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Value Questions Circle Lennar

Nicholas Yulico

Lennar's(LEN Quote) sale of a chunk of its land portfolio at a steep discount boosts liquidity for the homebuilder, but it also points to troubling signs about the stock's valuation.

The company sold its land to Morgan Stanley(MS Quote) at a 60% discount to book value. That raises the question: What if all of Lennar's land is worth 60% less than what is stated in the company's financials?

If that's the case, Lennar's stock is wildly overpriced.

The Morgan Stanley deal highlights how much land values are plummeting across the country. The discount falls within the range at which builders are shopping deals to real estate vulture funds, sources say.

KB Home(KBH Quote) and D.R. Horton(DHI Quote) are also said to be searching for similar deals to the one Lennar has pulled off, one industry source says.

The agreement, announced late Friday, is structured as a joint venture in which Lennar will keep a 20% ownership stake. The two parties will jointly acquire, develop and sell the properties, which consist of 11,000 home sites in 32 communities in California, Colorado, Florida, Illinois, Maryland, Massachusetts, Nevada and New Jersey.

The properties, which include raw land and partially developed home sites, carried a book value of $1.3 billion and were sold for $525 million, Lennar said. Since the properties are being sold at a loss, the deal will likely create tax write-offs for the builder.

The participation by Morgan Stanley's real estate arm shows that large financial institutions and opportunity funds continue to search for attractive opportunities in the distressed homebuilding sector.

John Peshkin, CEO of the real estate investing firm Starwood Land Ventures, told TheStreet.com last month that finished home sites and raw land are being sold by homebuilders for 50% to 75% discounts off peak values from 2005.

Lennar will receive fees and additional bonuses if the venture exceeds financial targets, which were not specified. Such ventures typically look for returns of 20%.

Lennar will keep the option to purchase some of the home sites at current market values in the future.

In a statement, Lennar CEO Stuart Miller said the deal gives the company "increased liquidity and flexibility at an opportune time."

While the deal surely creates liquidity for Lennar, it also raises the question of how much investors can trust homebuilder balance sheets.

"How can they sell land for 60% less than what they said it was fairly valued two months ago?" asks one homebuilder analyst, who declined to be named.

"It raises an accounting issue," the analyst says. "Auditors need to come in and take a close look at what assumptions builders are using."

A Lennar representative couldn't be reached for comment on the company's land valuation.

Management teams are given a lot of discretion in determining whether land and other housing inventories are required to be impaired each quarter. In theory, auditors are eyeing the builders' assumptions, but the impairment models remain a black box for investors.

Assume that all of Lennar's land is worth just 40 cents on the dollar, the price Morgan Stanley is paying for this deal.

Lennar reported $6.72 billion of inventories on its books at the end of August. With a 60% haircut, the inventories have a fair market value of $2.69 billion.

Other non-inventory assets on the company's balance sheet total $3.71 billion. This number includes cash and receivables -- which are probably stated correctly. The figure also includes $173 million of goodwill and a $1 billion investment in various joint ventures. (To be gentle, we'll assume these numbers are also stated correctly.)

Applying the 60% discount, Lennar's total assets are now worth $6.4 billion. Total liabilities equal $5.3 billion.

Book value -- the part left for shareholders -- is now $1.08 billion, or $6.80 per share.

Lennar's stock recently was trading at $16.05, up 21 cents, or 1.3%.

If all of Lennar's land is really worth 60% less than stated on its books, then the stock is trading at 2.3 times book value. Builders during the downturn have been trading at discounts to book value.

Thus the deal by Lennar once again raises the worry of catching a falling knife in the sector.