado, Coastal California, Coastal Carolinas, Inland Empire, Bay Area, the Central Valley, Sacramento, Seattle, and Portland. Each of these markets’ traffic has slowed, and we saw a pickup in cancellations. While inventory is limited in each of these markets, we've had to offer more aggressive financing programs, base price reductions, and/or increased incentives to regain sales momentum. The size of the adjustments has varied on a community-by-community basis and has often been limited to specific homes each week in each community. In some cases, to avoid cancellations, we have adjusted pricing on our homes in backlog. We believe we are being very proactive with our pricing and not reactive. This has allowed us to sell homes and avoid building finished inventory. We are outselling the competition and are increasing our market share. Category 3 markets, which reflect more significant market softening and correction, include 7 markets. These are the Philly Metro area, Minnesota, Pensacola, Austin, Reno, Boise, and Utah. While the drivers and individual dynamics of these markets are varied somewhat, traffic has slowed significantly, buyers are taking more time to make a purchase decision, and many need to be convinced that now is the time to buy. There is fear that sales prices have not hit bottom, which has led to an elevated level of cancellations. In these markets, we are focused on establishing pricing that generates new gross sales to offset cancellations. This has required us to work in many cases with backlog to prevent cancellations. It has also required a mix of significant base price adjustments, sales incentives, and aggressive mortgage buydowns. While we've made progress in these markets, we still need to make some adjustments on a community-by-community basis. There's not a one-size-fits-all solution. Everything needs to be fine-tuned to the specifics of the market and community. I'm confident that we'll make progress in each of these markets in the fourth quarter. We're fortunate to have solid gross margins and limited completed unsold inventory, so we should be able to get these markets on track shortly. I hope this gives you a better picture of our markets across the country and what we're doing to keep our sales activity going. Markets remain very fluid, and we are making proactive strategic decisions and adjustments every day. We are committed as a management team to address any future market changes quickly. As we've said in the past, we're going to keep our homebuilding machine going, maintain our starts pace, and price our homes to market. This is our balance sheet focus. Before I turn it over to Jon, I'd like to thank all of our trade partners and associates for their hard work and endless dedication during these rapidly changing times to successfully execute our operating strategies.

Thanks, Rick. This morning, I will discuss our sales and inventory management focus, our land strategy, and give an update on the status of the supply chain. I'd like to start by laying out a few additional thoughts on the detail that Rick just walked you through. As discussed, this quarter was all about the daily process of adjusting home prices to find market clearing values in each individual community. As noted, our starts and sales pace for the quarter were 4.4 homes and 4.0 homes, respectively. This gap between starts pace and sales pace comes from the time it takes to make the pricing adjustments necessary to be perceived as value by the consumer. Finding that value proposition is a process that takes several weeks and is ongoing. In other words, once market pricing is found through discovery, the market often experiences further adjustments, and a new value proposition must be discovered. As we went through the process of finding clearing prices in communities, this informed our decision-making, which enabled broader pricing adjustments, leading to our improved sales pace across our entire platform for the month of August. As Stuart noted, our operators use our dynamic pricing model to help them understand the timing of inventory as it moves through the construction process. This tool gives us visibility into sales pace and associated pricing by community and even by plan, allowing us to maintain our starts pace without building up excess inventory. Our inventory position at the end of the quarter was just over 500 completed unsold homes or 0.4 homes per community. Next, I want to discuss our land focus in the third quarter. As expected, we focused a lot of attention on reassessing every land deal in our pipeline along with updating our underwriting. Based on our intense review, we moved forward only on those deals with starts in 2023 and where we were also confident in the updated financial underwriting. Most of the land deals we closed on in the quarter came from our strong land relationships with existing structured quarterly takedowns. These takedowns are deals where we would be starting the homes quickly and still projected healthy margins. All other deals, based on the updated underwriting, either had its timing delayed, was restructured, or we did not proceed. Our intensified focus on our land-light strategy was evidenced by our controlled home site percentage increasing to 63% at the end of the third quarter, up from 53% last year. We also further reduced the years of owned home sites to 2.9 years at the end of the third quarter, down from 3.3 years last year. And we reduced the number of home sites purchased in the third quarter to about 13,100, down 21% and 25% year-over-year and sequentially, respectively. Our extreme focus on a deal-by-deal review and adherence to our disciplined land lighter model drove the significant improvement in the strength of Lennar's balance sheet, as Stuart discussed. Now, I'd like to turn to the current state of the supply chain. Our third quarter continued presenting some favorable cycle time results while still dealing with ongoing disruptions from certain material shortages. Although it was minor, it's still significant that we achieved a three-day reduction in cycle time in Q3 from Q2. Additionally, over 50% of our markets experienced cycle time reductions in the third quarter compared to 25% in the second quarter. The primary material disruption in the third quarter was related to the delivery of electrical equipment such as switchgear, multimeter boxes, and pad-mounted transformers. Construction labor remains very tight as industry-wide high levels of volume for second half deliveries move through the various stages of construction. We expect to start seeing some easing in labor as the overall industry reduces the level of construction starts. This easing should start to first occur in the fourth quarter with front-end trades and in the first quarter with finished trades. As expected, cost increased in our third quarter as increases from lumber that spiked in Q1 flowed through our third quarter closings. We also saw increases in other material costs and labor in Q3 closings, resulting in a total direct construction cost increase of 6% and 21% sequentially and year-over-year, respectively. As a reminder, the drop in lumber prices we saw earlier in the year materially benefited the cost of our starts in the third quarter and will flow through deliveries in the first half of 2023. Thank you. And I'll now turn it over to Diane.

Thank you, Jon, and good morning, everyone. So Stuart, Rick and Jon have provided a great deal of color regarding our homebuilding performance. So therefore, I'm going to spend a few minutes on the results of our other business segments and our balance sheet and then turn to Q4 guidance. So, starting with Financial Services. For the third quarter, our Financial Services team produced operating earnings of $99 million, excluding the recording of a one-time litigation accrual. And then looking at the details, our mortgage operating earnings was $64 million compared to $80 million in the prior year. As we've indicated for several quarters, the mortgage market continues to be extraordinarily competitive for purchase business. As a result, secondary margins have been decreasing. This decrease in earnings was partially offset by an increase in interest rate lock commitments. Total operating earnings were $33 million compared to $26 million in the prior year. Final earnings increased primarily as a result of higher volumes and an increase in revenue per transaction. Our Financial Services team continues to rise to the occasion each and every quarter to assist our homebuilder divisions to properly service our customers. And then turning to the Lennar Other segment. For the third quarter, our Lennar Other segment had an operating loss of $118 million. This loss was primarily the result of a noncash mark-to-market loss on our publicly traded technology investments, which totaled $86 million. As we have mentioned before, we are required to mark to market many of our technology investments that are publicly traded, and that valuation will fluctuate from quarter-to-quarter. However, we believe these technology partnerships provide significant operational efficiencies for both our homebuilding and Financial Services platform and greatly improve our customers' experience. And then looking at our balance sheet quickly, as you've heard all of us mention this quarter, we were laser-focused on managing our balance sheet. We focused on generating cash by pricing to market, and we focused on preserving cash by monitoring our stock space and carefully reviewing potential land purchases. The end result, as you heard us say, is that we ended the quarter with $1.3 billion of cash and no borrowings on our $2.6 billion revolving credit facility. This provided a total of $3.9 billion of homebuilding liquidity. During the quarter, we continued our progress of becoming land lighter. At quarter end, we owned 184,000 home sites and controlled 307,000 home sites for a total of 491,000 home sites. This translates into 2.9 years of home sites owned, an improvement from 3.3 years in the prior year and 63% home sites control, an improvement from 53% in the prior year. Most importantly, though, we believe this portfolio of home sites provides us with a strong competitive position to continue to grow our market share. Additionally, we continue to deleverage our balance sheet as we repaid $575 million of senior notes that were due in November of this year, and we have no additional maturities in fiscal 2023. In the last several years, we have repaid $5.4 billion of senior notes with an associated annual interest savings of almost $300 million. A continued paydown of senior notes and continued strong generation of earnings brought our homebuilding debt to total capital ratio down to 15% at quarter end, our lowest ever, which is an improvement from 21.2% in the prior year. Our stockholders' equity increased to $23 billion. Our book value per share increased to almost $79. Our return on inventory was 32.7%, and our return on equity was 21%. Finally, we received an upgrade from Moody's during the quarter. Our credit rating was increased from Baa3 to Baa2. We greatly appreciate Moody's confidence in our company and continue to be very pleased to have an investment-grade rating from all three agencies. In summary, the strength of our balance sheet, strong liquidity, and low leverage provide us with significant confidence and financial flexibility to navigate this uncertain market. With that brief overview, I'd like to turn to guidance. As Stuart mentioned, it continues to be difficult to provide the targeted guidance that we have historically provided, given the uncertainty in market conditions. So, as we did last quarter, we are providing very broad ranges to give some boundaries for each of the components. So, let's start with new orders. We expect Q4 new orders to be in the range of 14,000 to 15,500, and we expect our Q4 ending community count to increase about 5% from Q3. We anticipate our Q4 deliveries will be in the range of 20,000 to 21,000 homes. Our average sales price should be in the range of $475,000 to $480,000. Our gross margin is in the range of 26% to 27%, and our SG&A between 5.7% and 5.9% as we continue to price to market, turn our inventory, and generate cash. For the combined homebuilding joint venture, land sale, and other categories, including non-controlling interest, we expect a loss of approximately $15 million. We anticipate our Financial Services earnings for Q4 will be in the range of $50 million to $60 million as market competition for purchased business continues to increase. We expect earnings of $15 million to $20 million for our multifamily business. And for the Lennar Other category, we expect a loss of about $20 million. This guidance does not include any potential mark-to-market adjustments to our technology investments since that adjustment will be determined by their stock prices at the end of our quarter. We expect our Q4 corporate G&A to be about 1.2% of total revenue, and our charitable foundation contribution will be based on $1,000 per home delivery. We expect our tax rate to be about 24.5%, and the weighted average share count for the quarter should be approximately 288 million shares. And so, when you put all this together, this guidance should produce an EPS range of approximately $4.65 to $5.30 per share for the fourth quarter. And with that, let me turn it over to the operator.

Thank you. Truman Patterson with Wolfe Research, you may go ahead, sir.

Hey. Good morning, everyone. Thanks for taking my questions. So, you all have been pretty open about the fact that you intended to throttle the incentive level to really drive volumes, and the orders down 12% is I think a good result in the current environment. So your order ASP fell 9% sequentially. All four regions looked like they ticked lower. I'm just hoping you can help us understand how much of that 12% decline was a function of base price cuts, incentives, etc.? Was it the overwhelming majority, or was there some product mix shift in there?

Why don't I let Rick take that? Go ahead. I'm going to play the role of traffic cop here because we are in remote locations. So go ahead, Rick.

So as I mentioned in my commentary, there was about a 4.5% incentive that was priced in the quarter. Some of that was a base price change with a slight mix adjustment as we closed a more significant amount of entry-level homes during the quarter.

Okay. Perfect. So, that 4.5% increase captures both the incentive level and the base price cuts. All right. Thanks for that. And you all now have increased your option land 63% of your portfolio. It's been a pretty rapid shift over the past couple of years. And you mentioned that you reassessed every deal in your pipeline, and you're working with partners to improve underwriting standards. Could you help us understand if you've actually been walking away from deals at an accelerated pace? I noticed your option lot declined in the quarter. Could you discuss just the willingness of your partners to work with you all? And any chance you might be able to help us quantify what portion of controlled deals might be on the watch list or at risk?

Let me share a general thought on this topic. There are a few categories to consider. First, we have some shorter-term deals where we own home sites. These sites remain valuable assets that we are actively developing, generating a good profit even under current market conditions. We will keep building in these communities. One advantage of shorter-term deals is that they usually still yield an attractive margin. For every land deal in our pipeline, we continuously review our underwriting process, especially in light of changing market conditions. Therefore, we will step back from any programs or land contracts that no longer align with our underwriting standards, particularly where we can exit at a reasonable cost. We are not pursuing deals that fail to meet our underwriting criteria. This approach reflects the evolution of our land program over recent years. In the last quarter, we identified deals that fit our strict underwriting criteria and those that did not, and we excluded the latter. This has resulted in us walking away from approximately 10,000 home sites just in this past quarter. Is that everything, Diane?

Yes.

Yes. And Rick, Jon, do you want to weigh in on that?

I would just add that we have extremely strong relationships with a lot of land partners. And relative to your question, we are able to work with them to either adjust timing, restructure, or change pace. And that combined with, as Stuart described, just a constant refresh analysis just keeps us very current so that the land we are acquiring is turning into starts very quickly with very acceptable margins. And if it doesn't fit that criteria, we're finding the appropriate alternative solution for the asset.

Susan Maklari from Goldman Sachs, you may go ahead.

My first question is, Stuart, you talked a lot about cash generation. And as we do think about the overall market moderating, can you talk to some of the changes in the business today relative to the past cycle? What that will mean for your ability to generate cash as we think about things changing on the ground, and the areas that you're really focused on investing in, in order to position the business for that eventual recovery, and where you see Lennar going over time?

Great question. Historically, if we examine Lennar's structure, many builders have shifted away from long-term land positions that have hindered us during slow market periods. By converting our land assets to short-term assets, we can continue to produce under current market conditions, allowing for asset turnover. We will replace these assets with land that is repriced to reflect the current market. This represents a significant structural change within Lennar and the broader industry, which I believe will lead to increased cash generation. Homebuilders face several challenges during downtimes, one of which is long-term land, and we have addressed that issue. Additionally, when growing a homebuilding company, the growth component consumes a lot of cash as we continually purchase land and expand our operations. As we transition to a slower or stagnant growth pace, this will itself become cash generative. Thus, with our short-term land positions and the shift to a no-growth environment, we expect positive cash flow. The one exception is the extended cycle time caused by supply chain issues, which has increased our cash inventory buildup by about 25% compared to normal periods. Previously, we extended our typical six-month cycle time by approximately two months, which reflects an industry average. Eventually, this two-month delay will resolve, leading to a return to standard production cycle times, providing us with additional cash generation as conditions normalize. This normalization may occur within this year or over the next couple of years, but it is expected to enhance our cash flow moving forward.

Okay. That's very helpful color. And then following up, affordability is obviously a key focus as rates rise and the macro changes. Can you talk to some of the benefits of your underlying operations and how you're able to sort of drive that narrow band between the tensions that exist on the cost side relative to what the consumer needs and the ability to get those first-time kind of home buyers into a house?

Well, listen, I'm going to have Rick and Jon both speak to this. Let me just say as a general overview along those lines, the three of us just left a two-day session with our trade partners. And the partnership that exists among our operating groups in the field and our trade partners really came to light as we had straight conversation about what the market is doing and partnership and recognizing that we've all got to find a way to reconcile costs to enable affordability in the sales price of the home. That goes to our land partners as well as to our trade partners. I think that across the industry, everybody recognizes that there's going to have to be a cost reconciliation as interest rates go up. It's clear that there's going to be more increase in interest rates that we're going to be dealing with. So, we've got to band together to make the machine work, and that means a cost structure that enables affordability. Rick, Jon?

Yes. It's exactly what you said, Stuart. It's a combination of us reducing sales prices and having the margin impact, and you saw that we executed on that during the quarter. We've discussed with our trade partners that there needs to be a sharing. Everyone made a lot of money during the up cycle, and it's time to work as partners to restructure the cost side on both the labor and material side. And in addition, as Stuart walked through the land side of the business, there's going to be some adjustments in land pricing. So, it's the collective of all three of those that we will do in order to execute the strategy to keep the sales momentum going.

I would like to add that during this time, as Rick pointed out, we need to find the right price that aligns with our customers' affordability and reality. We are carefully reviewing our product offerings to identify areas where we can implement significant value engineering and introduce smaller, more efficient products in certain markets. We are continuing to lower prices to find the intersection of affordability for consumers with mortgage payments and home prices.

Yes. I guess the bottom line, this is a dynamic situation. And the execution part of that is alignment. You hear alignment with me, Rick and Jon, and we've conveyed that to the Lennar organization, to the trade partners and to our land partners as well that work has got to be done, and everybody is at work.

Stephen Kim with Evercore ISI, you may go ahead, sir.

Just first question just from a housekeeping perspective, from calculating your starts, we're probably about 15,700. Correct me if I'm wrong. And then, you talked about inventory, maybe freeing up some cash. I think you said that cycle times, moderating cycle times eventually was 25%, I guess, of the growth. I suppose that was a comment about your sticks and bricks inventory. So, the bottom line is, on the inventory, I'm thinking that the cycle time negative impact. Am I right in thinking that you're saying that that's about $1.8 billion of cash that's burdening your current inventory? So that number and then also the 15,700 starts, is that in the ballpark?

So, happy you asked the question that way, Steve. I will tell you that Diane has tried to figure out what the number is. And that specificity is we haven't been able to put our finger on it, but it is in that kind of neighborhood. It's a significant amount of dollars that are tied up because of the cycle time increase.

And Steve, you are pretty close, we had about 16,000 starts this quarter, so good math.

Got you. In addition to the $1.8 billion figure, you mentioned that your inventory could decrease further due to slower growth, particularly regarding land. However, I assume that this growth comment is temporary. In the near term, and looking ahead, the opportunity likely lies with work in progress. Please correct me if I'm mistaken. I also wanted to inquire about your current inventory level. Jon, you stated that there are around 500 finished homes right now. Based on my calculations, that is about two to three times fewer than what you typically had before the pandemic on a per community basis. I'm curious if this 500 is the new normal for you or a new target level. If that's the case, why is it so, especially if it's true that customers now seem to prefer homes they can move into more quickly? I would like to understand if there has been any shift in your strategy regarding managing specifications as they approach completion, and why you might aim to lower that number given customer preferences.

It's a valid point you're making. We typically maintain an inventory of about one home per community, which is currently less than half of what it was before the pandemic. We do expect to increase our inventory to a more standard level and possibly even exceed that. The goal of raising our low inventory is to emphasize that we're not just producing homes and letting inventory accumulate. We take a disciplined approach to sales and ensure we are reducing inventory effectively. Our dynamic pricing model supports this process, and we monitor it daily. However, you’re correct that having some available inventory can be advantageous for customers seeking immediate occupancy. During the pandemic, we struggled to have inventory ready. Ideally, we should hold a bit more than we currently do, and we plan to reach that level in a careful manner. Jon, Rick, would you like to add anything?

I think you really covered exactly what our operating strategy is, Stuart. And Stephen, your assessment of the numbers is right and the consumer desirability especially in a changing interest rate environment for a quick move-in. They can lock in their rate if they buy today and create that certainty for themselves. So, that is definitely an advantage. But we're very focused, as Stuart highlighted, using dynamic pricing to make sure our homes are sold in time. So, as they come off our construction assembly line, we're able to deliver them to the customer. And that will fall in that range in a more normalized time of about one community per week. It will fluctuate from time to time, but that's our focus.

The only thing I'd add to that, Steve, is as Stuart said in his comments and I mentioned as well, we're very focused on cash generation. Easiest cash to generate is the sale of a completed home. But to the extent that we have standing inventory, we're going to sell that home because we've got homes moving through the production cycle that are going to replace that. Whether it's a half or one, we've continued to refine our pricing strategy to maximize the cash and quickly sell the inventory as it progresses from stage to stage.

To revisit your earlier point, yes, a zero growth rate would be a temporary situation, not a lasting one. However, we recognize that we shouldn’t force growth when the market conditions indicate otherwise, and that is certainly the case now. As the market rebounds, I believe the long-term outlook for housing remains positive. When the market improves, we will be well equipped with strong cash reserves to take advantage of those better conditions.

Our next caller is Alan Ratner from Zelman & Associates. Please go ahead, sir.

I guess, first, Stuart, maybe directed to you. We've talked in the past about build for rent and that space being a potential kind of countercyclical vehicle in the event of a slowdown in primary demand, which is clearly what we're seeing today. I'm just curious if you could talk to your current BFR business, whether perhaps you're leaning a bit more heavily on that in the current climate. And obviously, with your relationship with the fund and the investors there, what the current appetite is among those investors?

Great. I'm going to ask Rick to jump in after. I'm going to give a first comment and say that I do believe that single-family for rent is going to continue to grow and be a meaningful part of the housing market. I've learned over the years that SFR has always been a part of the market more dominated by the mom-and-pop participants. Now, it's been professionalized, and more institutional buyers are a significant part of the market. But that part of the market has pulled back as interest rates have gone up, as prices have come down and it has moderated. So, it is still a very small part of our production and our sales program overall. And I have no question that as prices moderate, the SFR business will push in and become more of a significant part of the recovery. So Rick, do you want to fill in some of the thoughts and numbers there?

Yes. Stuart, as you mentioned, as rates have risen, several of the SFR players use leverage that's floating in order to underwrite and finance their deals. Accordingly, some of the investment in that space has slowed down, but rents are continuing to maintain. And as a result, they'll get their embedded yields that they're looking for. For us as a company, we had about 1,000 homes that we sold to the single-family rental space in the last quarter. It's probably underestimated because there were some additional sales in our communities that other folks are investing in and renting that aren't captured in that number. But it was about 1,000, and our SFR program itself was a little bit more than 700 during the quarter.

Let me add that your question implies a consideration of the percentage and how we are increasing the Quarterra segment of our SFR program. The reality is that our program has taken a disciplined approach by stepping back and allowing the market to adjust itself. So, contrary to what you might think, we are likely selling less within our own program and more to other SFR programs outside of Lennar.

Okay. No, that's really helpful. And thank you for that disclosure there. It's very helpful. I guess, second question just on the kind of the monthly cadence you described. I think, given the 4% increase in incentives/base price reductions, combined with the fact that in August, we obviously saw mortgage rates pull back temporarily, it's not too surprising to see that kind of be the strongest month of the quarter. I think you mentioned that September was kind of following a similar trajectory, which, I guess, I'm a little surprised given the continued increase in mortgage rates or the reemergence of mortgage rates since the end of August. So have you further increased incentives or gotten even more aggressive on price reductions to kind of combat that move we've seen in rates, or are you still seeing that momentum continue in spite of the higher rates?

Let me clarify something. For Q3, our incentives were approximately 4.5%. About 3% of that was due to a base price reduction in addition to the incentive, with the remaining amount being influenced by a shift towards lower price points. As we entered September, we have maintained a consistent performance compared to August and the third quarter. From a pricing perspective, we've only made slight adjustments in our incentives, and our actual net sales price has increased compared to August. This could be due to changes in our mix. Our cancellation rate remains steady with where we were for the quarter, and our sales pace has also been consistent with August. We haven't observed any significant changes. This reflects how we've effectively refined our sales execution strategy.

Got it. That's great to hear.

We are finding the market, and we are finding the market primarily with primary buyers. And as we find the market, there's demand out there, but the demand needs affordability. So, that's basically what's happening.

To that point, Stuart, if I could sneak in one more. It sounds like many of your competitors have been a bit more reluctant to be as aggressive as you have on the pricing side. So I'm curious if you're seeing more builders of late kind of respond in force to try to match what you guys are doing and presumably one or two of the other larger builders are doing, or is there really a clear divergence right now in terms of strategies out there, some builders trying to hold on to margin as long as possible and others trying to find the market as you guys are doing?

Look, it's a mixed bag. There are some builders that are going along with the program that we have in place. There are a lot of others that have different strategies. The smaller builders are reacting a little differently than some of the larger builders. And that just adds to the choppiness of the market condition. All I can tell you is that market by market, we know exactly what the competitors are doing. We see the inventory buildups where they're happening. We see the migration to sell to price, hold and wait and ultimately, falling off the cliff and saying reconciliation. Each of these plays out in each market. That's why we emphasize our dynamic pricing model to each of our divisions because that's what keeps us tuned into the competitive field, exactly what's happening and making the judgments that are necessary. I think Rick said it really well. This is an art, not a science. And we are playing the game in each market that exists by knowing what the competitive field is and reacting to it.

Thank you for taking my questions, guys. The first one is, can you just help us on the sequential walk in gross margin from 3Q to 4Q? It's about 270 basis points at the midpoint. How much is base price reductions? How much is other incentives, rising costs? And how much of an offset is sort of the typical seasonal operating leverage?

Rick, why don't you take that?

Yes. So, putting cost aside, I would say that half of it was probably sales incentives. 40% to 30% of it was base price reductions, and the balance was probably some cost and mix. Jon?

I think that's right. As we've talked about on prior calls, the second half and the fourth quarter will be our peak construction cost as the highest lumber work through that. And that will start coming down at the very end of the fourth quarter and into the first quarter. So, that makes sense what you said, Rick. And clearly, the biggest driver is what we're doing to adjust to market to keep our sales pace.

Yes. Let me just add to that and say that in addition to pricing and base price as well as incentives management, we're also managing our backlog, recognizing that as prices adjust, we also sometimes have to go back to our backlog. We don't want to turn yesterday's sales and customers into a cancellation. And so, there's some administration of that as well. And so, a lot of moving parts in the walk from third quarter to fourth quarter margins. It's not as linear as just what the new sales are.

Okay. That's helpful, guys. Thank you. And then, maybe switching gears to Quarterra. Third-party equity commitments for the asset management business, I think, were $4 billion last quarter. What has that grown to? And how much third-party capital has been committed to the land strategies?

We haven't put those numbers out, so I really can't put those numbers on the table. We're a bit restricted as to what we can disclose at this point. And we're going to do something more comprehensive and putting together a conference call to really let all of those pieces and numbers be known as we're getting ready to actually go public. So, I say it again, stay tuned.

I want to understand the trajectory of gross margins as we look beyond the fourth quarter. I completely understand that you're not providing specific guidance for fiscal '23 at this time. However, as we consider the first couple of quarters, with the 4.5% average incentive for the quarter and an end-of-August figure around 6%, it seems like there's potential for another 150 basis points if we maintain the current situation and manage costs effectively, which I know you're focused on. Could this be a reasonable starting point to estimate the difference in gross margins for the first quarter of '23 compared to what we are seeing now, assuming other critical variables remain steady?

So Mike, the best way for me to answer this is to say that we have definitely not provided guidance for the fourth quarter due to many variables at play. We understand that our goal is to provide some boundaries to assist with modeling. It becomes even more complicated as we look ahead to the first quarter. Therefore, we won't delve into that right now since there are many changes occurring. After listening to Chair Powell's perspective on the future, we realize we are in a dynamic environment that will shift frequently month by month and quarter by quarter. Our focus is on weekly updates. Our management team meets every other day to align and observe real-time patterns in the marketplace, which varies by market. So, while this might seem like a lengthy explanation, we aren’t prepared to discuss our first quarter numbers at this moment.

Okay. I appreciate that. I guess, similarly, at the risk of asking another question that might be hard to answer, but directionally, how should we think about community count in '23? Obviously, this year, you're looking to end with some sequential growth 3Q to 4Q. Given the moderation in sales pace, obviously, delays and such can impact the rate of openings. But is growth how we should think about next year? And if so, any sense of degree of magnitude?

Great question. We've given that a considerable amount of thought. I'm going to turn to Rick in a second on this because this is his favorite topic. But we are thinking about community count growth into next year. I can't prove it right now, but we think that there's going to be some comparable reconciliation in land pricing, which will enable us to find opportunities that will rightsize for current market conditions. But we're going to have to wait and see on that. Rick, could you add to that?

Community count can be complicated as it depends on the pace of sales, existing communities, development timing, and whether it's internally or externally developed, as well as the timing of completion. Currently, we believe our community count will likely rise in 2023, potentially by a low single-digit percentage. This increase may be influenced by the land market situation, as other builders might back out of deals on completed home sites, which could benefit us due to our cost structure. However, as Stuart mentioned, it's difficult to predict at the moment, but the outlook appears to be slightly positive.

Thank you, Mike. We'll conclude there. I appreciate everyone joining us. These are challenging times, but we have an experienced management team that has faced similar situations before. We have a plan and strategy in place, and you can count on us to stick to that strategy confidently. We look forward to updating you as we approach the end of the fourth quarter. Thank you, everyone.

Thank you. This concludes today's conference call. You may go ahead and disconnect at this time.