After years of decrying the failure of the public home building companies to earn adequate returns, Bruce Karatz is doing something about it. Chairman and CEO of Kaufman and Broad Home Corp., Karatz is remaking his company from the ground up, changing the way K&B designs homes, sells homes, buys land, and sets targets. Calling this new initiative KB2000, Karatz projects a bright future for K&B.

"We're going to be substantially larger and significantly more profitable than we are today, with much higher return on our capital invested than we have today," says Karatz. "This new model is a far lower risk model than the one the company ran on during the 1980s. We are not interested in being land speculators. We are not interested in buying portfolios of loans in default. We are really only interested in being the best operating home building company in the business. And we believe that when we are, we can get the kinds of returns that equal the top quartile companies in any industry."

According to Kaufman and Broad's customer survey, buyers placed less value on the exterior elevations than on the home's price per square foot. In response, K&B simplified its elevations, cutting out both frills and costs.

Re-engineering a company the size of Kaufman and Broad -- 10,249 U.S. closings in 1996, $1.8 billion in 1996 revenue, 1,600 employees -- is a formidable task. It's not enough just to set the new course and expect the company to turn in that direction. K&B has always had one of the strongest corporate cultures around, typified by aggressive deal makers in expensive suits. Orienting the K&B team to this new, risk-averse model may seem like trying to tame wolves by dressing them up in sheep's clothing. But Karatz has two aces in his hand.

The first is Rayco, the San Antonio-based home builder that K&B acquired in March 1996 for $110 million. Rayco operates almost exactly like Karatz's new model and has been one of the most profitable home builders in the country, so Karatz has a working model to adopt and adapt. Second, nothing convinces like success, and KB2000 is already showing impressive numbers. At one California project where the new designs and sales strategies are up and running, sales have more than doubled, construction schedules have been cut by one-third, hard costs are down, and returns are up. In 1995, K&B's return on equity (ROE) was a paltry 6.9%; in 1996, including Rayco's numbers for nine months of the year, the ROE jumped to 14.1 % (excluding a one-time write-down of long-term real estate holdings).

With this new model, Karatz predicts, Kaufman and Broad will increase its annual volume by about 5,000 units within four years and will post returns on investment exceeding 17%.

The Rayco Model

Rayco has long boasted mind-boggling performance results. In the year before K&B's acquisition, Rayco had more than a 40% share of the San Antonio market -- yes, that's four-zero -- closing 2,585 homes, and grossing $236.2 million. Net pretax income was $28.3 million (12%), return on assets exceeded 37%, and return on equity was 66.9%.

To achieve these numbers, says former CEO Jack Willome, Rayco followed a very disciplined, market-based approach to home building that had five key principles: customer knowledge, preselling, market-based land buys, sales limitations, and bottom-line incentives.

"The principles are simple, but the systems that undergird them are complicated," says Willome, who left Rayco in March 1996 after 17 years as CEO. "Several are counterintuitive and countercultural...but these are among the things that [secured] the long-term sustainability of the company."

1. Base decisions on customer based knowledge.

"We are so used to superimposing our values on the customer and superimposing the values of architects and designers on the customer that have nothing to do with how the customer perceives value," says Willome. " Listening to customers allows us to understand what they perceive about features across the board."

To learn what home buyers wanted, Rayco regularly sent surveys to everybody who had bought a home in San Antonio, whether it was a Rayco home, another new home, or an existing home. Based on the results, Rayco designed homes that included features that only the large majority of buyers wanted. Anything that a substantial minority wanted became an option. Following this strategy, Rayco became the price leader in San Antonio, even when buyers optioned up their homes, because the company wasn't putting in amenities that people didn't want.

2. Presell.

Every house that Rayco built was sold before it was started, eliminating the significant risks of spec building. "When you're a spec builder, you're always building the wrong house and never building the right house," says Willome. "You're always reacting to the mistake that you made yesterday. You're not able to be on top of what's happening with the customer.in the marketplace today."

By preselling, Rayco also achieved dramatic construction efficiencies through an even-flow production system in which the company started and closed 10 houses each day. By creating a steady flow of homes through the production department, Rayco gained better pricing from its trade contractors, higher productivity because neither the trades nor Rayco had to employ additional people for the periodic spikes in production, improved quality, and higher margins.

3. Limit land buys to predefined needs.

Rayco wouldn't buy land because it was a deal. Only when the company found land that met its market needs would Rayco buy property. "If it doesn't meet a predefined demand," asks Willome, "what is a good deal?"

4. Limit sales and don't raise prices.

"We could pump short-term profitability by raising prices, but then what happens?" says Willome. "[New competitors would] come into our marketplace. By limiting volume and limiting prices, our managers [would] focus on efficiency to achieve their profit objectives and to get the financial rewards from their profit objectives."

5. Focus the organization with bottom-line, team-based incentives.

Rayco shared all its financial information within the company, established bottom-line goals, and then incentivized deep into the company with a bonus pool. Of the 450 employees at Rayco, about 300 of them participated directly in the bonus pool, some of them earning as much as 300% to 400% of their base salary.

"There is a lot of brilliance in Rayco's model," says Jack Inselmann, a market analyst in San Antonio and Austin who has watched Rayco for several years. But there is also a lot of sweat. It's not enough just to have that model, you have to keep it on track."

Applying the Rayco Model

K&B's ability to apply the Rayco model and keep it on track will determine the ultimate success of the KB2000 initiative. Certainly KB2000 is bigger than the Rayco model, calling, for example, for a dramatic geographical expansion into the Southwest. Karatz has also added some initiatives, such as setting up each community as a business and organizing the line people to run it. Yet if the K&B team isn't willing to sweat the model, all the rest of the stuff will just be business as usual.

"It will be a tough task implementing these policies," says Ivy Schneider, Salomon Brothers' housing analyst who attended a K&B -hosted session for Wall Street types in San Antonio in February. "[K&B's] people are home building professionals and to be told that their systems aren't right is tough. But I was impressed by a lot of Rayco's policies, and I see a lot of positive correlations with Kaufman and Broad."

Because of those correlations, and the basic simplicity of this Rayco model, K&B has been successful in the early stages of adopting it. K&B has adapted each tenet of the model except for limiting sales, which, says Karatz, is an issue when you control 40% of the market but doesn't really apply when you only have 5%.

Over the past several months, K&B has sent an eight-page survey to everyone in its markets who has bought a home in the previous six months; in some of the larger markets, the company only surveyed home buyers from the previous three months. In every city, K&B got better than a 20% return.

"We ask them what value is," says Jeff Charney, K&B's vice president for marketing and communications. "Value in price, product, location. And we want to know from actual buyers. There's a big difference between what buyers want and what lookers want. Salespeople field comments that someone doesn't like the size of a bedroom. That's all well and good, but those people aren't necessarily buying homes. We now spend more time with people who made the purchase decision, and we're making our business decisions according to their definition of value."

The number-one definition of value among buyers across all the markets was more square footage per dollar. And Kaufman and Broad has responded with dozens of new planes that provide lots of square footage in fewer, but bigger rooms. It has discarded expensive features that buyers didn't value such as complicated roof lines, jogs in the foundation, seven or eight window sizes, porches, and the like. One feature that buyers didn't care about that surprised many long-time K & B staffers was volume.

"I've been in the business for 18 years, and it's hard for me to work away from volume," says Richard Petersen, who heads K&B's Antelope Valley Division in Southern California. "But of the first 45 homes we sold of the new models, only one buyer wanted volume, and he ended up canceling."

The Antelope Valley is one of the first markets where the new operational model is in place. Of the five communities in the market, four feature the new models, which K&B calls the U-Series; the other project is higher end, and K&B has yet to create new KB2000 floor plans for that market.

At the Kaufman and Broad at West Lancaster community, the U-Series came on the market on January 18 and had 24 net sales by the last week in February, a sales rate of 4.7 per week. Prior sales rates averaged about 2.25 per week. More than 500 people attended the grand opening, and each week about 60 people walk through the models; before introducing the U-Series, about 20 people walked through in an average week.

The base U-Series models in West Lancaster range from 1,200 to 2,000 square feet and from $83,990 to $119,900. At those prices, these homes compete directly with existing homes on a price per square foot basis and outstrip the closest competition by as much as $14 per square foot. Even when buyers customize their homes from the four-page option list -- most frequently adding more square footage -- the average price still comes in $3,500 under the competition, says Petersen.

And the margins are better. K&B now presells about 50% of its homes; a year ago it presold only about 30%, often forcing the company to offer incentives to move sitting specs. By preselling, the company can also even out its construction schedule, achieving the benefits of even-flow production. Finally, the homes are simpler, faster, and cheaper to build. The previous generation of K & B homes in the Antelope Valley took four days to frame, 60 days to build, and featured nine different window types; the U- Series takes 1.5 days to frame, 40 days to build, and has two window types. Kaufman and Broad is also changing the way it acquires land. No longer will the company warehouse land; instead it will buy land based on market demand and will option it where possible. The driving force behind this switch in land acquisition strategy is Karatz's mandate to improve the company's return on investment (ROI). "The new focus on return on investment is leading to higher-quality, lower-risk investments in new communities," says Karatz. "It's a focus that is helping the company determine where its capital should be allocated to ensure its highest end best use."

Motivating this ROI discipline is a new compensation system. According to Salomon Brother's Schneider, "Compensation of each division's management is dependent upon its ability to meet or exceed a stated return on investment rate (17% after tax). As a result, divisions will likely use more options to control land rather than tie up large sums of capital for land purchases."

Compensation Program Altered

K&B has wandered from the Rayco model's incentive compensation system. K&B's incentive compensation program applies only to upper management; an older, customer-satisfaction-based program still provides bonuses to the company's line personnel. Karatz says that this difference is not important, because the primary incentive for K&B's line employees is that through training and experience, anyone in the company can climb the corporate ladder.

Is that enough? Rayco's broad-based incentive program was one of the key tenets of its success. And it was a big commitment, with two thirds of the employees receiving anywhere from 70% to 400% of their base pay in incentives. K&B's decision to narrow the scope of the compensation raises a big question about the company's long-term success in applying the model. In remaking a company, the hardest part is getting the team to buy in, and without the incentives, K&B's price may be too high.

Karatz, of course, is certain of the company's prosperity in the next four years, and he confidently predicts that the K & B model will soon become the one that other builders adopt.

"As we show demonstrable success, I suspect we will become the example of best practices that others will try to duplicate," he says. "As long as they don't copy our homes, which are protected under the copyright, we'd be flattered."

Reprinted from the June 1997 issue of BUILDER Magazine, ©Hanley-Wood, Inc.

Gerry Donahue is the former executive editor of BUILDER

For More Information Contact:
Kate Mulhearn
(310) 231-4015
kmulhearn@kbhome.com