Man on a Mission
Why on earth has KB Home CEO Bruce Karatz launched a major building project in the wildly uncertain New Orleans real estate market?
(FORTUNE Magazine) - Late last August Bruce Karatz was at sea aboard a private yacht off the coast of Turkey, enjoying a lifestyles-of-the-rich-and-famous cruise with a half-dozen close friends. As executive vacations go, this one was definitely well deserved: The company Karatz heads, homebuilder KB Home (Research), was wrapping up its 18th consecutive quarter of double-digit earnings growth. The latest digits: 93%.
But a funny thing happened on the way to CEO nirvana. The 60-year-old Karatz found himself spending more time in front of the onboard television than enjoying the turquoise waters and brilliant Mediterranean sun. Mesmerized by cable news reports of Hurricane Katrina bearing down on New Orleans, he sat glued to the tube as a bad situation turned apocalyptic. "Absolutely horrendous," Karatz recalls thinking. "It was like we were watching a great city wither away and die. I kept wondering, How is it possible that our great country can do so many things well and yet could be floundering with this natural disaster?"
Karatz, like many U.S. business leaders, wound up writing a hefty personal check for the relief efforts. But Karatz's visceral reaction also led to an epiphany. Government had botched the evacuation and mangled the rescue. When it came to recovery, perhaps it was time to give free enterprise a try. Says Karatz: "I decided we were going to rebuild New Orleans."
And so was born a bold and unconventional business initiative, as much about hope and faith as dollars and cents. Before Katrina, Louisiana and Mississippi had been off the radar of national homebuilders. The schools were too woeful and the local economies too sleepy to support the kind of population growth big builders look for in housing markets. KB in particular has thrived by adhering to the dictates of rigorous market research. Yet in metropolitan New Orleans--where some 200,000 homes were destroyed by the storm and subsequent flooding--there were no reliable ways to measure demand. Nine months after the storm, it's still not clear how many displaced residents will return. As for those who do, says Ivan Miestchovich, director of the University of New Orleans Real Estate Market Data Center, "a lot of these people aren't going to be able to afford a new home."
Nevertheless, last December KB became the first and only national homebuilder to set up shop in New Orleans. Spurred, Karatz says, by moral obligation, KB established a major unit dedicated to the Katrina-ravaged Gulf Coast, pulling a top regional manager, New Orleans native Steven Davis, out of Atlanta and putting him in charge. Davis has already struck three land deals and says he's working on 40 more. Karatz won't get pinned down on how many homes KB will build in the region--"I'm not being evasive, I just don't know yet"--other than to say it will be "in the thousands" per year. "Anything less," he says, "won't impact people's lives. And that's really our goal."
It's not often you hear a CEO express goals in humanitarian, not bottom-line, terms, especially when it's shareholder money with which he's do-gooding. Indeed, KB's own board of directors voiced reservations about Karatz's plan when he broached it at a board meeting last October. The CEO calmed the objections, says outside director Luis Nogales, by bringing in the Shaw Group, a well-connected engineering firm based in Baton Rouge, as a 50% partner in Louisiana. That not only trims KB's financial exposure but also adds a powerful political ally to help obtain local building permits. "This is a for-profit venture," Karatz stresses, noting that the Gulf Coast unit should have net profit margins in line with KB's 15% average.
Certainly New Orleans is a risk Karatz did not need to take. KB started fiscal 2006 with a record backlog of orders--27,000 new homes and $6.7 billion in revenue. Yes, the national housing market has been cooling. In Las Vegas, for instance, the number of homebuilding permits issued fell 5% last year. KB itself warned in a February filing with the Securities and Exchange Commission that it might be forced to lower revenue guidance for fiscal 2006 "if the current trends do not improve." But Karatz says concerns about a housing bubble are overblown, and he's hopeful that KB's new Martha Stewart communities, among other building projects, will offset cooling in Vegas and elsewhere. (Designed with the style maven's input, the first Martha Stewart community just opened in Cary, N.C.)
So far, Wall Street has been supportive of KB's New Orleans efforts. Karatz says he isn't expecting a meaningful revenue contribution from the Gulf Coast until 2007, while upfront costs have been substantial. But, says Friedman Billings Ramsey analyst Craig Kucera, "Bruce Karatz isn't going to go in there unless he thinks he's going to make money." "I think it's okay," echoes fund manager Sam Lieber, who holds 440,000 KB shares in his Alpine U.S. Real Estate Equity fund. Lieber figures that the upside from KB's being on the leading edge of a New Orleans rebuilding boom outweighs the risk that the city won't bounce back: "I'm actually surprised other builders aren't doing it too."
Taking unorthodox risks is nothing new for Karatz. He grew up in Minnesota--his dad was a movie theater owner, his mom a homemaker--but as a teenager fell in love with Southern California after traveling to see the University of Minnesota play in the 1961 Rose Bowl. "I saw the palm trees swaying and the beaches, and I thought to myself, This is better than Minneapolis," Karatz recalls. He enrolled in the University of Southern California Law School in 1967, and after a brief stint working at the SEC in Washington, D.C., he returned to Los Angeles to join a law firm. After two years a headhunter working for Kaufman & Broad (the company took the KB Home name in 2001) persuaded him to interview: "He said that there's this company that was one of the hottest, fastest-growing companies in L.A., and they were looking for an associate general counsel."
Karatz knew nothing about homebuilding. But, he says, "something about it just felt right." That something became more apparent to Karatz after a few weeks on his new job: "I realized I didn't want to be a lawyer anymore." So he walked into the office of KB president Gene Rosenfeld and asked to be moved to the field. Karatz turned out to have a knack for buying land, hiring crews, and everything else that goes into running a homebuilding operation. By age 30, he was head of KB's French division. He gained near-celebrity status in the Parisian business community in 1977 when he installed a full-sized model home on the roof of the Au Printemps department store. More than 500,000 people wound up touring the house, and under his guidance KB grew into one of France's largest homebuilders. (Years later Karatz drew on that experience when KB wanted to jump-start operations in Las Vegas: Working with Fox Broadcasting, which was celebrating the tenth anniversary of The Simpsons, KB constructed a real-life replica of the Simpsons' home in one of KB's Nevada subdivisions. The publicity helped turn Vegas into KB's top market.)
Karatz returned to the L.A. headquarters in 1981 and five years later was appointed CEO. When the Southern California real estate market crashed in the early 1990s--home values fell some 30%--Karatz had the red-ink-laden company double-down, expanding into Texas by acquiring San Antonio-based builder Rayco for $105 million in 1996. He then ditched KB's Field of Dreams business model--build homes and buyers will come--in favor of Rayco's more scientific approach. Not only did Rayco use market surveys to set designs and price points (a novelty at the time) but its houses were built to order, not on spec. The upshot: KB got stuck with fewer unsold homes. "Maybe it takes a recession to seriously rethink the model," Karatz said at the time. KB stock has soared 800% since then, as the new practices were rolled out across the country. (Karatz's rewards include a $38 million compensation package in 2005.)
In New Orleans, where housing demand simply can't be measured, KB is once again building on faith. Steve Davis, KB's man on the ground there, views his assignment as more a calling than a job. Davis grew up in the Crescent City's now decimated Lower Ninth Ward. His first visit home in October was heartbreaking, he says. But taking FORTUNE on a tour of his old neighborhood in January, Davis displayed more resolve than despair. A deeply religious man, he says it wasn't hard persuading his wife to give up their comfortable life in Atlanta for the surrealness of 2006 New Orleans: "We believe it's God's will to provide housing for the people who have been displaced."
Davis, 47, has been busy buying up options on raw land around the outskirts of the city. (Karatz says KB would be interested in redeveloping existing neighborhoods only if the city or state bought out homeowners and auctioned off cleaned-up land.) Among the biggest properties under contract is a 3,000-acre tract in Jefferson Parish called Churchill Farms, where KB plans to build 8,000 to 12,000 homes, with prices ranging from $150,000 to $400,000.
Davis feels strongly that New Orleans is on the verge of a renaissance. Years ago he left his hometown for Houston (and later Phoenix and Atlanta) because there weren't enough job opportunities, and he felt that poor schools and a high crime rate made New Orleans an undesirable place to start a family. But Davis now points to school reforms--post-Katrina New Orleans has become a charter-school haven--and the sharp drop in New Orleans's crime rate (many once crime-ridden neighborhoods are empty) as evidence that the area is finally poised to participate in the Sunbelt population boom. It's a view shared by Jim Bernhard, CEO of the Shaw Group, KB's local partner. Between the money spent on rebuilding and the billions more in federal economic assistance, "the economic opportunities are going to be tremendous," Bernhard says. "As one of Louisiana's biggest employers, I can tell you that the No. 1 difficulty we have is finding qualified workers. Everywhere you look, there are HELP WANTED signs."
Still, there are serious challenges for KB's venture, including local politics. While Jefferson Parish president Aaron Broussard tells FORTUNE he's committed to expediting the approval process for Churchill Farms (where groundbreaking could begin later this year), there is opposition. "Our concern is whether KB is going to come in and strangle local builders," says Toni Wendel, president of the Home Builders Association of Greater New Orleans.
And just how much demand for new housing will there ultimately be? Many existing homeowners are in a bind. Take Melissa Hebert, a 32-year-old parole officer from Chalmette who's just the kind of customer KB might hope to attract. The five-bedroom home she shares with her husband and four kids sustained $100,000 worth of Katrina damage, from both floodwaters and an oil spill from a nearby refinery. "When we got back, there were dead fish and several inches of black gook all over our property," says Hebert, who'd like nothing better than to move to a brand-new place. "Unfortunately," she goes on, "we don't have that option." Because the Heberts lacked flood insurance, their insurer is covering only a third of the damage. Given the property's condition, it's unlikely they could sell the house--which was worth about $220,000 pre-Katrina--for enough to pay off their $133,000 mortgage.
Stories like Hebert's are so common in New Orleans that if state and federal officials don't come up with some sort of homeowner bailout plan--Shaw's Bernhard says he has "full confidence" they will--KB could well be gearing up for demand that never materializes. Of course, it's just as possible that KB is entering the New Orleans market at the forefront of a land boom not unlike the one that Miami--Dade County experienced in the aftermath of Hurricane Andrew. "There's just a tremendous amount of ambiguity," says Rick Haase, general manager of Prudential Gardner Realtors, a major New Orleans realty firm. "We can't find anybody--no economist, no civic leader, no politician--who claims to know what the future looks like."
Karatz is in the same camp. "Things have become so dislocated here, it's not even clear who the buyers are," Karatz admitted during a walking tour of the Churchill Farms property in January. "It is quite possible that a large percentage of the buyers here may be families who didn't live in New Orleans six months ago." But that doesn't make Karatz any less convinced that his Gulf Coast gamble is worth taking. "Nobody knows what demand will be," he says. "I just know we're doing the right thing."