Green Brick Partners Inc (GRBK) 2022 Q3 法說會逐字稿

Good afternoon, and welcome to Green Brick Partners Earnings Call for the Third Quarter ended September 30, 2022. Following today's remarks, we will hold a Q&A session. As a reminder, this call is being recorded and will be available for playback. In addition, a presentation will accompany today's webcast and is also available on the company's website at investors.greenbrickpartners.com. Joining us on the call today is Jim Brickman, Co-Founder and Chief Executive Officer; Rick Costello, Chief Financial Officer; and Jed Dolson, Chief Operating Officer.

Some of the information discussed on this call is forward-looking, including the company's financial and operational expectations for 2022 and beyond. In yesterday's press release and SEC filings, the company detailed material risks that may cause its future results to differ from its expectations. The company's statements are as of today, November 3, 2022, and the company has no obligation to update any forward-looking statements it may make. The comments also include non-GAAP financial metrics. The reconciliation of these metrics and the other information required by Regulation G can be found in the earnings release that the company issued yesterday and in the presentation available on the company's website.

With that, I'll turn the call over to Jim Brickman.

Thank you. During our call today, we are going to discuss the current housing landscape, Green Brick's overall business strategy and our land and lot position in much more detail than in past calls. Rick will discuss Q3 2022 financial results in depth, and then Jed will discuss the market dynamics, capital allocation strategy and our supply chain. We are pleased to report another strong quarter despite multiple challenges the homebuilding industry is facing. Residential revenue for the third quarter of 2022 increased 17.1% year-over-year to $397 million based on an increase in our average sales price of 33%. This contributed to a record high homebuilding gross margin of 32.4%.

As a result, the company generated $74 million in net income or $1.57 per diluted share, representing a year-over-year increase of 65%. Year-to-date annualized return on equity was 34.9%, about 1,100 basis points higher than last year. We believe this demonstrates our ability to consistently deliver superior returns to our shareholders. Looking ahead, the U.S. housing market has taken a dramatic shift as mortgage rates have more than doubled from a year ago and hit a 20-year in October. Consistent inflationary pressure and high mortgage rates have been keeping potential homebuyers on the sidelines.

Despite a strong labor market, consumer confidence has been negatively impacted by geopolitical risks, political uncertainty surrounding the upcoming elections, supply chain disruptions, and particularly how aggressively the Fed is hitting the economic breaks to contain inflation. Until the dust settles, we expect the housing inventory and housing market to remain very choppy. While it is difficult to actively predict what will happen in the short-term, our long-term view on the immense imbalance of housing supply and demand remains intact. A decade-long underproduction of housing has resulted in a gap of approximately 4 million housing units that will take many years to adjust, if not another decade.

Recent and expected future reductions in housing starts are likely to [exacerbate] the housing shortage. Our markets have one of the best demographics and in-migration trends. Many builders have already reported the results. As you have heard on these calls, Dallas and Atlanta, which produce over 90% of our revenues, have fared much better than markets such as California, Denver, Phoenix and Las Vegas. For example, the DFW Metroplex, our largest market at 70% of our year-to-date revenues, has attracted over 140 companies for office relocations and/or expansions in 2021 and 2022. The resulting in-migration means more people and more housing.

We believe the job growth, economic diversity, a younger population, climate, tax rates and relative affordability in our core markets vis-a-vis the rest of the nation will result in our core markets continuing to outperform the nation. Let's take a quick look at Slide 4 of our presentation. Despite the slowdown in sales, on a national scale, as shown here, inventory of both existing and new single-family homes remains near historic lows. We take a closer look at Dallas on Slide 5. In DFW, existing home listings represent a 2.2-month supply on the left graph and finished new home inventory represents a 1.3 month supply on the right graph. Both measures are below pre-pandemic levels. We expect existing inventory to increase in Q4 and into 2023, but also see that builders are quickly responding to decreased demand by lowering starts.

The byproduct of lower starts is that we believe construction costs have peaked. Furthermore, as the third largest builder in DFW, we believe that our scale and the slowdown will provide us leverage to produce our construction spend. We believe that existing home inventory growth will continue to be limited due to homeowners leasing rather than selling their homes based on this line market. Inventory will be further limited due to homeowners who have purchased or refinanced over the past 10 years and particularly during the last 3 years because they have very low mortgage range, which disincentivizes selling their residences. We believe that long-term home demand will continue as millennials now need their first home and are financially ready and we continue to see a record level of rents rising in our primary markets.

We highlight the growth of millennial cohort on Page 6 of our presentation. Please turn to Slide 7 where we focus on Green Brick's strategic advantages. First, we have been disciplined and deliberate on maintaining a strong balance sheet. Despite purchasing almost 10% of our stock year-to-date, our debt to total capital ratio fell to 28% and our net debt to total capital was 25.5% at the end of the quarter. About 89% of our outstanding debt is long-term fixed rate with an annual cost of about 3.5%. We issued [50 million] of perpetual preferred stock in late 2021 at a 5.75% coupon that would be prohibitively expensive to issue today. Our goal is to always have a superior balance sheet and ample dry powder.

Second, as Jed will discuss in more detail later, we have been consistently disciplined with our land investment underwriting, which leads to a superior land pipeline to support our business. Unlike many of our peers who operate under a land-light playbook, we do not use land banking to secure lots. We believe this puts us in a strong position relative to these peers for multiple reasons. First, cost of financing. The land bankers who provide financing for land-light builders typically charge a high cost of capital. The recent rise in interest rates had made previously expensive land bank capital much more expensive. As noted in peers' earnings calls, because of these increased costs and slowing demand, some builders are walking away from lot option contract or land bank deals.

These are typically in C locations. We expect land banking capital will contract and become more expensive in the future, and third-party lot development will be more challenging. Second, takedown costs. Builders must buy lots from lot developers or land bankers at retail prices instead of wholesale prices. Green Brick, on the other hand, is the developer, a code developer on over 90% of our lots owned and controlled, giving us a wholesale pricing advantage and the more majority of our lots. Third, price escalation. Many lot contracts and most on A location neighborhoods have a 6% price escalator, which means that builders must pay 6% more to purchase a lot the following year even if the housing market slows further.

While there is a lot of renegotiating taking place on option lots, very few renegotiations are taking place on lots and prime A locations. High-quality lots in prime A locations are not easily replaceable and those neighborhoods are performing better than lots in C locations. Lastly, penalty. Most high-quality option lots demand 15% or more of retail lot price as a first loss earnest money deposit, making it a very expensive proposition for builders to walk away from their lots. At the end of the quarter, we owned and controlled approximately 26,000 lots. We have no need to buy land to grow our business and don't plan to buy much or any land in Q4 2022 or well into 2023.

Our third strategic advantage is location, location and location. Not only do you operate in some of the best markets in the country, but you also primarily build an infill submarkets. Over 80% of our year-to-date revenues were generated from those infill markets where supply is constrained, accompanying significant demographic tailwinds. We believe our markets will outperform the rest of the country. Jed will expand this discussion on our land and lot position as well as our preferred locations later on. Fourth, operational efficiency. We have invested significant capital and resources to improve our technology and processes across Green Brick's brands. These investments have provided us more transparency into our workflow and cost structure.

As a result, as the market slows, we believe that we will have the ability to react quickly to improve overhead efficiency and negotiate what we think will be better pricing with vendors and subcontractors. Finally, and most significantly, as shown on Slide 8, our industry-leading gross margins at 32.4% gives us a tremendous amount of cushion to manage pace versus price.

With that, I'll now turn it over to Rick. Rick?

Thank you, Jim. Please turn to Slide 9 of the presentation. Our total revenues in Q3 2022 increased 19% year-over-year to $408 million, primarily driven by a 33% increase in ASPs of closed homes to $607,000. This was partially offset by a 12% decline in the number of closings to 650 homes. The decline in the number of closings was due to a lower start pace in prior quarters and a smaller backlog entering the quarter because of weakened demand. Higher residential units revenues led to a 550 basis point year-over-year improvement in homebuilding gross margin to 32.4% in Q3 of 2022, breaking the previous record of 32.3% set in Q2 of '22.

Although we are not likely to maintain this level of margin in this housing market, our ability to outperform our peers has been consistently demonstrated quarter-over-quarter, and we believe we will continue to generate superior margins in a more trying time. SG&A leverage ratio increased slightly year-over-year to 10.9% during the third quarter of 2022. As a result of higher revenues and gross margins, net income attributable to Green Brick grew 52% year-over-year for the quarter. Additionally, our reduced tax rate resulting from energy tax credits further improved diluted EPS for Q3 2022 to $1.57 for the quarter, a year-over-year growth of 65%.

As mortgage rates rose to their highest level in 20 years, housing demand cooled quickly. Net new home orders during the third quarter of 2022 decreased 41% year-over-year to 404, while our quarterly absorption rate per average active selling community decreased to 5.3 homes. Despite the lower sales pace, our decline in new order revenues during the third quarter was just 34%, smaller than the decline in order count as our average sales price in new orders rose by 12.5% from $553,000 to $622,000. Our cancellation rate increased to 17.6% for the third quarter of 2022 compared to 6.9% for the same period last year and was up from 11.4% last quarter. As you would expect, our cancellation rate is the highest with Trophy's entry-level buyer. We do not see this improving soon.

Jed will provide more commentary on sales and market dynamics. On Slide 10, we highlight our year-to-date results. Our total revenues were up 40% year-over-year on an ASP increase of 31%. Our year-to-date gross margin was up 460 basis points to 31.1%, and our SG&A leverage improved 150 basis points to 9.4%. Our net income attributable to Green Brick was up 86% with our diluted EPS up 94% year-over-year. Our annualized year-to-date return on equity was up 1,090 basis points to 34.9%, the highest among our peer group. Backlog at the end of the third quarter of 2022 declined 45% year-over-year to $564 million.

This was due to a 54% drop in backlog units, partially offset by a 20% increase in the average sales price of backlog units. The drop in backlog units is a function of the lower levels of new home orders and the higher cancellation rate described above. As a result of fewer sales, increase of units closed and decrease in backlog units, spec units under construction as a percentage of total units under construction rose to 65% at the end of September, 2022 from 31% a year ago. We are assessing our inventory level on a daily basis to make sure we are aligning our sales pace starts in construction.

Consequently, we expect to start fewer homes in Q4, and this trend will likely continue into the first part of 2023. As Jim mentioned earlier, we continue to deleverage our balance sheet with strong operating cash flow and one of the lowest debt to total capital ratios of 28%. As of September 30, 2022, our weighted average cost of debt was 3.5% and 89% of the outstanding debt was fixed. Maintaining the strength of our balance sheet will remain as a top priority.

I will now turn it over to Jed for market commentary. Jed?

Thank you, Rick. Please turn to Slide 11. The impact of rising interest rates was felt in our markets. As Rick mentioned earlier, our net sales orders during the quarter were down 41% year-over-year with revenues on sales orders down 34% because of our continued increase in average sales price. And as seen on this slide, even though our cancellation rate has continued to go up since May of this year, it is still outperforming most of our peers. Cancellations were heavily weighted to buyers who signed contracts when interest rates were lower. We also experienced higher cancellations among products with lower price points and lower deposits compared with the rest of our portfolio.

People are still buying houses as there are still unmet demands. We have nondiscretionary buyers who need to move out of rentals due to milestone changes in life, such as marriage, new child or new job. During this price discovery phase, we continue to be laser-focused on several key priorities that were laid out last quarter, which are: one, preserving backlog and acting quickly to restore sales momentum; two, being stringent and nimble with capital allocation; and lastly, managing bottlenecks in the supply chain to bring down production costs and cycle times. We are carefully managing our sales pace and starts on a community-by-community basis. The market as a whole experienced an abrupt slowdown in June.

Since then, we have adopted more aggressive incentives in underperforming communities. Sales activity picked up in the second half of July, while mortgage rates temporarily dropped before rising again in the second half of August. With an increased level of incentives, we were able to entice a reticent market and maintain a constant sales pace from June through September. Overall, discounts and incentives for new orders were up from 2% in the previous quarter to 4.2% in Q3 2022. During October, traffic and sales pace have been slower with monthly sales down approximately 19% versus the prior 4-month average and incentives increasing from 4.2% to 6.3%.

Discounts and incentives include base price reductions, rate buydowns and other closing credits. We expect elevated incentives, higher cancellations and lower sales volume to remain the biggest headwinds to our margin performance in the near term. We will continue to monitor the market carefully to adjust our pricing and to balance starts in inventory with sales. As Jim noted, our industry-leading gross margins allow us to be very aggressive pricing our homes.

Next, we continue to focus on managing capital allocation prudently. Considering current market developments, we have significantly slowed down our land acquisitions and expect the trend to continue until the land markets adjust. Additionally, we conducted a thorough review of our lots owned and controlled. As a reminder, a vast majority of our lots were purchased before the upsurge of land prices on top of conservative underwriting. Therefore, our underwriting for these lots still generates adequate returns in today's environment, and we do not see immediate impairment risk and have no communities on a watch list.

Given recent volatility in the market and slower sales, we are planning to postpone land development in certain communities that are entering the next phases of land development. As shown on Slides 12 and 13, communities that have been delayed in the DFW area are for more periphery locations, while the majority of our land book in DFW Atlanta are in infill locations. We project that our land and lot development spending will decline approximately 45% next year from full year 2022. We are surveying the market condition as to determine the best cadence and timing for the resumption of these development projects.

Please turn to Slide 14. The self-developing nature of our land business gives us tremendous flexibility to control delivery schedule and costs and an upper hand on achieving higher margins. Despite a slowdown in development, we expect to complete almost 8,800 finished lots between 2022 and 2023 in 73 communities. As shown on Slides 15 and 16, our 2023 deliveries in DFW and Atlanta will be concentrated in infill and adjacent desirable areas. Depending on market conditions, as many peers pull back, we expect to have the opportunity to increase our count on [indiscernible] selling communities by 20% to 30% from the end of September over the next 4 to 5 quarters. We believe these new communities with a favorable land and lot basis provides the optionality of aggressively pricing without the overhang of protecting backlog.

We also believe this will generate favorable sales per community at more traditional gross margins. We expect this capability will be an opportunity to build market share and effectively manage price versus pace decisions. In addition to the flexibility regarding timing of community [opens] our self-development of lots is expected to generate higher margins and therefore, more pricing flexibility compared to builders who have accumulated the higher priced lots from third-party developers. This also provides us with the capability to start more homes under construction without an outlay of cash to purchase these finished lots when demand returns.

Next, I would also like to provide some update on our expansion into Austin. In August, we fulfilled several key roles, including our new division President, Ryan Jerke, to operate the Trophy brand in Austin. Ryan brings tremendous experience and knowledge in home buildings, and we are excited to have him join the team. Austin is a tough market today, but we think we will be able to deliver homes from $275,000 where there is a pent-up demand. We will keep everyone posted when we break ground on homes in early 2023. The last focal point for us is the value engineer to bring down cycle times and costs. Our cycle time for homes closed during Q3 of 2022 very significantly from -- by brand and price point but in aggregate, shortened modestly by 21 days sequentially.

Although we are not back to pre-COVID levels, we are pleased to see improvements in the supply chain across multiple categories, especially with front-end construction. The falloff in starts across the industry gives us more leverage and negotiations on new communities as we become more selective with vendors as in regards to both pricing and quality. To be clear, we are still experiencing struggles in certain aspects of the supply chain, but we will continue to work with our trade partners to resolve bottlenecks in the supply chains and unlock additional savings.

With that, I'll turn it over to Jim for closing remarks. Jim?

Thank you, Jed. I would like to thank our entire Green Brick team for their continued hard work in this more challenging environment. We believe that Green Brick is entering this cycle in a strong position. We have a significant footprint in some of the best markets in the country, a broad spectrum of product types and customer bases, a strong balance sheet and ample dry powder to deploy, a disciplined land pipeline to support growth, and most importantly, an experienced team in place to navigate our business in this environment and achieve our long-term goals.

As far as stock buybacks and capital allocation are concerned, for the first time in many years, we think unique investment opportunities may arise in 2023. Consequently, we expect to evaluate buying back stock versus these direct investment opportunities as the opportunities arise. This concludes our prepared remarks. We will now open the line for questions.

(Operator Instructions) We'll take our first question from Carl Reichardt with BTIG.

I'm not sure what time it is actually. I wanted to ask about the SG&A, which was ahead of what we were expecting, and there was some negative leverage despite the relatively good sized increase in revenue. I know there was some unabsorbed overhead, I think you said in the Q. Can you just expand on why that number increased year-over-year on a percentage basis? And then what kind of run rate should we be thinking for core G&A on a go-forward basis?

I thought those are great questions, Carl. This is Rick. First, particularly, if you look Q-to-Q, we went from $512 million of homebuilding revenues in Q2, down to $397 million in Q3. So most of SG&A -- well, I shouldn't say that. Commissions generally are going to be your most significant singular variable cost. In the short run, a lot of your overhead are going to be fixed cost. In the long run, everything is variable, right? So about 60% of the quarter-to-quarter increase from 8.2% to 10.9% was that function of math, just having a bigger denominator versus your cost, because cost excluding commissions were in about the same.

Other than the other 40%, about a 1% delta related to a cumulative year-to-date incentive comp adjustment, an increase for the kind of year that we're having. But if you normalize that, that would have only been 0.3% instead of 1% in the quarter. So it would have been about 10.2%. It's a lot more interesting to talk about the long-term run rate because we're going to be cutting costs just in this view of having fewer starts until demand comes back more robustly. We're going to be looking to chop that number down. So lower is the answer.

But that will lag.

Yes, it will lag. It will always lag as we still have a bunch of homes to complete at this point.

Okay. All right. I think I've got that. And then, Jim, I have a question here, and you got to it at the very end of your prepared remarks, which is, obviously, Green Brick was started at effectively the bottom of an awful housing market. We're looking at, at least some struggles in the near to intermediate term.

So when you're thinking about opportunities, are those opportunities that you think you'd see in your existing markets, so any opportunity to grow your share? Or is this the opportunity for Green Brick now to begin to spread its wings into new markets? I'd just like your perspective on that.

Okay, Carl. Well, first of all, we quit seeing much deal flow from brokers to sell -- builders because they knew we wouldn't buy based on [rosy] going-forward assumptions. So I'd like to say that we see a lot of deals, but frankly, we didn't because they knew that we weren't going to be buyers. Right now, we are in a cyclical business. I think this is my fourth real estate cycle.

I've never seen a real estate cycle where optimism didn't revert to realism. So that's why I think that maybe -- may is the operative word, the opportunities in 2023, purchasing a private builder for the first time because I think you're going to see optimism revert to realism and pricing adjust accordingly. The perfect scenario would be to find a private builder that fits our culture and more importantly, fits our economic hurdle rates in a South or Southeastern market.

Great. I appreciate that color.

We'll take our next question from Michael Rehaut with JPMorgan.

It's [Andrew DeRenzi] on for Mike. Congrats on the results this quarter. I wanted to ask if you can give us some of your thoughts around directionally how gross margins might be shaping up over the next 1 or 2 quarters.

Sure. I think I'm going to start that, and Jed can chime in later as he tracks this almost on a daily basis neighborhood by neighborhood. It's really interesting in the A class infill neighborhoods, we're seeing margins maintained because it's so supply constrained from a competitive lot position and the builders competitive situation. I don't want to make -- be overly optimistic. We actually raised prices in $1 million neighborhood this week and are having really good demand even at a slower sales pace in a AAA location neighborhood.

The neighborhoods that are really hard to handicap right now are C location neighborhoods and Jed is going to chime in how most of our neighborhoods are not in C location neighborhoods, but Trophy does have some. We think it's going to be much more challenging because there's more builders down the street, housing is more commoditized. And frankly, what our gross margins are going to be are going to be dependent to a great degree in what our peers do down the street. So your guess is really as good as mine.

Yes. I would just add that gross margin is also going to be our gross margin and below the gross -- our gross margin will be affected by financing and increased over commissions that would probably in these periphery markets all having to add to incentivized sales.

Okay. Great. And then you mentioned raising prices, so -- in your AAA market. So how should we be thinking about closing ASPs in the next 2, 3 quarters ahead of you opening these new communities?

Jed, why don't you take the product mix question because obviously, we're not raising prices in many -- in as many neighborhoods as either they're flat or decreasing.

Yes. I think it will be -- I think our ASP will continue to increase slightly because what we've seen is the periphery locations that we say we're selling 10 to 12 a month. Sales have really dropped to about 4. So that's quite a dramatic decrease, whereas the preponderance of our communities are in AAA locations, and we've seen a slight decrease. Maybe we're selling 3 a month instead of 4. So the percentage drop in the A locations, which again are the preponderance of our communities is much smaller. And the ASP in those communities is typically very high.

Andrew, I think that probably some of the best color we gave was on just the increase in October of the average discount going from up 6.3%. So that's going to have an impact certainly on the ASP in part if it's a price discount and/or on incentives, so it becomes a little bit of a combination between gross margin hit and just right off the top for a discount.

Okay. Great. Yes, super helpful to get your thoughts on that.

We'll take our next question from Jay McCanless with Wedbush.

So Rick, I did not follow your answer to Carl on the SG&A question. Can you talk about why that was up year-over-year and what we shouldn't be forecasting going forward?

Well, the bottom line is it's a function of lower revenues and our cost structure is going to have to come down. So it was probably 0.7 too high this quarter for the incentive comp adjustment. And otherwise, it's going to be a function of us making adjustments to the core cost probably in the beginning of 2023.

Okay. And then, Jed, in your prepared comments --

[Indiscernible] I wouldn't expect a big decrease in SG&A in 2004. We're going to start addressing the cost structure more into 2023. We don't want to have a kneejerk reaction to that based upon 3 or 4-month sales, but we're watching very closely.

And then, Jed, in your comments, I've caught about half of it. I think you said something about 20% to 25% community growth. Is that what you said for next year?

Yes.

Yes.

Okay. And does that community growth include the potential purchase of the Southern builder you were talking about, Jim? Or is that [indiscernible] you already have under contract?

We have no place in our -- for a builder, and we have some maps in our slide deck showing new community opening locations, Rick, that I think investors really need to stay in tune with the map. On your presentation, which slide is that?

Yes. There are a couple of slides in there, 15 and 16, but 14 is probably really on point because it shows how we have between this year and next year, 73 total communities where we're delivering lots. So that's going to drive the opening of those communities will be driving that growth in 2023.

And what's really interesting, we don't get this granular in our presentations. But if you take a look at the slide deck on 15 and you take a look where those communities are open, you can see that they're in the areas that Burns describes as most desirable and desirable areas. And I don't think any CEO is jumping up and down excited about what's happening in the market, but we're relatively optimistic because the communities that are opening in these new highly desirable neighborhoods, we have a very favorable lot cost. We purchased them when the land was low. Some of them have low-cost but debt on them. And we already have other neighborhoods, not far from that, and our lot cost in these new neighborhoods is very favorable compared to our older neighborhoods that are already producing very nice margins.

So we feel good about that. You'll see 2 dots that -- or a few dots that are not in the highly desirable locations. And as we said in the call, those are in more Horton, higher competitive neighborhoods, where there's more competition, and we're going to see margin compression in those neighborhoods, and we know it. We just don't know what it's going to be because we know we can price a house more than Horton because, frankly, it's a pressure architecture, more windows, better indoor outliving space, but we can only go so with the spread over a Horton product can only be so much.

So to that end, Jim, if this is a longer-term downturn and shorter one, what's the future for Trophy Signature. Do you just put a lot of that lamp and mothball and wait till J-POWER's doing jacking up rates? Or what's the near to medium-term outlook for Trophy Signature?

Well, obviously, [indiscernible] harder to grow Trophy Signature unless you want to take lower margins and are going to evaluate that. We've already made the investment in land. So in terms of return on capital stuff, if we think it's going to be accretive, but how accretive, we don't know. In terms of Austin, for example, Jed, why don't you tell him what we're doing in Austin?

We think we can still be very successful in Austin because we can price a home under $300,000. And we think there's a huge amount of demand. And in this market, it's kind of a winner take all because the consumer is so smart. And if you open at $300,000 and you can make decent margins, and some other builders not far from you have $350,000, you don't get 1 incremental sale, you get 10 a month.

Yes. I would just add that -- Jay, I would just add that our lot cost basis in a lot of these periphery locations is around $50,000. We saw our vertical construction costs really kind of run out of control, not just us, but the whole industry to say it's costing close to $2,000 -- $200,000 a house to build and we think we can beat those down in the $150,000 to $175,000 range and really deliver, as Jim pointed out, a much cheaper product at a very industry standard historically nice gross margin of 25%, 26%.

Got it. The last one I had if infill is still selling that well and on the company average, you had a 41% order decline, what -- I guess, what was the level of declines in the softer areas versus the level of declines in the better areas for the quarter?

Yes. This is Jed. I'll take that. I don't have the exact numbers, but it was -- the cancellations in the A locations was at least half of what it was in the periphery locations. We're -- and right now --

And the real problem in the periphery locations is not demand. It was the cancellation factor that was so much higher than the A locations. We're taking $60,000, $70,000 in some of the higher-end price points in lot deposits. And it's obviously, those people are more qualified and they're less likely to walk away from $65,000 and an entry-level buyers that puts $5,000 in a house. So our -- what was really affecting the sales pace, the demand was there, our cancellations were too high. I think they were running 29%, 30% at Trophy. And sometimes in some week, they can even be higher than that, and they're much lower than that for the aggregate of the rest of our builders.

(Operator Instructions) We will takes our -- take our next question from Alex Rygiel with B. Riley Securities.

First, a quick clarification. Did you say that incentives and cancellations increased in the month of October?

Yes. Yes, the incentives went from 4.2% in Q3 to 6.3% in October, for instance.

And then how many finished spec homes did you have at the end of the quarter?

63.

And then lastly, what's your land spend likely to be for 2022?

I don't think we provided that detail. I think we were internally taking a look at land spend in 2022 and 2023, and I think it was going to be -- was it about $140 million delta?

Yes, we're going to be down 45% between land and development spend from '22 to '23. And the delta on that is about $150 million.

But that's somewhat fluid depending on costs and other phasing issues that we're looking at right now. Obviously, with lower demand, any time that we can reduce development spend, that's a good idea, and we're really evaluating that in a neighborhood by neighborhood basis, and all of our builders are coming to Dallas, November 8 and 9 to discuss that issue with us.

We'll take our next question from Alex Barron with Housing Research Center.

I wanted to see if you guys could provide a number of starts this quarter and how that compared to last quarter and last year.

Yes, it's actually that you can do the math pretty easily because every quarter, we tell you what the closings are, obviously, and we tell you what the ending units under construction. But in Q3, we started 490 homes.

Okay. And a year ago?

A year ago, it was 801.

It's very difficult. I would caution anybody to take a look at comparing COVID sales results and required starts that were resulting of that and matching that in other periods because it's going to skew your results because we just had a -- when we were starting 801 and that we were selling homes really in hindsight that I wish we would have delayed selling some of them because of the cycle times.

My next question was, with these new communities that you guys plan on opening and where you said that you have a cost advantage, does that imply that you will open them at lower prices than you would have otherwise to gain an advantage over other builders or --?

Well, first of all, the market is not surprise. We don't set the price. But we do know that you can hit a jet-stream of buyers offering a real value when you're in a peripheral neighborhood compared to peers. So our pricing strategy really is very dependent upon the neighborhood location. In terms of opening some of these new neighborhoods, one of the things we're going to be very cautious of is that we want to get sales kicked off better, and we want to be able to raise prices and not have to worry about the impact of pricing on backlog. So I think we can be more competitive as we price orders in some existing neighborhoods that we had a large backlog, we frankly didn't want to jeopardize that backlog and get too aggressive on pricing when we only had, say, 20 home sites left in the neighborhood.

But does that imply that most of these homes are going to be specs that you sell very close to completion?

Yes. Because -- yes, I think more and more specs. I think we had 65% level specs at the end of 3Q. I think you're going to see that progress for 2 reasons. First of all, the buyer right now just doesn't want to take the risk on interest rates. They want to be able to -- when they contract for a home, they want to be able to move in, in 2 months because they're concerned about rising interest rates and then they're concerned just generally about jobs, costs and a lot of other uncertainties that we weren't dealing with a year ago.

That makes sense. Now if I could ask one more. Some builders have said that they plan on maintaining a certain sales pace, let's say, 3 or 4 months and that they're just going to keep finding the market current price. I'm curious if you guys share that philosophy or if you look at the world from a different perspective.

Well, it's going to be interesting in the A locations we don't look at the world that way because we don't have to. On the peripheral locations, as I said, they said, what's going to happen to our gross margins. And when you say things like some peers are going to maintain sales pace, obviously, if we want to maintain sales pace, we're going to be impacted by those guys because we're down to the street. So we're going to have to see what they do.

And we'll take our next question from Carl Reichardt with BTIG.

Actually, Alex just got to the point I was trying to get to, which is -- and so Jed, so what -- where on average are you releasing Trophy Signature Homes for sale in the construction process now?

At [slab work].

At slab work. And so then you've got another, what, that's 4, 5, 6 months to get to finished, yes? Is there a thing that you would do it later than maybe at wrap or something like that in process?

Well, the thing -- reality is that most buyers even though release this slab work, they don't want to buy at slab work. They want to buy after a drywall and when carpet's getting ready to get put in. So we're opening for sales, but we're not seeing the buyer interest at that level because they don't want to take the risk we just described.

Yes. Okay. So Jim, you're saying that, that will transition -- Trophy will transition as you move into '23 to releasing for sale deeper in the construction process, the vertical process?

Yes. But we just -- we don't see a lot of buyer demand there. And frankly, that buyer is putting up such a small amount of earnest money at Trophy compared to our other builders had. Yes, for SEC and your reporting, we count into the sale, but we watch it very closely because they have very little skin in the game.

We'll take our next question from Bill Dezellem with Tieton Capital.

That's Tieton Capital. And you, I think, began to answer this question, but with input costs adjusting downwards, would you discuss the possible benefit to gross margin and maybe link that to the commentary before that if you had $200,000 of building costs, you think you can bring that down to $150,000 to $175,000. And with that magnitude of a percentage drop in cost apply to higher-priced homes also. So I recognize there are several questions kind of embedded in that. But maybe you could talk to the whole input cost phenomenon.

Bill, I'll try to address it. It's really an unusual situation in this cycle compared to cycle, say, 20 years ago. We think labor costs as starts go down significantly, we think they could, they're going to react very quickly, okay? And we think labor costs and the total cost of a home represent about 25% of the cost of a home. We think those costs are going to adjust fairly quickly. We're already seeing framers and concrete people interested in our business that really weren't a year ago.

The side that's very difficult to evaluate on input costs is cement and some of the other large costs involved in our business. Unfortunately, in the last 20 years, oligopolies have been created with lumber companies, cement companies, aggregates and those things. Those guys are still very reluctant to lower prices. We think firing up the cement plant is very expensive. When they see demand, they're not lowering prices right now. But when they have less demand, we're still hopeful that we're going to see the impact of those next spring, but we haven't seen it yet.

Yes. I would add, we've already realized huge labor -- or sorry, huge lumber savings, a lot of the homes that we're now closing and that we will close in Q4 and Q1 are on very expensive lumber packs that were at the -- let's call it, March, April of this year. And we've seen dramatic savings on those.

Bill, when he's talking dramatic, we're talking on a 2,000, 2,200 square foot house $20,000 savings. So that then creates a lot of volatility in these gross margins you're looking at too.

That's insightful. So the reference to bringing costs down $25,000 to $50,000, that was basically incorporating lumber and labor into the thought process? Or were there other --

No, that was everything. And I thought it was $175,000. Did you go to $150,000 on that conversation?

No, I said $150,000 to $175,000. So we -- Bill, we're hopeful we can get cement down. Concrete's at an all-time high, like Jim mentioned, the concrete suppliers are not bending yet, but we're hopeful that we'll see some price decreases there. Lumber, the mill lumber is way down. The specialty lumber is still high. We're hopeful we'll see some of that. The container shipping prices out of China that we're getting a lot of our flooring on. Those are sky-high. We're starting to see those dropped. Hopefully, we see the fuel charges start evaporating. So home buildings, a collection of 1,000 line items to build a house. And if we start whittling them down 10% to 20% per line item, we're going to see some really -- a totally different cost structure than these homes that we started back in March and April this year that are now closing over the next 30 to -- sorry, next 30 to 120 days.

Yes, prices go up quickly, they just go down slowly.

And then one additional question tied to this, do you have an indication yet of the elasticity of demand that's in place in the market, meaning that if you were to use those lower input costs to bring prices down even though you might be maintaining margin, does that drive additional sales? Or is the buyer relatively inelastic at this point? Any insights?

We're still -- we're actually discovering that really and don't have a good answer. In some areas, we're seeing there's really price elasticity where if we lower price $10,000, $15,000, we get demand. Again, in some of the perimeter neighborhoods, that $15,000 is not as important as the ability of that buyer to qualify. So we're looking at rate buydowns and every things that are not price related, but I guess, indirectly related to our margin at the end of the day and trying to provide a more affordable mortgage options for these buyers because that's more important to many buyers in price.

We'll take a follow-up question from Jay McCanless with Wedbush.

2 max. So the first one, if you think about the cost actions you talked about possibly starting in '23, I guess, how are you going to be able to take those type of cost actions, but then grow the community count 25% to 30% -- or 20% to 25%? Could you talk about that in terms of where the staffing levels have to be to drive that level of community growth?

Well, the community level growth is more of an indirect costs, a lot of those costs. But Rick, do you want to chime in on that?

Yes. We've got capacity with a lot of our builders to man a couple of projects, perhaps when you're starting a community up, you start with a fairly limited number of -- you're going to build the model fast, try to get it open as fast as you can. And once it's open, you're starting your production. So there's a buildup over time. So transitioning from an old community to a new community or transitioning to modify the number of [super tents] that you've got because certainly, the costs related to our field overhead is going to be variable over the next 6 to 12 months just based on what we see from a sales standpoint because we're measuring our starts based on our sales pace. So a lot of that answer is yet to be discovered from what is the right human count out in the field, but it's a matter of moving pieces around the chessboard and making sure that we keep our strongest players on the team. I'm not going to quantify it for you because we're going to have to discover this as we go.

And then that 6.3% in incentives for October, and I apologize, I don't remember how you guys line those out, but is all that going to hit the gross margin? Or is some of that going to show up in SG&A?

No, it's all in gross margin. It's between price drops or closing cost incentives for buydowns, et cetera. There -- the only thing that's going to be below the line would be anything that we do with the brokerage community on promotions to them.

And that concludes the question-and-answer session. I would like to turn the call back over to Jim Brickman for any additional or closing remarks.

No, we would just invite anybody to give us a call in person if you have any questions. The market is challenging. It's not impossible. We've been through this before, and we appreciate everybody's support.

And that concludes today's presentation. Thank you for your participation and you may now disconnect.