One way builders further reduce risks: Options to buy land

Builders are actually super real estate investors. They usually leverage themselves to the extreme. One strategy they use is "Option to buy land". Similar to the lease-option business, builders sign up hundreds of option contract to lock price on hundreds of parcels of land. They not only locked the price at earlier year's level, but also blocked the availability of such land parcel to other investors. Toll Brothers Inc started to lock land under option contract as early as 80s at extremely low price. So they can apply for county zoing approval. In many states, it often take 10 years to get the land approved for residential construction.

Option contract also serves to reduce builders' risk. When the market slows down, builders simply walk away from the contracts. Of course, they may lose million of dollars in contract premium, but it's far better to actually buying these land at high cost and experience physical loss.

Therefore, even in the face of a big housing slump, big builders have earned enough money from their go-go years. And from the protection scheme like land options, their risk is still very small. As far as the existing communities with pre-built homes, simple, just reduce price 30%, they will sell quickly. By the end of next year, I expect most builders to have cleaned out their inventories.

Builders have learned a lot of lesson from the mistakes they made in the last cycle, late 80s housing bust. At that time, many builders didn't bother to put land deal in option contract, then the storm came, many went bankrupt or nearly bankrupt because they were holding too many useless land...