ITEM 1. BUSINESS
As used in this Annual Report on Form 10-K, unless the context otherwise requires or indicates, references to “the Company,” “we,” “us,” “our” and “UCP” refer (1) prior to the
July 23, 2013
completion of the initial public offering of Class A common stock, par value
$0.01
per share (“Class A common stock”) of UCP, Inc. (the “IPO”) and related transactions, to UCP, LLC and its consolidated subsidiaries and (2) after our IPO and related transactions, to UCP, Inc. and its consolidated subsidiaries including UCP, LLC.
OUR COMPANY
The Company is a homebuilder and land developer with expertise in residential land acquisition, development and entitlement, as well as home design, construction and sales. We operate in the states of California, Washington, North Carolina, South Carolina and Tennessee. We design, construct and sell high quality single-family homes through Benchmark Communities, LLC (“Benchmark Communities”), our wholly owned homebuilding subsidiary. Prior to completion of our IPO, we operated as a wholly owned subsidiary of PICO Holdings, Inc. ("PICO"), a NASDAQ-listed, diversified holding company. Subsequent to our IPO, PICO holds a majority of the voting power of UCP, Inc. and of the economic interests of UCP, LLC, the subsidiary through which we operate our business under the name UCP.
Company’s History
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The Company’s operations began in 2004 and principally focused on acquiring land, and entitling and developing it for residential construction, and selling residential lots to third-party homebuilders.
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Company’s assets were acquired by PICO in January 2008, which allowed the Company to accelerate the development of its business and gain access to a capital partner capable of funding its growth.
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Formed Benchmark Communities, LLC, its wholly-owned homebuilding subsidiary, to design, construct and sell high quality single-family homes.
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The Company completed its IPO on July 23, 2013 and purchased a 42.3% economic interest in UCP, LLC with the net proceeds.
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Completed the acquisition of the assets and liabilities of Citizens Homes, Inc. ("Citizens Acquisition") on April 10, 2014 to expand its operations for the purchase of real estate and the construction and marketing of residential homes in the Southeast.
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Construction management services acquired as part of the Citizens Acquisition was sold in the fourth quarter of 2015.
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Benchmark Communities reached a milestone of 2,000 new home deliveries since its parent company, UCP, went public in 2013, with over 1,000 occurring since the beginning of 2015.
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OUR BUSINESS STRATEGY
We actively source, evaluate and acquire land for residential real estate development and homebuilding. For each of our real estate assets, we periodically analyze ways to maximize value by either (i) building single-family homes and marketing them for sale under our Benchmark Communities brand or (ii) completing entitlement work and horizontal infrastructure development and selling lots to third-party homebuilders. We perform this analysis using a disciplined analytical process, which we believe is a differentiating component of our business strategy.
We believe that our sizable inventory of well-located land provides us with a significant opportunity to develop communities and design, construct and sell homes under our Benchmark Communities brand. While we expect to opportunistically sell select residential lots to third-party homebuilders when we believe it will maximize our returns or lower our risk, we expect that homebuilding and home sales will constitute our primary means of generating revenue growth for the foreseeable future.
When acquiring real estate assets, we focus on seeking maximum long-term risk-adjusted returns. Our underwriting and operating philosophies emphasize capital preservation, risk identification and mitigation, and risk-adjusted returns.
We seek to mitigate our exposure to market downturns and capitalize on market upturns through the following key strategies:
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identifying and regularly reviewing the risks associated with our assets and business, including market, entitlement and environmental risks, and structuring transactions designed to reduce the impact of those risks;
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maintaining high quality in our construction activities;
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maintaining a strong balance sheet, using a prudent amount of leverage;
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leveraging our purchasing power and controlling costs;
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attracting highly experienced professionals and encouraging them to maintain a deep understanding and ownership of their respective disciplines;
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maintaining a strong corporate culture that is based on our core values including integrity, honesty, transparency, innovation, quality and excellence; and
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maintaining rigorous supervision over our operations.
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SEGMENTS AND GEOGRAPHIC MARKETS
The Company has segmented its operating activities into two geographical regions and currently has homebuilding reportable segments and land development reportable segments in the West and Southeast.
In California, we primarily operate in the Central Valley area (Fresno and Madera counties), the Monterey Bay area (Monterey County), the South San Francisco Bay area (Santa Clara and San Benito counties) and in Southern California (Los Angeles, Ventura and Kern counties). In Washington State, we operate in the Puget Sound area (King, Snohomish, Thurston and Kitsap counties). In North Carolina, we operate in the Charlotte and Raleigh areas (Mecklenburg, Iredell, Union, Chatham counties). In South Carolina, we operate in the Myrtle Beach area (Horry County). In Tennessee, we operate in the Nashville area (Davidson, Rutherford, Wilson and Sumner counties).
We believe that these markets have attractive residential real estate investment characteristics, such as favorable long-term population demographics, consumer demand for single-family housing that often exceeds available supply, large and growing employment bases, and the ability to generate above-average investment returns. We continue to experience significant homebuilding and land development opportunities in our current markets and are evaluating potential expansion opportunities in other markets that we believe have attractive long-term investment characteristics.
For a more detailed description of and financial information about our segments, see
Note 12
, "Segment Information" to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
HOMEBUILDING OPERATIONS
We build homes through our wholly owned homebuilding subsidiary, Benchmark Communities, LLC. Benchmark Communities operates under the principle that “Everything Matters!” This principle underlies all phases of our new home sale and construction process including planning, design, construction, marketing, sales and the customer experience. We are diversified by product offering, which we believe reduces our exposure to any particular market or customer segment. We decide to target specific and identifiable buyer segments by project and geographic market, in part dictated by each particular asset, its location, topography and competitive market positioning, and the amenities of the surrounding area and the community in which it is located.
We believe our customers look for distinctive new homes; accordingly, we design homes in thoughtful and creative ways to create homes that we expect buyers will find highly desirable. We seek to accomplish this by collecting and analyzing information about the characteristics of our target buyer segments and incorporating our analysis into new home designs. We source information about our target buyer segments from our experience selling new homes and through market research that enables us to identify design preferences that we believe will appeal to our customers. We target diverse buyer segments, including first-time buyers, first-time move-up buyers, second-time move-up buyers and active-adult buyers. Most of our communities target multiple buyer segments, enabling us to seek increased sales pace and reduce our dependence on any single buyer segment
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We contract with third party architects, engineers and interior designers to assist our experienced internal product development personnel in designing homes that are intended to reflect our target customers’ tastes and preferences. In addition to identifying desirable design and amenities, this process includes a rigorous value engineering strategy that allows us to seek efficiencies in the construction process.
Customer Experience
We seek to make the home buying experience friendly, effective and efficient. Our integrated quality assurance and customer care functions assign the same personnel at each community the responsibility for monitoring quality control and managing the customer experience. As a standard practice, we seek to communicate with each homeowner multiple times during their first two years of ownership in an effort to ensure satisfaction with their new home. Additionally, we monitor the effectiveness of our customer experience efforts with third-party surveys that measure our home buyers’ perception of the quality of our homes and the responsiveness of our customer service. Our customer experience program seeks to optimize customer care in terms of availability, response time and effectiveness, and we believe that it reduces our exposure to future liability claims. We believe that our continuing commitment to quality and the customer experience provides a compelling value proposition for prospective home buyers and reduces our exposure to long-term construction defect claims.
Homebuilding, Marketing and Sales Process
We realize homebuilding is a local business. As a result, we focus on the unique characteristics of each market and submarket. Each of our markets is managed locally by a division president who has a deep understanding of the local market, including our competition. Additionally, our division presidents maintain a broad network of relationships with land sellers, land developers, subcontractors and realtors.
In order to balance construction capacity with consumer demand, we release homes for sale in small phases, usually four to eight homes. We use sales prices as the lever to maintain equilibrium between capacity and demand. In markets where demand is outpacing construction capacity we have been able to raise prices and improve gross margins. From time to time we may identify, specific communities where demand has lagged construction capacity. In these cases, we have used incentives in order to increase demand.
We utilize a construction methodology that allows us to standardize the time of new home starts in order to reduce labor and material costs and the administrative inefficiencies in the construction process. Our even flow method provides visibility to our material suppliers, vendors and subcontractors, helping them balance their labor and material needs consistently over time, which we believe results in higher-quality craftsmanship and lower production costs. Our even flow method provides us with enhanced visibility, oversight and control of our production process, staffing and cash flow requirements. As a result, we believe that we are able to more effectively manage our working capital and borrowing needs.
Generally, we seek to pre-sell homes before we commence construction. This allows customers to choose certain structural and finish options and often offers us higher profitability as compared to homes that are constructed prior to identifying a buyer. Pre-sold homes often result in superior customer satisfaction and higher gross margins. During periods of strong demand, we have been successful in pre-selling a majority of our homes before construction begins. Given our even flow method, when there is an
opportunity to start construction of a home that is not yet sold we will do so in order to have homes available for customers who would like to move into a new home quickly. Homes that are under construction or completed that are not yet sold are attractive to customers who are renting, who are relocating, and who have had or are having a major change in their lives such as marriage, birth of a child or divorce. Homes that are unsold and under construction or completed allow us to compete more aggressively with the resale market where time from contract to close is usually 45 to 60 days.
We routinely monitor and actively manage our even flow production process to align our inventory with prevailing and expected future home absorption trends. In the even our inventory begins to build faster than homes are sold, we will typically reduce or halt the start of any additional unsold homes in order to bring our supply in balance with consumer demand. This allows us to more efficiently manage our inventory and asset levels as well as our capital needs with the objective of improving our overall return metrics.
Our sales and marketing process uses extensive advertising and promotional strategies, including Benchmark Communities’ website, community marketing brochures, and the use of billboards and other roadside signage. Brokerage operations are conducted through our wholly owned subsidiaries in each state, as follows: (1) BMC Realty Advisors, Inc. in California and Washington; (2) Builders BMC, Inc. in North Carolina; (3) BMCH Tennessee, LLC in Tennessee; and (4) Benchmark Communities, LLC in South Carolina.
We typically staff two sales professionals at each of our communities. Our in-house sales teams have offices in their respective model home complex and are responsible for selling homes, interfacing with customers between the time a sales contract is executed and the home sale closes, and coordinating with our escrow management department. Our sales professionals work with potential buyers to determine their unique needs and then by demonstrating the functionality and livability of our homes with floor plans, price information, development and construction timetables, tours of model homes and the selection of amenities. Our sales professionals are internally trained, generally have prior experience selling new homes in their respective markets and are licensed by applicable real estate oversight agencies.
Model homes are one of our primary sales tools. Depending on the amount of time we expect it will take to complete sales at a community and the number of different homes we are offering, we typically build between two and four model homes. Our marketing staff uses interior designers, architects and color consultants to create model homes designed to appeal to our targeted buyer segments. Our models typically include features that are included in the base price of the particular home model, and options and upgrades that a home buyer may elect to purchase. We often use an on-site design center that offers our customers the opportunity to purchase various options and upgrades and provides additional revenue opportunities for us.
Home Buyer Financing
The majority of our home buyers finance a significant portion of the purchase price of their home with long-term mortgage financing. We assist prospective purchasers in obtaining mortgage financing by providing referrals to one of our preferred lenders. Our preferred lenders have a track record of offering our customers competitive rates and terms, a desire to enhance our customer's experience and the ability to perform on an agreed schedule in order to meet our expectations and those of our customers. Through our lender referral process we seek to reduce the challenges our customers encounter when trying to obtain mortgage financing for our homes.
Quality Control and Customer Service
We pay particular attention to the product design process and carefully consider quality and choice of materials in order to attempt to eliminate building deficiencies. The quality and workmanship of the subcontractors we employ are monitored and we make regular internal and third party inspections and evaluations of our subcontractors to seek to ensure that our standards are met.
We have quality control and customer service staff who seek to provide a positive experience for each home buyer throughout the pre-sale, sale, building, closing and post-closing periods. These employees are responsible for providing after sales customer service. Our quality and service initiatives include taking home buyers on a comprehensive tour of their home prior to closing and using customer survey results to improve our standards of quality and customer satisfaction.
Warranty Program
We provide a “fit and finish” warranty on our home sales that covers workmanship and materials consistent with local market custom (two years in the West homebuilding segment and one year in the Southeast homebuilding segment). As is customary in the homebuilding industry, our trade partners who build our homes are contractually obligated to provide warranty repairs inside the fit and finish warranty period, including structural and water intrusion repairs up the to the period designated by the relevant state statute.
Along with our homeowners receiving warranty information, they also receive important home maintenance guidelines in an effort to help them enjoy and prolong the durability of their home. Customers who actively and correctly maintain their home not only protect the value of their home, but minimize the longer-term risk to the Company that is normally associated with homes that are not properly maintained.
The limited warranty covering construction defects is transferable to subsequent buyers not under direct contract with us and requires that home buyers agree to the conditions, restrictions and procedures set forth in the warranty. We accrue estimated warranty costs based upon our estimates of the expense we expect to incur for work under warranty.
Raw Materials
When constructing homes, we use various materials and components. It has typically taken us four to six months to construct a home, during which time we are subject to price fluctuations in raw materials.
LAND DEVELOPMENT OPERATIONS
As a homebuilder and land developer, we are positioned to either build new homes on our lots or to sell our lots to third-party homebuilders. While our current business plan emphasizes building new homes, we proactively monitor market conditions and our operations allow us to opportunistically sell a portion of our lots to third-party homebuilders if we believe that will maximize our returns or lower our risk. We believe that our ability and willingness to opportunistically build on or sell our lots to third-party homebuilders afford us the following important advantages:
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exploit periods of cyclical expansion by building on our lots;
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manage our operating margins and reduce operating income volatility by opportunistically selling lots as operating performance and market conditions dictate; and
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manage operating risk in periods where we anticipate cyclical contraction by reducing our land supply through lot sales.
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We benefit from the long-standing relationships our executive management team has with key land owners, brokers and lenders, as well as development and real estate companies in our markets. These relationships have provided us with opportunities to evaluate and privately negotiate acquisitions outside of a broader marketing process. In addition, we believe that our financial position and positive reputation in our markets provide land sellers and brokers confidence that we will consummate transactions in a highly professional, efficient and transparent manner. Our ability to regularly do so in turn strengthens these relationships for future opportunities. We believe our relationships with land owners and brokers will continue to provide opportunities to source land acquisitions prior to a full marketing process, helping us to maintain a significant pipeline of opportunities on favorable terms and prices.
The land development process in our markets can be very complex and often requires highly-experienced individuals that can respond to numerous unforeseen challenges with a high degree of competency and integrity. We actively seek land acquisition opportunities where others might seek to avoid complexities, as we believe we can add significant value through our expertise in entitlements, re-entitlements, horizontal land planning and development.
Acquisition Process
Our ability to identify, evaluate and acquire land in desirable locations and on favorable terms is critical to our success. We evaluate land opportunities based on risk-adjusted returns and employ a rigorous due diligence process to identify risks, which we then seek to mitigate.
We leverage our relationships with land owners, brokers, developers and financial institutions, and our history of purchasing land, to seek the “first look” at land acquisition opportunities or to evaluate opportunities before they are broadly marketed. We use a variety of transaction structures, including purchase and option contracts, to maximize our risk-adjusted return, with particular emphasis on reducing our risk, conserving our capital while accommodating the particular needs of each seller.
We combine our entitlement, land development and homebuilding expertise to increase the flexibility of our business, seek enhanced margins, control our lot deliveries and maximize returns. Additionally, we believe that the integration of the entitlement,
development and homebuilding process allows us to deliver communities that achieve a high level of customer satisfaction. Our entitlement expertise allows us to add value through the zoning and land planning process. Our land development entitlement expertise allows us to consider a broader range of land acquisition opportunities from which to seek superior risk-adjusted returns.
We selectively evaluate expansion opportunities in our existing markets as well as new markets that we believe have attractive long-term investment characteristics. These characteristics include, among others, demand for single-family housing that exceeds available supply, well regarded educational systems and institutions, high educational attainment levels, desirable transportation infrastructure, proximity to major trade corridors, positive employment trends, diverse employment bases and high barriers to the development of residential real estate, such as geographic or political factors.
OUR FINANCING STRATEGY
We intend to use debt and equity as part of our ongoing financing strategy, coupled with redeployment of cash flows from continuing operations. We intend to employ prudent levels of leverage to finance the acquisition and development of our lots and construction of our homes. We attempt to match the duration of our real estate assets with the duration of the capital that finances each asset.
Our indebtedness is primarily comprised of our 8.5% Senior Notes due 2017 (the "2017 Notes") and project-level secured acquisition, development and constructions loans. Substantially all of our project debt is guaranteed by UCP, LLC and UCP, Inc. Our board of directors considers a number of factors when evaluating our level of indebtedness and when making decisions regarding the incurrence of new indebtedness, including the purchase price of assets to be acquired with debt financing, the estimated market value of our assets, the expected asset's duration and the ability of particular assets, and our Company as a whole, to generate cash flow to cover the expected debt service. Though we intend to remain prudently capitalized, our charter does not contain a limitation on the amount of debt we may incur and our board of directors may change our target debt levels within the covenants and restrictions currently in place with our lenders at any time without the approval of our stockholders.
We intend to finance future acquisitions and developments with the most advantageous source of capital available to us at the time of the transaction, which may include a combination of common and preferred equity, secured and unsecured corporate-level debt, property-level debt and mortgage financing and other public, private or bank debt.
For a more detailed description of and financial information about our indebtedness, see
Note 8,
"Notes Payable and Senior Notes, Net" to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
REGULATION AND ENVIRONMENTAL MATTERS
We are subject to various local, state, and federal statutes, ordinances, rules, and regulations concerning zoning, building design, construction, and similar matters, including local regulations which impose restrictive zoning and density requirements in order to limit the number of homes that can be built within the boundaries of a particular locality. In addition, we are subject to registration and filing requirements in connection with the construction, advertisement, and sale of our communities in certain states and localities in which we operate. We may also be subject to periodic delays or may be precluded entirely from developing communities due to building moratoriums that could be implemented in the future in the states in which we operate. Generally, such moratoriums relate to insufficient water or sewerage facilities or inadequate road capacity.
In addition, some state and local governments in markets where we operate have approved, and others may approve, slow-growth, or no-growth initiatives that could negatively affect the availability of land and building opportunities within those areas. Approval of these initiatives could adversely affect our ability to build and sell homes in the affected markets and/or could require the satisfaction of additional administrative and regulatory requirements, which could result in slowing the progress or increasing the costs of our homebuilding operations in these markets. Any such delays or costs could have a negative effect on our future revenues and earnings.
We are also subject to a variety of local, state, and federal laws and regulations concerning protection of health and the environment. The particular environmental laws which apply to any given community vary according to the community site, the site’s environmental conditions, and the present and former uses of the site. These environmental laws may result in delays, may cause us to incur substantial compliance, remediation, and/or other costs; and prohibit or severely restrict development and homebuilding activity.
Despite our past ability to obtain necessary permits and approvals for our communities, we anticipate that increasingly stringent requirements will be imposed on developers and homebuilders in the future. Although we cannot predict the effect of these requirements, they could result in time-consuming and expensive compliance programs and in substantial expenditures, which could cause delays and increase our cost of operations. In addition, our ability to obtain or renew permits or approvals and the continued effectiveness of permits already granted or approvals already obtained is dependent upon many factors, some of which are beyond our control, such as changes in policies, rules, and regulations and their interpretation and application.
SEASONALITY
The homebuilding industry generally exhibits seasonality. We have historically experienced, and in the future expect to continue to experience, variability in our operating results and capital needs on a quarterly basis. Although we enter into home sales contracts throughout the year, a significant portion of our sales activity takes place during the spring and summer, with the corresponding closings taking place during the fall and winter. Additionally, our capital needs are typically greater during the spring and summer when we are building homes for delivery later in the year. Accordingly, our revenue may fluctuate significantly on a quarterly basis, and we must maintain sufficient liquidity to meet short-term operating requirements. As a result of seasonal variation, our quarterly results of operations and financial position at the end of a particular quarter are not necessarily representative of the results we expect at year-end.
COMPETITION
The homebuilding and land development industry is highly competitive. We compete with numerous large national and regional homebuilding companies and with smaller local homebuilders and land developers for, among other things, home buyers, financing, desirable land parcels, raw materials and skilled management and labor resources. We also compete with sales of existing homes and, to a lesser extent, with the rental housing market. Our homes compete on the basis of design, quality, price, location and our reputation. In addition to home sales, we sell lots to third-party homebuilders. We compete for land buyers with other land owners. Our land holdings compete on the basis of quality, market positioning, location and price.
The homebuilding and land development industry has historically been subject to significant volatility. We may be at a competitive disadvantage with regard to certain of our national competitors whose operations are more geographically diversified than ours, as these competitors may be better able to withstand any future regional downturn in the housing market.
We compete directly with a number of national homebuilders who are larger than we are and may have greater financial and operational resources than we do. This may give our competitors an advantage in marketing their products, securing materials and labor at lower prices, purchasing land and allowing their homes to be delivered to customers more quickly and at more favorable prices. This competition could reduce our market share and limit our ability to expand our business.
EMPLOYEES
As of
December 31, 2016
, we had 203 employees consisting of 59 executive, management or administrative personnel, 96 construction personnel and 48 sales and marketing personnel. Although none of our employees are covered by collective bargaining agreements, certain of the subcontractors engaged by us are represented by labor unions or are subject to collective bargaining arrangements. We believe that we have good relations with our employees and subcontractors.
EXECUTIVE OFFICERS
The executive officers of UCP, Inc. are:
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Name
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Age
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Position
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Dustin L. Bogue
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42
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President, Chief Executive Officer and Director
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James M. Pirrello
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58
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Chief Financial Officer, Chief Accounting Officer and Treasurer
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Dustin L. Bogue.
Mr. Bogue has served as our President since 2008. Since our IPO in July of 2013, he has served as our President and Chief Executive Officer and as a member our board of directors. Mr. Bogue was involved with the formation of our predecessor, Union Community Partners, LLC in 2004 as the President and Managing Member until 2008. Mr. Bogue was instrumental in Union Community Partners, LLC’s acquisition and entitlement of several communities in Northern California. In 2008, Union Community Partners, LLC was acquired by PICO and its name was changed to UCP, LLC. Mr. Bogue was instrumental in creating our subsidiary, Benchmark Communities in 2010, with the goal of creating designing and delivering outstanding homes in communities with exceptional value and sustainability. Since Union Community Partners, LLC’s inception in 2004, Mr. Bogue has been principally responsible for developing the strategic direction of our Company and our operations. Prior to joining our Company, Mr. Bogue was the Vice President of Development and Sales at Landcastle Real Estate from 2001 to 2004. From 1999 to 2001, Mr. Bogue worked for Wellington Corporation of Northern California, a subsidiary of Triple Five National Development Company. At Wellington, Mr. Bogue was the Director of Land Acquisitions and Development, managing Wellington’s California real estate portfolio, including acquisition, disposition and development. Additionally, at Wellington, Mr. Bogue was actively involved in creating two technology start-ups; Bridgewater Ventures, an early-stage venture capital company, and Cenatek, Inc., a solid-state storage device company where Mr. Bogue served as an executive vice president.
James M. Pirrello.
Mr. Pirrello serves as our Chief Financial Officer, Chief Accounting Officer and Treasurer; he has served in these roles since January 2016. Mr. Pirrello has over 30 years of homebuilding experience in both senior financial and senior operational roles, including chief operating officer, chief financial officer, and division president. Mr. Pirrello most recently served as President and Founder of American New Homes Group. Over his career he has held senior financial positions at numerous homebuilder and real estate development firms including BCB Homes, Builder Acquisition Corp., First Homebuilders of Florida, The Longford Group, and The Fortress Group and NVR. During his career, he has negotiated numerous debt and equity capital market financings, and over 20 merger and acquisition transactions. Mr. Pirrello earned MBAs, from both Columbia University and the University of California, Berkeley, along with an undergraduate degree in accounting from Juniata College.
OUR STRUCTURE
The amended and restated certificate of incorporation of UCP, Inc. authorizes
two
classes of common stock: Class A common stock and Class B common stock, par value $0.01 per share (“Class B common stock”). Shares of Class A common stock represent
100%
of the economic rights of the holders of all classes of UCP, Inc.'s common stock. Shares of Class B common stock, which are held exclusively by PICO, are not entitled to any dividends paid by, or rights upon liquidation of, UCP, Inc. PICO holds 100 shares of Class B common stock of UCP, Inc., providing PICO with no economic rights but entitling PICO, without regard to the number of shares of Class B common stock held by PICO, to
one
vote on matters presented to stockholders of UCP, Inc. for each UCP, LLC Series A Unit (as defined below) held by PICO. Holders of the Company’s Class A common stock and Class B common stock will vote together as a single class on all matters presented to the Company’s stockholders for their vote or approval, except as otherwise required by applicable law. As of
December 31, 2016
, PICO held 10,593,000 UCP, LLC Series A Units and
100
shares of Class B common stock, which provided PICO with
56.8%
of the aggregate voting power of UCP, Inc.'s outstanding Class A common stock and Class B common stock, which equals PICO’s economic interest in the Company. PICO effectively has control over the outcome of votes on all matters requiring approval by the Company’s stockholders. As described in more detail below, each Series A Unit of UCP, LLC can be exchanged for one share of Class A common stock.
The Company's charter provides that its board of directors has the authority, without action by the stockholders, to designate and issue up to
50,000,000
shares of preferred stock in one or more classes or series and to fix for each class or series the powers, rights, preferences and privileges of each series of preferred stock, including dividend rights, conversion rights, voting rights, terms of redemption, liquidation preferences and the number of shares constituting any class or series, which may be greater than the rights of the holders of the Class A common stock or Class B common stock.
As of
December 31, 2016
, UCP, Inc. held a
43.2%
interest in UCP, LLC, through its ownership of UCP, LLC Series B Units (as defined below), and PICO held the remaining
56.8%
interest in UCP, LLC through its ownership of UCP, LLC Series A Units. UCP, Inc. is a holding company, and its sole material asset is its equity interest in UCP, LLC.
In connection with the IPO, UCP, LLC's Amended and Restated Limited Liability Company Operating Agreement (the "Operating Agreement") was amended and restated to, among other things, designate UCP, Inc. as the sole managing member of UCP, LLC and establish a new series of units (“UCP, LLC Series B Units”), which are held solely by UCP, Inc., and reclassify PICO's units into
10,593,000
UCP, LLC Series A Units (the “UCP, LLC Series A Units”), which are held solely by PICO (and its permitted transferees). UCP, Inc. purchased
7,750,000
UCP, LLC Series B Units through its investment in UCP, LLC with the net proceeds from the IPO. The UCP, LLC Series B Units rank on parity with the UCP, LLC Series A Units as to distribution rights and rights upon liquidation, winding up or dissolution. Subsequent to the IPO and related transactions, as the sole managing member of UCP, LLC, UCP, Inc. operates and controls all of the business and affairs and consolidates the financial results of UCP, LLC and its subsidiaries.
Tax Distribution
Pursuant to the Operating Agreement, UCP, Inc. has the right to determine when distributions (other than tax distributions) will be made to the members of UCP, LLC and the amount of any such distributions. If UCP, Inc. authorizes a distribution, such distribution generally will be made to the members of UCP, LLC pro rata in accordance with their respective percentage interests. During the years ended
December 31, 2016
and
December 31, 2015
, UCP, LLC made distributions of
$4.8 million
and
$1.0 million
, respectively, to PICO toward its tax liability as required by the Operating Agreement and a pro rata distribution
of
$3.7 million
and
$0.7 million
,
respectively
, to UCP, Inc. There were no other distributions by UCP, LLC for the year ended
December 31, 2016
.
The holders of limited liability company interests in UCP, LLC, including UCP, Inc., generally have to include for purposes of calculating their U.S. federal, state and local income taxes their allocable share of any taxable income of UCP, LLC. In general, taxable income of UCP, LLC will be allocated to PICO and UCP, Inc. on a pro rata basis in accordance with their respective percentage interests. However, as a result of certain taxable “built-in gains” in the assets of UCP, LLC that existed at the time of the IPO which, by statute, must be allocated solely to PICO, UCP, Inc. is expected at times to be allocated a disproportionately smaller amount of net taxable income and PICO is expected to be allocated a disproportionately larger amount of net taxable income. UCP, LLC is obligated, subject to available cash, applicable law and contractual restrictions (including limitations imposed by any financing agreements), to make cash distributions, which we refer to as “tax distributions,” based on certain assumptions (including a combined federal, state and local tax rate of 41% (or such other rate determined by UCP, Inc. to be the highest marginal effective rate of federal, state and local income tax applicable to corporations doing business in California or such other jurisdiction in which UCP, LLC is doing business)), to its members (including UCP, Inc.). Generally, these tax distributions will be pro rata in accordance with the respective percentage interests of PICO and UCP, Inc. and will be in an amount sufficient to allow PICO and UCP, Inc. to pay taxes on their allocable shares of the taxable income of UCP, LLC. If, however, there is insufficient cash to make pro rata tax distributions to PICO and UCP, Inc. in an amount that would allow PICO and UCP, Inc. to pay taxes on their allocable shares of the taxable income of UCP, LLC, PICO and UCP, Inc. would receive distributions in proportion to their respective tax liabilities based upon their allocable shares of UCP, LLC’s taxable income. It is expected in that case that PICO would receive a larger proportional distribution than UCP, Inc. would receive and, in some cases (for instance if all of the taxable income is allocable to PICO), UCP, Inc. could receive no tax distributions. In any case in which UCP, Inc. received a smaller proportional distribution than PICO, UCP, LLC would have an obligation to make future distributions to UCP, Inc. to eliminate the difference as soon as funds become available and UCP, LLC would be required to pay interest to UCP, Inc. at a prevailing market rate on such difference.
As a result of the potential differences in the amount of net taxable income allocable to UCP, Inc. and to PICO described above, it is expected that UCP, Inc. will receive tax distributions significantly in excess of UCP, Inc.’s tax liabilities and obligations to make payments under the tax receivable agreement (as described below). To the extent, as currently expected, UCP, Inc. does not distribute such cash balances as dividends on its Class A common stock and instead, for example, holds such cash balances or lends them to UCP, LLC, PICO would benefit from any value attributable to such accumulated cash balances as a result of its ownership of our Class A common stock following an exchange of its UCP, LLC Series A Units (including any exchange upon an acquisition of UCP, Inc.).
On June 6, 2016, our Board of Directors authorized the repurchase of up to
$5.0 million
of the Company’s Class A common stock between June 7, 2016 and June 1, 2018 (the “Stock Repurchase Program”). As part of the Company's Stock Repurchase Program, the Company used
$1.2 million
of cash received through these tax distributions to repurchase stock. See
Note 2
, "Summary of Significant Accounting Policies--Stock Repurchase Program" and
Note 10
, “Equity--Stock Repurchase Program” to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding the Stock Repurchase Program.
The diagram below depicts our organizational structure as of
December 31, 2016
:
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(1)
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We carry out our business generally through a number of operating subsidiaries and project-specific subsidiaries that are directly or indirectly wholly owned by UCP, LLC. Benchmark Communities, LLC, a Delaware limited liability company, is our wholly owned general contractor subsidiary in all states except North Carolina. Benchmark Builders North Carolina, LLC, a Delaware limited liability company, is our wholly owned general contractor subsidiary in North Carolina. BMC Realty Advisors, Inc., a California corporation, is our wholly-owned subsidiary through which we conduct real estate brokerage activities relating to our business in California and Washington. Builders BMC, Inc., a Delaware corporation, is our wholly-owned subsidiary through which we conduct real estate brokerage activities relating to our business in North Carolina. BMCH Tennessee, LLC, a Delaware limited liability company, is our wholly-owned subsidiary through which we conduct real estate brokerage activities relating to our business in Tennessee. Benchmark Communities, LLC, a Delaware limited liability company, is our wholly-owned subsidiary through which we conduct real estate brokerage activities relating to our business in South Carolina.
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Exchange Agreement
In connection with the IPO, UCP, Inc. entered into an Exchange Agreement dated July 23, 2013 by and among UCP, Inc., UCP, LLC and PICO (the "Exchange Agreement"), pursuant to which PICO (and its permitted transferees) have the right to cause UCP, Inc. to exchange PICO's UCP, LLC Series A Units for shares of UCP, Inc. Class A common stock on a
one-for-one
basis, subject to equitable adjustments for stock splits, stock dividends, stock repurchases and reclassifications. As of
December 31, 2016
, giving effect to the Class A common stock that the Company would issue if PICO were to elect to exchange all of its UCP, LLC Series A Units for shares of Class A common stock, the Company would have
18,635,834
shares of Class A common stock outstanding. Any UCP, LLC Series A Units being exchanged will be reclassified as UCP, LLC Series B Units in connection with such exchange.
Exchanges by PICO of its UCP, LLC Series A Units for shares of UCP, Inc. Class A common stock are expected to result, with respect to UCP, Inc., in increases in the tax basis of the assets of UCP, LLC that otherwise would not have been available. These increases in tax basis may reduce the amount of tax that UCP, Inc. would otherwise be required to pay in the future. These increases in tax basis may also decrease gains (or increase losses) on future dispositions of certain assets to the extent tax basis is allocated to those assets.
Tax Receivable Agreement
UCP, Inc., UCP, LLC and PICO are party to a Tax Receivable Agreement dated July 23, 2013 (the "TRA"). When PICO sells or exchanges its UCP, LLC Series A Units for shares of the Company’s Class A common stock, such a sale or exchange by PICO would result in an adjustment to the tax basis of the assets owned by UCP, LLC at the time of an exchange. An increase in tax basis is expected to increase the Company's depreciation and amortization income tax deductions and create other tax benefits and therefore may reduce the amount of income tax that the Company would otherwise be required to pay in the future. Under the TRA, the Company generally is required to pay to PICO
85%
of the applicable cash savings in U.S. federal and state income tax that the Company actually realizes (or is deemed to realize in certain circumstances) as a result of sales or exchanges of the UCP, LLC Series A Units held by PICO for shares of Class A common stock, leaving the Company with
15%
of the benefits of the tax savings. Cash savings in income tax will be computed by comparing the Company’s actual income tax liability to the amount of income taxes that the Company would have been required to pay had there been no increase in the tax basis of the tangible and intangible assets of UCP, LLC as a result of the exchanges. If the Company would not have reported taxable income in a given year had there been no increase in the tax basis of assets as a result of the exchanges, no payment under the TRA for that taxable year is required because no tax savings will have been realized.
As of
December 31, 2016
, PICO has not exchanged any of its UCP, LLC Series A Units. Estimating the amount of future payments to be made under the TRA cannot be done reliably at this time because any increase in tax basis, as well as the amount and timing of any payments, will vary depending on a number of factors, including:
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the timing of any exchanges of UCP, LLC Series A Units for shares of the Company’s Class A common stock by PICO, as the increase in any tax deductions will vary depending on the allocation of fair market value to the assets of UCP, LLC at the time of any such exchanges, and this value allocation may fluctuate over time;
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the price of the Company’s Class A common stock at the time of any exchanges of UCP, LLC Series A Units for shares of the Company’s Class A common stock (since the increase in the Company’s share of the basis in the assets of UCP, LLC, as well as the corresponding increase in any tax deductions, will be related to the price of the Company’s Class A common stock at the time of any such exchanges);
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the tax rates in effect at the time the Company uses the increased amortization and depreciation deductions or realize other tax benefits; and
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the amount, character and timing of the Company’s taxable income.
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The effects of the TRA on the Company’s consolidated balance sheet if PICO elects to exchange all or a portion of its UCP, LLC Series A Units for the Company’s Class A common stock are expected to be as follows:
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an increase in deferred tax assets for the estimated income tax effects of the increase in the tax basis of the assets owned by UCP, LLC based on enacted federal, state and local income tax rates at the date of the relevant transaction. To the extent the Company believes that it is more likely than not that the Company will not realize the full tax benefit represented by the deferred tax asset, the Company will reduce the deferred tax asset with a valuation allowance;
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the Company may record
85%
of the applicable cash tax savings in U.S. federal and state income taxes resulting from the increase in the tax basis of the UCP, LLC Series A Units and certain other tax benefits related to entering into the TRA, including tax benefits attributable to payments under the TRA as an increase in a payable due to PICO; and
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an increase to additional paid-in capital equal to the difference between the increase in deferred tax assets and the increase in the liability due to PICO.
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The Company has the right to terminate the TRA at any time. In addition, the TRA will terminate early if the Company breaches obligations under the TRA or upon certain mergers, asset sales, other forms of business combinations or other changes of control. In either case, the Company’s payment obligations under the TRA would be accelerated and would become due and payable based on certain assumptions, including that (a) all the UCP, LLC Series A Units are deemed exchanged for their fair value, (b) the Company would have sufficient taxable income to fully utilize the deductions arising from the increased tax deductions and tax basis and (c) the subsidiaries of UCP, LLC will sell certain non-amortizable assets (and realize certain related tax benefits) no later than a specified date. In each of these instances, the Company would be required to make an immediate payment to PICO equal to the present value of the anticipated future tax benefits (discounted over the applicable amortization and depreciation periods for the assets the tax bases of which are stepped up (which could be as long as
fifteen
years in respect of intangibles and goodwill) at a discount rate equal to the 30-day London Interbank Offered Rate ("LIBOR") plus 100 basis points). The benefits would be payable even though, in certain circumstances, no UCP, LLC Series A Units are actually exchanged at the time of the accelerated payment under the TRA, thereby resulting in no corresponding tax basis step up at the time of such accelerated payment under the TRA.
Investor Rights Agreement and Transition Services Agreement
Pursuant to an Investor Rights Agreement dated July 23, 2013 (the "Investor Rights Agreement"), PICO has the right to nominate two individuals for election to UCP, Inc.'s board of directors for as long as PICO owns
25%
or more of the combined voting power of UCP, Inc.'s outstanding Class A and Class B common stock and one individual for as long as it owns at least
10%
(in each case, excluding shares of any of UCP, Inc.'s common stock that are subject to issuance upon the exercise or exchange of rights of conversion or any options, warrants or other rights to acquire shares). However, the Investor Rights Agreement does not entitle PICO to nominate individuals for election to UCP, Inc.'s board of directors if their election would result in PICO nominees comprising more than two of UCP, Inc.'s directors (for as long as PICO owns
25%
or more of the combined voting power of UCP, Inc.'s outstanding Class A and Class B common stock) or one of UCP, Inc.'s directors (for as long as PICO owns at least
10%
of the combined voting power of UCP, Inc.'s outstanding Class A and Class B common stock).
UCP also entered into a Transition Services Agreement ("TSA"), dated July 23, 2013 with PICO, pursuant to which PICO provided UCP, Inc. with certain accounting, human resources and information technology services. This agreement was completed on July 31, 2015, and PICO no longer provides such services to UCP, Inc.
CORPORATE INFORMATION
Our principal executive offices are located at 99 Almaden Boulevard, Suite 400, San Jose, California 95113. Our telephone number is (408) 207-9499. Our website is located at www.unioncommunityllc.com. Our homebuilding subsidiary, Benchmark Communities, also maintains an Internet website at www.benchmarkcommunities.com. The information that is found on or accessible through our websites is not incorporated into, and does not form a part of this Annual Report on Form 10-K or any other report or document that we file with or furnish to the Securities and Exchange Commission (the "SEC"). We have included our website addresses in this Annual Report on Form 10-K as an inactive textual reference and do not intend it to be an active link to our websites.
We make available on our website, free of charge, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934, as amended (the "Exchange Act") as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. We also make our Code of Business Conduct and Ethics for our directors, officers and employees available on our website on the Corporate Governance page under the Investor Relations section of our website.
This Annual Report on Form 10-K and other reports filed with the SEC can be read or copied at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC; the website address is www.sec.gov.
ITEM 1A. RISK FACTORS
Set forth below are the risks that we believe are material to our investors. You should carefully consider the following risks and the other matters in this Annual Report on Form 10-K in evaluating our business and prospects. The occurrence of any of the following risks could materially adversely impact our financial condition, results of operations, cash flow, liquidity, the market price of our Class A common stock and our ability to achieve our objectives, which in turn could cause our stockholders to lose all or part of their investment. Some statements in this report, including statements in the following risk factors constitute forward-looking statements. Please refer to the section entitled “Special Note about Forward-Looking Statements” elsewhere in this Annual Report on Form 10-K.
RISKS RELATED TO OUR BUSINESS
Our long-term growth depends, in part, upon our ability to successfully identify and acquire desirable land parcels for residential buildout, which may be limited due to a variety of factors.
Our future growth depends, in part, upon our ability to successfully identify and acquire attractive land parcels in geographic areas in which we operate for development of single-family homes at reasonable prices, either by ourselves, through Benchmark Communities, or by our third-party homebuilder customers. Our ability to acquire land parcels for new single-family homes may be adversely affected by changes in the general availability of land parcels, the willingness of land sellers to sell land parcels at reasonable prices, competition for available land parcels, availability of financing to acquire land parcels, zoning and other market conditions. If the supply of land parcels appropriate for development of single-family homes is limited because of these factors, or for any other reason, our ability to grow could be significantly limited, and our revenue and gross margin could decline. To the extent that we are unable to purchase land parcels or enter into new contracts or options for the purchase of land parcels at reasonable prices, our revenue and results of operations could be negatively impacted.
Our industry is cyclical and adverse changes in general and local economic conditions could reduce the demand for homes and, as a result, could have a material adverse effect on us.
The residential homebuilding industry is cyclical and is highly sensitive to changes in general economic conditions, such as levels of employment, consumer sentiment and income, availability and cost of financing for acquisitions, construction and mortgages, interest rate levels, inflation and demand for housing. The health of the residential homebuilding industry may also be significantly affected by “shadow inventory” levels during recessionary and recovery periods.
“Shadow inventory” refers to the number of homes with mortgages that are in some form of distress but that have not yet been listed for sale. Shadow inventory can occur when lenders put properties that have been foreclosed or forfeited to lenders or available for short sale (i.e. potentially available for sale for an amount that is less than the unpaid principal balance on a related mortgage loan) on the market gradually, rather than all at once, or delay the foreclosure process. A significant shadow inventory in our markets could, were it to be released, adversely impact home and land prices and demand for our homes and land, which would have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations. In addition, an important segment of our end-purchaser and customer base consists of first-time and second-time “move-up” buyers, the latter often purchase homes subject to contingencies related to the sale of their existing homes. The difficulties facing these buyers in selling their homes during recessionary periods may adversely affect our sales. Moreover, during such periods, we may need to reduce our sales prices and offer greater incentives to buyers to compete for sales, and that may result in reduced gross margins.
Our long-term growth depends, in part, upon our ability to acquire undeveloped land suitable for residential homebuilding at reasonable prices.
The availability of partially finished developed lots and undeveloped land for purchase at reasonable prices depends on a number of factors outside our control, including land availability in general, competition with other homebuilders and land buyers, inflation in land prices, zoning, allowable housing density, the ability to obtain building permits and other regulatory requirements. Should suitable lots or land become less available, the number of homes we may be able to build and sell could be reduced, and the cost of land could be increased, perhaps substantially, which could adversely impact us. As competition for suitable land increases, the cost of acquiring partially finished developed lots and undeveloped lots and the cost of developing owned land could rise and the availability of suitable land at acceptable prices may decline, which could adversely impact us. The availability of suitable land assets could also affect the success of our land acquisition strategy, which may impact our ability to increase the number of actively selling communities, grow our revenue and gross margins, and achieve or maintain profitability. Additionally, developing undeveloped land
is capital intensive and time consuming. It is possible that we may develop land based upon forecasts and assumptions that prove to be inaccurate, resulting in projects that are not economically viable.
Because of the seasonal nature of our business our quarterly operating results fluctuate.
We generally experience seasonal fluctuations in our quarterly operating results and capital requirements that can have a material impact on our results and our consolidated financial statements. We typically experience the highest new home order activity in spring and summer, although this activity is also highly dependent on the number of active selling communities, the timing of new community openings and other market factors. Since it typically takes four to six months to construct a new home, we deliver more homes in the second half of the year as spring and summer home orders convert to home deliveries. Because of this seasonality, home starts, construction costs and related cash outflows have historically been highest in the second and third quarters, and the majority of cash receipts from home deliveries occur during the second half of the year. We expect this seasonal pattern to continue over the long‑term, although it may be affected by volatility in the homebuilding industry. In a recovering housing market, we expect the traditional seasonality and its impact on our results of operations would become more pronounced. This seasonality requires us to finance our construction activities significantly in advance of the receipt of sales proceeds. Accordingly, there is a risk that we will invest significant amounts of capital in the acquisition and development of land and construction of homes that we do not sell at anticipated pricing levels or within anticipated time frames. If, due to market conditions, construction delays or other causes we do not complete home sales at anticipated pricing levels or within anticipated time frames, our liquidity, financial condition and results of operations would be adversely affected.
If the market value of our land inventory decreases, our results of operations could be adversely affected by impairments and write-downs.
The market value of our land and housing inventories depends on market conditions. We acquire land for expansion into new markets and for replacement of land inventory and expansion within our current markets. There is a risk that the value of the land owned by us may decline after purchase. The valuation of property is inherently subjective and based on the individual characteristics of each property. We may have acquired options on or bought and developed land at a cost we will not be able to recover fully or on which we cannot build and sell homes profitably. In addition, our deposits for lots controlled under purchase, option or similar contracts may be put at risk.
Factors such as changes in regulatory requirements and applicable laws (including in relation to building regulations, taxation and planning), political conditions, the condition of financial markets, both local and national economic conditions, the financial condition of customers, potentially adverse tax consequences, and interest and inflation rate fluctuations subject land valuations to uncertainty. Moreover, our valuations are made on the basis of assumptions, including assumptions relating to economic conditions and demographics that may prove to be inaccurate. If housing demand fails to meet our expectations when we acquired our inventory, our profitability may be adversely affected and we may not be able to recover our costs when we sell homes that we build or land that we own.
We regularly review the value of our land holdings and continue to review our holdings on a periodic basis. Material write-downs and impairments in the value of our inventory may be required, and we may in the future sell land or homes at a loss, which could adversely affect our results of operations and financial condition. See
Note 2
, “Summary of Significant Accounting Policies” and
Note 9
, "Fair Value Disclosures" to the consolidated financial statements for further discussion on impairment and estimated fair values of real estate inventories included elsewhere in this report.
The homebuilding industry is highly competitive, and if our competitors are more successful or offer better value to our customers our business could decline.
We operate in a very competitive environment which is characterized by competition from a number of other homebuilders and land developers in each of the markets in which we operate. Additionally, there are relatively low barriers to entry into our business and new competitors arise from time to time. We compete with numerous large national and regional homebuilding companies and with smaller local homebuilders and land developers for, among other things, home buyers, desirable land parcels, financing, raw materials and skilled management and labor resources. Our competitors may develop land and construct housing units that are superior or substantially similar to our products, which could make our products less attractive to consumers.
We may be at a competitive disadvantage with regard to certain of our large national and regional homebuilding competitors whose operations are more geographically diversified than ours, as these competitors may be better able to withstand any future regional downturn in the housing market. Many of these competitors have longer operating histories and greater financial and operational resources than we do. Additionally, many of these competitors also have longstanding relationships with subcontractors
and suppliers in the markets in which we operate. This may give our competitors an advantage in marketing their products, securing materials and labor at lower prices and allowing their homes to be delivered to customers more quickly and at more favorable prices. This competition could reduce our market share and limit our ability to expand our business.
Increased competition could hurt our business, as it could prevent us from acquiring attractive land parcels on which to build homes or make such acquisitions more expensive, adversely affect our market share and cause us to increase our selling incentives and reduce our prices. An oversupply of homes available for sale or discounting of home prices could adversely affect pricing for homes in the markets in which we operate. Oversupply and price discounting can be exacerbated by supply from the resale, or “previously owned,” home market, with which we also compete. Oversupply and price discounting have periodically adversely affected certain markets, and it is possible that our markets will be adversely affected by these factors in the future. If we are unable to compete effectively in our markets, our business could decline disproportionately to our competitors, and our results of operations and financial condition could be adversely affected.
If home buyers are not able to obtain suitable mortgage financing, due to more stringent lending standards, rising interest rates, changes in regulation, reduced investor demand for mortgage loans and mortgage backed securities, changes in the relationship between Fannie Mae and Freddie Mac and the federal government or other reasons, our results of operations may decline.
A majority of home buyers finance their home purchases through lenders that provide mortgage financing. The availability of mortgage financing may be constrained, due in part to lower mortgage valuations on properties, various regulatory changes and lower risk appetite by lenders, with many lenders requiring increased levels of financial qualification, lending at lower multiples of income and requiring larger down payments. First-time home buyers are generally more affected by the availability of mortgage financing than other potential home buyers. These buyers are a key source of demand for new homes. A limited availability of home mortgage financing may adversely affect the volume of our home and land sales and the sales prices we achieve.
Additionally, housing demand is adversely affected by reduced availability of mortgage financing and factors that increase the upfront or monthly cost of financing a home, such as increases in interest rates, insurance premiums or limitations on mortgage interest deductibility. Any decrease in the willingness and ability of lenders to make home mortgage loans, the tightening of lending standards and the reduction in the types of financing products available, will make it more difficult for home buyers to obtain acceptable financing. Any substantial increase in mortgage interest rates or unavailability of mortgage financing may adversely affect the ability of prospective first-time and move-up home buyers to obtain financing for our homes, as well as adversely affect the ability of prospective move-up home buyers to sell their current homes. The housing industry is benefiting from the current low interest rate environment, which has allowed many home buyers to obtain mortgage financing with relatively low interest rates as compared to long-term historical averages. While the timing of any increase in interest rates is uncertain, it is widely expected that interest rates will increase over time, and any such increase will make mortgage financing more expensive and adversely affect the ability of home buyers to purchase our homes. The recent disruptions in the credit markets and the curtailed availability of mortgage financing has adversely affected, and is expected to continue to adversely affect, our business, prospects, liquidity, financial condition, results of operations and cash flows as compared to prior periods.
Beginning in 2008, the mortgage lending industry has experienced significant instability, beginning with increased defaults on sub-prime loans and other non-conforming loans and compounded by expectations of increasing interest payment requirements and further defaults. This in turn resulted in a decline in the market value of many mortgage loans and related securities. Lenders, regulators and others questioned the adequacy of lending standards and other credit requirements for several loan products and programs. Credit requirements have tightened, and investor demand for mortgage loans and mortgage-backed securities has declined. The deterioration in credit quality during the economic downturn caused almost all lenders to stop offering sub-prime mortgages and most other loan products that were not eligible for sale to Fannie Mae or Freddie Mac or loans that did not meet Federal Housing Administration and Veterans Administration requirements. Fewer loan products, tighter loan qualifications and a reduced willingness of lenders to make loans may continue to make it more difficult for certain buyers to finance the purchase of our homes.
These factors may reduce the pool of qualified home buyers and make it more difficult to sell to first-time and move-up buyers who have historically made up a substantial part of our homebuilding customers.
The liquidity provided by Fannie Mae and Freddie Mac to the mortgage industry has been very important to the housing market. These entities have required substantial injections of capital from the federal government and may require additional government support in the future. Several federal government officials have proposed changing the nature of the relationship between Fannie Mae and Freddie Mac and the federal government and even nationalizing or eliminating these entities entirely. If Fannie Mae and Freddie Mac were dissolved or if the federal government determined to stop providing liquidity support to the mortgage market, there would
be a reduction in the availability of the financing provided by these institutions. Any such reduction would likely have an adverse effect on interest rates, mortgage availability and our sales of new homes.
If suitable mortgage financing is not available to home buyers generally, our home buyers may not be able to sell their existing homes in order to buy a new home from us, which would adversely affect our results of operations.
In each of our markets, decreases in the availability of credit and increases in the cost of credit adversely affect the ability of home buyers to obtain or service mortgage debt. Even if potential home buyers do not themselves need mortgage financing, where potential home buyers must sell their existing homes in order to buy a new home, increases in mortgage costs, lack of availability of mortgages and/or regulatory changes could prevent the buyers of potential home buyers’ existing homes from obtaining a mortgage, which would result in our potential customers’ inability to buy a new home from us. Similar risks apply to those buyers who are awaiting delivery of their homes and are currently in backlog. Our success depends, in part, on the ability of potential home buyers to obtain mortgages for the purchase of homes. If our customers (or potential buyers of our customers’ existing homes) cannot obtain suitable financing, our sales and results of operations could be adversely affected.
Our geographic concentration could materially and adversely affect us if the homebuilding industry in our current markets should experience a decline.
Our business strategy is focused on the acquisition of suitable land and the design, construction and sale of single-family homes in residential subdivisions, including planned communities, in Northern and Southern California, Washington State, North Carolina, South Carolina and Tennessee. In California, we principally operate in the Central Valley area, the Monterey Bay area, the South San Francisco Bay area, and the Los Angeles area; in Washington State, we operate in the Puget Sound area. In North Carolina, we principally operate in the Charlotte area. In South Carolina, we principally operate in the Myrtle Beach area, and in Tennessee, we principally operate in the Nashville area. Because our operations are concentrated in these areas, a prolonged economic downturn in one or more of these areas, particularly within California, could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations, and a disproportionately greater impact on us than other homebuilders with more diversified operations.
Any limitation on, or reduction or elimination of, tax benefits associated with owning a home would have an adverse effect upon the demand for land and homes for residential development, which could adversely affect our business.
Changes in federal income tax laws may affect demand for new homes and land suitable for residential development. Current tax laws generally permit significant expenses associated with owning a home, primarily mortgage interest expense and real estate taxes, to be deducted for the purpose of calculating an individual’s federal and, in many cases, state taxable income. Various proposals have been publicly discussed to limit mortgage interest deductions and to limit the exclusion of gain from the sale of a principal residence. If the federal government or a state government changes or further changes its income tax laws, as some lawmakers have proposed, by eliminating, limiting or substantially reducing these income tax benefits, without offsetting provisions, the after-tax cost of owning a new home would increase for many of our potential customers. Enactment of any such proposal may have an adverse effect on the homebuilding industry in general and our business and profits in particular, as the loss or reduction of homeowner tax deductions could decrease the demand for new homes and land suitable for residential development.
Difficulty in obtaining sufficient capital could result in an inability to acquire land for development or increased costs and delays in the completion of development projects.
The homebuilding and land development industry is capital-intensive and requires significant up front expenditures to acquire land parcels and begin development. In addition, if housing markets are not favorable or permitting or development takes longer than anticipated, we may be required to hold our investments in land for extended periods of time. If internally generated funds are not sufficient, we may seek additional capital in the form of equity or debt financing from a variety of potential sources, including additional bank financings and/or securities offerings. The availability of borrowed funds, especially for land acquisition and construction financing, may be greatly reduced nationally, and the lending community may require increased amounts of equity to be invested in a project by borrowers in connection with both new loans and the extension of existing loans. The credit and capital markets have in the recent past experienced significant volatility. If we are required to seek additional financing to fund our operations, continued volatility in these markets may restrict our flexibility to access such financing. If we are not successful in obtaining sufficient capital to fund our planned capital and other expenditures, we may be unable to acquire land for development or to develop housing.
Additionally, if we cannot obtain funds required for the purchase of land under our purchase or option contracts, we may incur contractual penalties and fees. Any difficulty in obtaining sufficient capital for planned development expenditures could also cause
project delays and any such delay could result in cost increases. Any one or more of the foregoing events could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
We face potentially substantial risk with respect to our land and lot inventory.
We intend to acquire land parcels for replacement and expansion of land inventory within our current and any new markets we choose to enter. The risks inherent in purchasing and developing land parcels increase as consumer demand for housing decreases. As a result, we may buy and develop land parcels on which homes cannot be profitably built and sold. The market value of land parcels, building lots and housing inventories can fluctuate significantly as a result of changing market conditions, and the measures we employ to manage inventory risk may not be adequate to insulate our operations from a severe drop in inventory values. When market conditions are such that land values are depreciating, previously entered into option agreements may become less desirable, at which time we may elect to forego deposits, option costs and pre‑acquisition costs and terminate the agreements. Land parcels, building lots and housing inventories are illiquid assets and we may not be able to dispose of them efficiently or at all if we are in financial distress. In addition, inventory carrying costs can be significant and can result in losses in a poorly performing project or market. In the event of significant changes in economic or market conditions, we may have to sell homes at significantly lower margins or at a loss, if we are able to sell them at all.
Because real estate investments are relatively illiquid, our ability to promptly sell one or more properties for reasonable prices in response to changing economic, financial and investment conditions may be limited and we may be forced to hold non‑income producing properties for extended periods of time.
Real estate investments are relatively difficult to sell quickly. As a result, our ability to promptly sell one or more properties in response to changing economic, financial and investment conditions is limited and we may be forced to hold non‑income producing assets for an extended period of time. We cannot predict whether we will be able to sell any property for the price or on the terms that we set or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a property.
Adverse weather and geological conditions may increase costs, cause project delays and reduce consumer demand for housing, all of which could materially and adversely affect us.
As a homebuilder and land developer, we are subject to the risks associated with numerous weather-related and geologic events which are beyond our control. These weather-related and geologic events include but are not limited to droughts, floods, wildfires, landslides, hurricanes, tornadoes, soil subsidence and earthquakes. The occurrence of any of these events could damage our land parcels and projects, cause delays in completion of our projects, reduce consumer demand for housing, and cause shortages and price increases in labor or raw materials, any of which could affect our sales and profitability. For example, our California markets are in areas which have historically experienced significant earthquake activity and seasonal wildfires. Other unique meteorological and geographic conditions exist in all of the markets in which we operate.
In addition to directly damaging our land or projects, earthquakes, wildfires or other natural events could damage roads and highways providing access to those assets or affect the desirability of our land or projects, thereby adversely affecting our ability to market homes or sell land in those areas and possibly increasing the costs of homebuilding completion.
There are some risks of loss for which we may be unable to purchase insurance coverage. For example, losses associated with landslides, earthquakes and other geologic events may not be insurable and other losses, such as those arising from terrorism, may not be economically insurable. A sizeable uninsured loss could materially and adversely affect our business, prospects, liquidity, financial condition and results of operations.
Continued acquisition activity could expose us to additional risks and future results will suffer if we do not effectively manage our expanded operations.
We may continue to expand our operations through acquisitions and other strategic transactions. In connection with any such transactions, we may be required to integrate geographically diverse operations, additional employees, and different information technology and management systems, which may involve complex challenges. Our future success will depend, in part, upon our ability to: manage our expansion opportunities; integrate new operations into our existing business in an efficient and timely manner; successfully monitor our operations, costs and regulatory compliance; and develop and maintain other necessary systems, processes and internal controls. We cannot assure you that our expansion or acquisition initiatives will be successful, or that we will realize their expected operating efficiencies, cost savings, revenue enhancements, synergies or other benefits. For example, we may be required to integrate widely dispersed operations with different corporate cultures, operating margins, competitive environments, computer
systems, compensation programs, business plans and growth potential, which would likely require significant management time and attention. This could disrupt our ongoing operations and divert management resources that would otherwise focus on developing our existing business. Depending upon the circumstances of any particular acquisition, successful integration may depend, in large part, on retaining key personnel who have, for example, unique experience or business relationships. The loss of key personnel at any business we may acquire could result in a disruption of operations, a loss of information and business relationships, unanticipated recruitment and training costs, and otherwise diminish anticipated benefits of any such acquisitions. Acquisitions could also result in our assumption of unknown contingent liabilities, which could be material, expose us to the risk of impaired inventory and other assets relating to the acquisition, and the risks associated with entering markets in which we have limited or no direct experience. When financing any acquisitions, we may choose to issue additional shares of our Class A common stock or incur substantial additional indebtedness. Issuance of additional shares of Class A common stock would dilute the ownership interest of existing stockholders.
Accordingly, any acquisition activity could expose us to significant risks, beyond those associated with operating our existing business, and may adversely affect our business, financial position and results of operation.
Our business and results of operations are dependent on the availability and skill of subcontractors.
Substantially all of our construction work is done by third-party subcontractors with us acting as the general contractor. Accordingly, the timing and quality of our construction depend on the availability and skill of our subcontractors. We do not have long-term contractual commitments with any subcontractors, and there can be no assurance that skilled subcontractors will continue to be available at reasonable rates and in our markets. Certain of the subcontractors engaged by us are represented by labor unions or are subject to collective bargaining arrangements that require the payment of prevailing wages that are higher than normally expected on a residential construction site. A strike or other work stoppage involving any of our subcontractors could also make it difficult for us to retain subcontractors for our construction work. In addition, union activity or a scarcity of skilled labor supply could result in higher costs to retain our subcontractors. The inability to contract with skilled subcontractors at reasonable costs on a timely basis could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
In addition, despite our quality control efforts, we may discover that our subcontractors were engaging in improper construction practices or installing defective materials in our homes. When we discover these issues, we, generally through our subcontractors, repair the homes in accordance with our new home warranty and as required by law. We reserve a portion of the sales price of each home we sell to satisfy warranty and other legal obligations to our home buyers. We establish these reserves based on market practices, our historical experience, and our judgment of the qualitative risks associated with the types of homes built. However, the cost of satisfying our warranty and other legal obligations in these instances may be significantly higher than our reserves, and we may be unable to recover the cost of repair from such subcontractors. Regardless of the steps we take, we can in some instances be subject to fines or other penalties, and our reputation may be adversely affected.
Labor and raw material shortages and price fluctuations could delay or increase the cost of home construction, which could materially and adversely affect us.
The residential construction industry experiences serious labor and raw material shortages from time to time, including shortages in qualified tradespeople, and supplies of insulation, drywall, cement, steel and lumber. These labor and raw material shortages can be more severe during periods of strong demand for housing or during periods following natural disasters that have a significant impact on existing residential and commercial structures. Certain of our markets have recently begun to exhibit a scarcity of skilled labor relative to increased homebuilding demand in these markets. The cost of labor and raw materials may also be adversely affected during periods of shortage or high inflation. During the last economic downturn, a large number of qualified tradespeople went out of business or otherwise exited the market. A reduction in available tradespeople will likely exacerbate labor shortages if demand for new housing continues to increase. Shortages and price increases could cause delays in and increase our costs of home construction, which in turn could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
New and existing laws and regulations or other governmental actions may increase our expenses, limit the number of homes that we can build or delay completion of our projects.
We are subject to numerous local, state, federal and other statutes, ordinances, rules and regulations concerning zoning, development, building design, construction and similar matters which impose restrictive zoning and density requirements, the result of which is to limit the number of homes that can be built within the boundaries of a particular area. Projects that are not entitled may be subjected to periodic delays, changes in use, less intensive development or elimination of development in certain specific areas due to government regulations. We may also be subject to periodic delays or may be precluded entirely from developing in certain communities due to building moratoriums or “slow-growth” or “no-growth” initiatives that could be implemented in the future. Local governments also have broad discretion regarding the imposition of development fees and exactions for projects in their jurisdiction.
Projects for which we have received land use and development entitlements or approvals may still require a variety of other governmental approvals and permits during the development process and can also be impacted adversely by unforeseen health, safety and welfare issues, which can further delay these projects or prevent their development. As a result, home sales could decline and costs increase, which could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
We may be unable to obtain suitable bonding for the development of our housing projects.
We are often required to provide bonds to governmental authorities and others to ensure the completion of our projects and/or in support of obligations to build community improvements such as roads, sewers, water systems and other utilities. As a result of market conditions, surety providers have been reluctant to issue new bonds and some providers are requesting credit enhancements (such as guarantees, cash deposits or letters of credit) in order to maintain existing bonds or to issue new bonds. If we are unable to obtain required bonds in the future for our projects, or if we are required to provide credit enhancements with respect to our current or future bonds, our business, prospects, liquidity, financial condition and results of operations could be materially and adversely affected.
We are subject to environmental laws and regulations, which may increase our costs, result in liabilities, limit the areas in which we can build homes and delay completion of our projects.
We are subject to a variety of local, state, federal and other laws, statutes, ordinances, rules and regulations concerning the environment, hazardous materials, the discharge of pollutants and human health and safety. The particular environmental requirements which apply to any given site vary according to multiple factors, including the site’s location, its environmental conditions, the current and former uses of the site, the presence or absence of state-listed or federal-listed endangered or threatened plants or animals or sensitive habitats, and conditions at nearby properties. We may not identify all of these concerns during any pre-acquisition or pre-development review of project sites. Environmental requirements and conditions may result in delays, may cause us to incur substantial compliance and other costs, and can prohibit or severely restrict development and homebuilding activity in environmentally sensitive regions or in areas contaminated by others before we commence development. We are also subject to third-party challenges, such as by environmental groups or neighborhood associations, under environmental laws and regulations governing the permits and other approvals for our projects and operations. Sometimes regulators from different governmental agencies do not concur on development, remedial standards or property use restrictions for a project, and the resulting delays or additional costs can be material for a given project.
In addition, in cases where a state-listed or federally-listed endangered or threatened species is involved and related agency rule-making and litigation are ongoing, the outcome of such rule-making and litigation can be unpredictable and can result in unplanned or unforeseeable restrictions on, or the prohibition of, development and building activity in identified environmentally sensitive areas.
Furthermore, the Company is evaluating the impact of recent regulatory action under the federal Endangered Species Act on a project that it is developing in Washington State. The project, known as the Preserve at Tumwater Place (the “Preserve”), currently has approximately 462 lots consisting of Divisions 1, 2, 3 and 4. The preliminary residential subdivision was approved by the City of Tumwater and the Washington State Department of Fish and Wildlife based, in part, on an approved Habitat Protection Plan for the Mazama pocket gopher. Based on that plan, the Preserve contains a 25-acre, on-site habitat preservation area for the gopher. The Preserve has recorded a final subdivision for Division 1. We have obtained building permits from the City of Tumwater for some of the Division 1 lots and are currently building single family homes for sale therein.
Since these approvals, the U.S. Fish and Wildlife Service (“USFWS”) adopted a final rule listing gopher as “threatened” under the federal Endangered Species Act and designated certain areas of Washington State, including land in close proximity to the Preserve, as critical habitat for the gopher. The listing is broad and applies to areas near critical habitat area, including areas where the gopher may not be present. At this time, the USFWS has not provided guidance as to how USFWS intends to address ongoing development in light of the rule. However, USFWS has indicated that existing set-asides created under state and local authorities, such as the on-site habitat preservation area that we have previously established at the Preserve, will not provide sufficient mitigation for the take of the gopher as a matter of federal law. Accordingly, we will be required to implement additional restrictions and requirements at the Preserve. Any such restrictions or requirements could cause us to incur increased expense at the Preserve or delay or limit our activities there.
The recent regulatory action involving the listing of a certain species of gopher as “threatened” under the federal Endangered Species Act may adversely affect this project, for example by imposing new restrictions and requirements on our activities there and possibly delaying, halting or limiting, our development activities. However, an estimate of the amount of impact cannot be made as there is not enough information to do so due to the lack of clarity regarding any restrictions that may be imposed on our development
activities or other remedial measures that we may be required to make. We will continue to assess the impact of this regulatory action and will record any future liability as additional information becomes available.
We may suffer uninsured losses or suffer material losses in excess of insurance limits.
We could suffer physical damage to property and liabilities resulting in losses that may not be fully recoverable by insurance. In addition, certain types of risks, such as personal injury claims, may be, or may become in the future, either uninsurable or not economically insurable, or may not be currently or in the future covered by our insurance policies or otherwise be subject to significant deductibles or limits. Should an uninsured loss or a loss in excess of insured limits occur or be subject to deductibles, we could sustain financial loss or lose capital invested in the affected property as well as anticipated future income from that property.
In addition, we could be liable to repair damage or meet liabilities caused by risks that are uninsured or subject to deductibles. We may be liable for any debt or other financial obligations related to affected property. Material losses or liabilities in excess of insurance proceeds may occur in the future.
Increases in our cancellation rate could have a negative impact on our home sales revenue and homebuilding margins.
Home order cancellations can result from a number of factors, including declines or slow appreciation in the market value of homes, increases in the supply of homes available to be purchased, increased competition, higher mortgage interest rates, home buyers’ inability to sell their existing homes, home buyers’ inability to obtain suitable financing, including providing sufficient down payments, and adverse changes in economic conditions. Upon a home order cancellation, the escrow deposit is returned to the prospective purchaser (other than with respect to certain design-related deposits, which we retain). An increase in the level of our home order cancellations, due to stringent lending standards or otherwise, could have a negative impact on our business, prospects, liquidity, financial condition and results of operations.
We are subject to product liability and warranty claims arising in the ordinary course of business.
As a homebuilder, we are subject to construction defect, product liability and home warranty claims, including moisture intrusion and related claims, arising in the ordinary course of business. While we maintain general liability insurance and generally seek to require our subcontractors and design professionals to indemnify us for the liabilities arising from their work, there can be no assurance that these insurance rights and indemnities will be collectible or adequate to cover any or all construction defect and warranty claims for which we may be liable. For example, contractual indemnities can be difficult to enforce, we are often responsible for applicable self-insured retentions (particularly in markets where we include our subcontractors on our general liability insurance and our ability to seek indemnity for insured claims is significantly limited), certain claims may not be covered by insurance or may exceed applicable coverage limits, and one or more of our insurance carriers could become insolvent. Further, in the United States, and California in particular, the coverage offered and the availability of general liability insurance for construction defects is currently limited and is costly. As a result, an increasing number of our subcontractors may be unable to obtain insurance, particularly in California where we have instituted an “owner controlled insurance program,” under which subcontractors are effectively insured by us.
For our projects we obtain liability insurance that generally covers subcontractors. If we cannot effectively recover construction defect liabilities and costs of defense, or if we have self-insured, we may suffer losses. Coverage may be further restricted and become even more costly. Such circumstances could adversely affect our business, prospects, liquidity, financial condition and results of operations. Further, any product liability or warranty claims made against us, whether or not they are viable, may lead to negative publicity, which could impact our reputation and our home sales.
In addition, we conduct the substantial portion of our business in California, one of the most highly regulated and litigious jurisdictions in the United States, which imposes a ten year, strict liability tail on many construction liability claims. As a result, our potential losses and expenses due to litigation, new laws and regulations may be greater than those of our competitors who have more limited California operations.
Our operating performance is subject to risks associated with the real estate industry.
Real estate investments are subject to various risks and fluctuations and cycles in value and demand, many of which are beyond our control. These events include, but are not limited to:
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adverse changes in international, national or local economic and demographic conditions;
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adverse changes in financial conditions of buyers and sellers of properties, particularly residential homes and land suitable for development of residential homes;
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competition from other real estate investors with significant capital, including other real estate operating companies and developers and institutional investment funds;
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reductions in the level of demand for and increases in the supply of land suitable for development;
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fluctuations in interest rates, which could adversely affect our ability, or the ability of home buyers, to obtain financing on favorable terms or at all;
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unanticipated increases in expenses, including, without limitation, insurance costs, development costs, real estate assessments and other taxes and costs of compliance with laws, regulations and governmental policies; and
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changes in enforcement of laws, regulations and governmental policies, including, without limitation, health, safety, environmental, zoning and tax laws, governmental fiscal policies and the Americans with Disabilities Act of 1990.
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In addition, periods of economic slowdown or recession, rising interest rates or declining demand for real estate, or the public perception that any of these events may occur, could result in a general decline in the purchase of homes or an increased incidence of home order cancellations. If we cannot successfully implement our business strategy, our business, prospects, liquidity, financial condition and results of operations will be adversely affected.
Poor relations with the residents of our communities could negatively impact sales, which could cause our revenue or results of operations to decline.
Residents of communities we develop rely on us to resolve issues or disputes that may arise in connection with the operation or development of their communities. Efforts made by us to resolve these issues or disputes could be deemed unsatisfactory by the affected residents and subsequent actions by these residents could adversely affect sales or our reputation. In addition, we could be required to make material expenditures related to the settlement of such issues or disputes or to modify our community development plans, which could adversely affect our results of operations.
If we are unable to develop our communities successfully or within expected timeframes, our results of operations could be adversely affected.
Before a community generates any revenue, time and material expenditures are required to acquire land, obtain development approvals and construct significant portions of project infrastructure, amenities, model homes and sales facilities. It can take several years from the time we acquire control of a property to the time we make our first home sale on the site. Delays in the development of communities expose us to the risk of changes in market conditions for homes. A decline in our ability to develop and market our communities successfully and to generate positive cash flow from these operations in a timely manner could have a material adverse effect on our business and results of operations and on our ability to service our debt and to meet our working capital requirements.
We depend on key senior management personnel and other experienced employees.
Our success depends to a significant degree upon the contributions of certain key senior management personnel including, but not limited to, Dustin L. Bogue, our President and Chief Executive Officer, and James M. Pirrello, our Chief Financial Officer, each of whom would be difficult to replace. Although we entered into employment agreements with Messrs. Bogue and Pirrello, there is no guarantee that these executives will remain employed by us. If any of our key senior management personnel were to cease employment with us, our operating results could suffer. Our ability to retain our key senior management personnel or to attract suitable replacements should any members of our management team leave is dependent on the competitive nature of the employment market. The loss of services from key senior management personnel or a limitation in their availability could materially and adversely impact our business, prospects, liquidity, financial condition and results of operations. Further, such a loss could be negatively perceived in the capital markets. We have not obtained key senior management life insurance that would provide us with proceeds in the event of death or disability of any of our key senior management personnel.
Experienced employees in the homebuilding, land acquisition and construction industries are fundamental to our ability to generate, obtain and manage opportunities. In particular, local knowledge and relationships are critical to our ability to source attractive land acquisition opportunities. Experienced employees working in the homebuilding and construction industries are highly sought after. Failure to attract and retain such personnel or to ensure that their experience and knowledge is not lost when they leave the business through retirement, redundancy or otherwise may adversely affect the standards of our service and may have an adverse impact on our business, prospects, liquidity, financial condition and results of operations. The loss of any of our key personnel could adversely impact our business, prospects, financial condition and results of operations.
Fluctuations in real estate values may require us to write-down the book value of our real estate assets.
The homebuilding and land development industries are subject to significant variability and fluctuations in real estate values. As a result, we may be required to write-down the book value of our real estate assets in accordance with U.S. generally accepted accounting principles ("GAAP"), and some of those write-downs could be material. Any material write-downs of assets could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations. For the year ended
December 31, 2016
, we recorded
$2.6 million
of impairment to real estate inventory in two of our projects, Sundance, located in Bakersfield, California ("Sundance"), and Heathers at Westport, located in Charlotte, North Carolina ("Heathers at Westport"). For the year ended
December 31, 2015
, we recorded
$0.9 million
of impairment to homebuilding real estate inventory in our River Run project, located in Bakersfield, California ("River Run"). See
Note 2
, “Summary of Significant Accounting Policies” and
Note 9
, "Fair Value Disclosures" to the consolidated financial statements for further discussion on impairment and estimated fair values of real estate inventories included elsewhere in this Annual Report on Form 10-K.
Inflation could adversely affect our business and financial results.
Inflation could adversely affect us by increasing the costs of land, raw materials and labor needed to operate our business. If our markets have an oversupply of homes relative to demand, we may be unable to offset any such increases in costs with corresponding higher sales prices for our homes. Inflation may also accompany higher interest rates, which could adversely impact potential customers’ ability to obtain financing on favorable terms, thereby further decreasing demand. If we are unable to raise the prices of our homes to offset the increasing costs of our operations, our margins could decrease. Furthermore, if we need to lower the price of our homes to meet demand, the value of our land inventory may decrease. Inflation may also raise our costs of capital and decrease our purchasing power, making it more difficult to maintain sufficient funds to operate our business.
We may become subject to litigation, which could materially and adversely affect us.
We may become subject to litigation, including claims relating to our operations, financings and otherwise in the ordinary course of business. Some of these claims may result in significant defense costs and potentially significant judgments against us, some of which are not, or cannot be, insured against. We cannot be certain of the ultimate outcomes of any claims that may arise in the future.
Resolution of these types of matters against us may result in our having to pay significant fines, judgments, or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely impact our earnings and cash flows, thereby materially and adversely affecting us. Certain litigation or the resolution of certain litigation may affect the availability or cost of some of our insurance coverage, which could materially and adversely impact us, expose us to increased risks that would be uninsured, and materially and adversely impact our ability to attract directors and officers.
Our business could be negatively affected as a result of actions of activist stockholders and shareholder advisory firms.
Campaigns by stockholders to effect changes at publicly traded companies are sometimes led by investors seeking to increase short-term stockholder value through actions such as financial restructuring, increased debt, special dividends, stock repurchases or sales of assets or the entire company. If we become engaged in a process or proxy contest with an activist stockholder in the future, our business could be adversely affected, as such activities could be costly and time-consuming, disrupt our operations and divert the attention of management and our employees from executing our business plan. Additionally, perceived uncertainties as to our future direction as a result of stockholder activism or actual or potential changes to the composition of our board of directors or management team may lead to the perception of a change in the direction of our business, instability or lack of continuity, which may be exploited by our competitors, cause concern to current or potential transactional counterparties and financing sources, and make it more difficult to attract and retain qualified personnel. If potential or existing transactional counterparties or financing sources choose to delay, defer or reduce transactions with us or transact with our competitors instead of us because of any such issues, then our results of operations could be adversely affected. Similarly, we may suffer damage to our reputation (for example, regarding our corporate governance or stockholder relations) or brand by way of actions taken or statements made by outside constituents, including activist investors and shareholder advisory firms, which could adversely affect the market price of our Class A common stock and the value of our debt securities, resulting in significant loss of value, which could impact our ability to access capital, increase our cost of capital and decrease our ability to finance our business on attractive terms.
A major health and safety incident relating to our business could be costly in terms of potential liabilities and reputational damage.
Building sites are inherently dangerous, and operating in the homebuilding and land development industry poses certain inherent health and safety risks. Due to health and safety regulatory requirements and the number of projects we work on, health and safety performance is critical to the success of all areas of our business.
Any failure in health and safety performance may result in penalties for non‑compliance with relevant regulatory requirements or litigation, and a failure that results in a major or significant health and safety incident is likely to be costly in terms of potential liabilities incurred as a result. Such a failure could generate significant negative publicity and have a corresponding impact on our reputation, our relationships with relevant regulatory agencies, governmental authorities and local communities, and our ability to win new business, which in turn could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
Acts of war or terrorism may seriously harm our business.
Acts of war, any outbreak or escalation of hostilities between the United States and any foreign power or acts of terrorism may cause disruption to the U.S. economy, or the local economies of the markets in which we operate, cause shortages of building materials, increase costs associated with obtaining building materials, result in building code changes that could increase costs of construction, affect job growth and consumer sentiment, or cause economic changes that we cannot anticipate, all of which could reduce demand for our homes and adversely impact our business, prospects, liquidity, financial condition and results of operations.
Information technology failures and data security breaches could harm our business.
We use information technology for financial and operational management functions to conduct our operations. Any disruption in these systems could adversely affect our ability to conduct our business. Furthermore, we use information technology, digital telecommunications and other computer resources to carry out important operational and promotional marketing activities and to maintain our business records. Many of these resources are provided to us and/or maintained on our behalf by third-party service providers pursuant to agreements that specify to varying degrees certain security and service level standards. Although we and our service providers employ what we believe are adequate security, disaster recovery and other preventative and corrective measures, our ability to conduct our business may be impaired if these resources, including our primary websites, are compromised, degraded, damaged or fail, whether due to a virus or other harmful circumstance, intentional penetration or disruption of our information technology resources by a third party, natural disaster, hardware or software corruption or failure or error or poor product or vendor/developer selection (including a failure of security controls incorporated into or applied to such hardware or software), telecommunications system failure, service provider error or failure, intentional or unintentional personnel actions (including the failure to follow our security protocols), or lost connectivity to our networked resources. A significant and extended disruption in the functioning of these resources, including our primary websites, could damage our reputation and cause us to lose customers, orders, deliveries of homes and revenues, result in the unintended and/or unauthorized public disclosure or the misappropriation of proprietary, personal identifying and confidential information (including information about our buyers and business partners), and require us to incur significant expenses to address and remediate or otherwise resolve these kinds of issues, expenses that we may not be able to recover in whole or in any part from our service providers or responsible parties, or their or our insurers. The release of confidential information may also lead to litigation or other proceedings against us by affected individuals and/or business partners and/or by regulators, and the outcome of such proceedings, which could include penalties or fines and cause reputational harm, could have a material and adverse effect on our business and consolidated financial statements. In addition, the costs of maintaining adequate protection against such threats, based on considerations of their evolution, pervasiveness and frequency and/or government-mandated standards or obligations regarding protective efforts, could be material to our consolidated financial statements in a particular period or over various periods.
RISKS RELATED TO OUR CONTROLLING STOCKHOLDER
PICO holds a majority equity interest in our Company and its interests may not be aligned with ours or those of our other investors.
PICO holds
56.8%
of the voting power of UCP, Inc. as of
December 31, 2016
. For so long as PICO continues to beneficially own a controlling stake in us, PICO will have the power to elect and remove all of our directors and to approve any action requiring the majority approval of our stockholders. PICO also has the power to transfer its controlling stake in our Company. In addition,
pursuant to an Investor Rights Agreement that we entered into with PICO, PICO will have the right to nominate two individuals for election to our board of directors for as long as PICO owns 25% or more of the combined voting power of our outstanding Class A and Class B common stock and one individual for as long as it owns at least 10% of the combined voting power of our outstanding Class A and Class B common stock (in each case, excluding any shares of our common stock that are subject to issuance upon the exercise or exchange of rights of conversion or any options, warrants or other rights to acquire shares); and Dustin L. Bogue, our President and Chief Executive Officer, James W. Fletcher, the President of our Northern California Division, and our former Chief Financial Officer, have agreed to vote all shares of our Class A common stock that they own in favor of such PICO nominees in any election of directors for as long as PICO owns at least 10% of the combined voting power of our outstanding Class A and Class B common stock. In the event that any board member nominated by PICO shall for any reason cease to serve as a member of our board of directors during his or her term of office, the resulting vacancy on the board will be filled by an individual selected by PICO.
PICO’s interests may not be fully aligned with ours and those of our other investors, and this could lead to actions that are not in our or in our other investors’ best interests. PICO holds all of the outstanding UCP, LLC Series A Units. Because PICO holds its economic interest in our business through UCP, LLC, rather than through the public company, it may have conflicting interests with holders of shares of our Class A common stock. For example, PICO may have different tax positions from us which could influence its decisions regarding whether and when we should dispose of assets or incur new or refinance existing indebtedness, especially in light of the existence of the TRA that we entered into with PICO, and whether and when we should undergo certain changes of control within the meaning of the Tax Receivable Agreement or terminate the TRA, which would accelerate our obligations thereunder. In addition, the structuring of future transactions may take into consideration these tax or other considerations even where no similar benefit would accrue to us. In addition, PICO’s significant ownership in us and resulting ability to effectively control us may discourage someone from making a significant equity investment in us, or could discourage transactions involving a change in control, including transactions in which you as a holder of shares of our Class A common stock might otherwise receive a premium for our shares over the then-current market price.
We are a "controlled company" within the meaning of the corporate governance rules of the NYSE as a result of the ownership positions and voting rights of PICO. A "controlled company" is a company of which more than 50% of the voting power is held by an individual, group or another company. More than 50% of the combined voting power of our outstanding Class A and Class B common stock is held by PICO. As a controlled company, we are entitled to not comply with certain corporate governance of the NYSE that would otherwise require our board of directors to have a majority of independent directors and our compensation committee and our nominating and corporate governance committee to be comprised entirely of independent directors, have written charters addressing such committee's purpose and responsibilities and perform an annual evaluation of such committee. Accordingly, holders of our Class A common stock do not have the same protection afforded to stockholders of companies that are subject to all of the corporate governance requirements of the NYSE and the ability of our independent directors to influence our business policies and affairs may be reduced.
As a result of PICO’s relationship with our Company, conflicts of interest may arise with respect to any transactions involving or with PICO or its affiliates.
Maxim C. W. Webb, a member of our board of directors, is the Chief Executive Officer of PICO. As a result of our relationship with PICO, there may be transactions between us and PICO that could present an actual or perceived conflict of interest.
This conflict of interest may lead Mr. Webb to recuse himself from actions of our board of directors with respect to any transactions involving or with PICO or its affiliates. In addition, Mr. Webb will devote only a portion of his business time to his duties with our board of directors, and he will devote the majority of his time to his duties with PICO and other commitments. PICO or its affiliates may also pursue transactions in competition with us.
RISKS RELATED TO OUR INDEBTEDNESS
We have substantial indebtedness, which may exacerbate the adverse effect of any declines in our business, industry or the general economy and exposes us to the risk of default. We may be unable to service our indebtedness.
As of
December 31, 2016
, we had approximately
$161.0 million
of consolidated outstanding debt (including capital lease obligations) of which
$74.9 million
was related to our 2017 Notes and
$86.9 million
for our acquisition and construction loans expected to mature during 2018. Our organizational documents do not limit the amount of indebtedness we may incur, our board of directors may change our target debt levels at any time without the approval of our stockholders or creditors as long as the Company is in compliance with the covenants and restrictions then in effect with its existing lenders. As a result, we may incur significant
additional indebtedness in the future. Our substantial outstanding indebtedness, and the limitations imposed on us by the instruments and agreements governing out outstanding indebtedness, could have significant adverse consequences, including the following:
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our cash flow may be insufficient to meet our required principal and interest payments;
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we may use a substantial portion of our cash flows to make principal and interest payments and we may be unable to obtain additional financing as needed or on favorable terms, which could, among other things, have a material adverse effect on our ability to complete our development pipeline, capitalize upon emerging acquisition opportunities, fund working capital or capital expenditures, or meet our other business needs;
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we may be unable to refinance our indebtedness at maturity or the refinancing terms may be less favorable than the terms of our original indebtedness;
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we may be forced to dispose of one or more of our properties, possibly on unfavorable terms or in violation of certain covenants to which we may be subject;
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we may be required to maintain certain debt and coverage and other financial ratios at specified levels, which may limit our ability to obtain additional financing in the future, thereby reducing our financial flexibility to react to changes in our business;
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our vulnerability to general adverse economic and industry conditions may be increased;
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approximately
$81.3 million
of our indebtedness bears interest at variable rates, which exposes us to increased interest expense in a rising interest rate environment;
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we may be at a competitive disadvantage relative to our competitors that have less indebtedness;
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our flexibility in planning for, or reacting to, changes in our business and the markets in which we operate may be limited; and
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we may default on our indebtedness by failure to make required payments or to comply with certain covenants, which could result in an event of default entitling a creditor to declare all amounts owed to it to be due and payable, and possibly entitling other creditors (due to cross-default or cross-acceleration provisions) to accelerate the maturity of amounts owed to such other creditors or, if such indebtedness is secured, to foreclose on our assets that secure such obligation.
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The occurrence of any one of these events could have a material adverse effect on our financial condition, liquidity, results of operations and/or business.
Our ability to make interest and principal payments on our indebtedness, complete our development pipeline and fund other planned capital expenditures and expansion efforts (including any strategic acquisitions we may make in the future), will depend on our ability to generate cash. This, to a certain extent, is subject to general economic, financial, competitive, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations in the future or that future borrowings will be available to us in an amount sufficient to enable us to service our indebtedness, to refinance our indebtedness when it matures or to fund other liquidity needs. If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. The terms of our existing debt instruments restrict us from adopting some of these alternatives. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. We cannot assure you that we will be able to service or refinance our indebtedness on commercially reasonable terms or at all.
In particular, our 2017 Notes, with an aggregate outstanding principal amount of $75 million, mature on October 21, 2017. This significant maturity represents approximately
46.3%
of our outstanding debt (including capital lease obligations but excluding intercompany liabilities) as of
December 31, 2016
. Our ability to satisfy this maturity when it becomes due will depend on our future operating performance and financial results, which will be subject, in part, to factors beyond our control, including interest rates and general economic, financial and competitive conditions. Our sources of capital to satisfy this maturity may include retained capital, the issuance of equity securities, debt financing and refinancing and asset sales or a combination of any of the foregoing. However, no assurance can be given that any of these sources of capital will be available to us on favorable terms, or at all, or that such sources will enable us to be able to satisfy this maturity. Any refinancing of the 2017 Notes may be on terms less favorable than those applicable to the 2017 Notes. As a result, we can provide no assurance that we will be able to refinance or repay our 2017 Notes as we currently anticipate or at all. Our failure to refinance or repay our 2017 Notes at their stated maturity would have a material adverse impact on
our financial condition, results of operations, cash flow, liquidity, the market price of our Class A common stock and our ability to achieve our objectives.
The agreements governing our indebtedness, including our indenture, contain various covenants and other provisions which limit management’s discretion in the operation of our business, reduce our operational flexibility and create default risks.
The agreements governing our existing indebtedness, including the indenture relating to the 2017 Notes, contain covenants and other provisions that impose significant restrictions on us and our subsidiaries. The indenture contains covenants that restrict, among other things, our and our subsidiaries’ ability to:
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incur or guarantee additional unsecured and secured indebtedness;
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pay dividends and make certain investments and other restricted payments;
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acquire unimproved real property;
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create or incur certain liens;
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transfer or sell certain assets; and
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merge or consolidate with other companies or transfer or sell all or substantially all of our consolidated assets.
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These covenants could impair our ability to grow our business, take advantage of attractive business opportunities or successfully compete, and we may be unable to amend, or obtain a waiver of, any applicable covenant in any given situation. In addition, the indenture provides the holders thereof the right to require us to repurchase all or any part of their securities at a purchase price in cash equal to 101% of the principal amount of such securities plus accrued and unpaid interest to the date of purchase in the event a change of control occurs (which the indenture generally defines as certain persons (excluding PICO) having the right to acquire more than 35% of the voting power of our voting stock).
The indenture also requires, and certain of our and our subsidiaries’ acquisition, construction and development loan agreements require, us to maintain specified financial measures and ratios and satisfy financial condition tests. Our ability to comply with these ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Senior Notes" included elsewhere in this report.
A breach of any of these covenants or covenants under any other agreements governing our indebtedness or our subsidiaries indebtedness could result in an event of default. Such a default may allow the creditors, if the agreements so provide, to declare the related debt immediately due and payable, as well as any other debt to which a cross-acceleration or cross-default provision applies. In addition, lenders may have the right in these circumstances to terminate any commitments they have to provide further borrowings. Our assets and cash flow may not be sufficient to fully repay borrowings under our outstanding debt agreements if accelerated upon an event of default. In addition, if we were unable to repay or refinance any secured debt that becomes accelerated, the lenders could proceed against any assets pledged to secure that debt, including foreclosing on or requiring the sale of our or our subsidiaries’ ownership interests in land parcels (and improvements thereon), and such assets may not be sufficient to repay such debt in full.
Secured indebtedness exposes us to the possibility of seizure of the pledged collateral.
Incurring mortgage and other secured indebtedness increases our risk of loss of our ownership interests in our pledged land parcels or other assets, because defaults under such indebtedness may result in foreclosure actions initiated by lenders. As of
December 31, 2016
, we had mortgage indebtedness of approximately
$86.7 million
. This debt is secured by project-level real estate (i.e., real estate held in special purpose entities formed to hold the real estate interests for particular projects).
Access to financing sources may not be available on favorable terms, or at all, which could adversely affect our ability to maximize our returns.
Our access to additional third-party sources of financing will depend, in part, on:
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general market conditions;
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the market’s perception of our growth potential;
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with respect to acquisition and/or development financing, the market’s perception of the value of the land parcels to be acquired and/or developed;
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our expected results of operations;
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the market price of our Class A common stock.
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Credit spreads for major sources of capital widened significantly during the U.S. credit crisis as investors demanded a higher risk premium. During periods of volatility and weakness in the capital and credit markets, potential lenders may be unwilling or unable to provide us with financing that is attractive to us or may charge us prohibitively high fees in order to obtain financing. Investment returns on our assets and our ability to make acquisitions could be adversely affected by our inability to secure additional financing on reasonable terms, if at all.
Depending on market conditions at the relevant time, we may have to rely more heavily on additional equity financings or on less efficient forms of debt financing that require a larger portion of our cash flow from operations, thereby reducing funds available for our operations, future business opportunities and other purposes. We may not have access to such equity or debt capital on favorable terms at the desired times, or at all.
Failure to hedge effectively against interest rate changes may adversely affect us.
We currently do not hedge against interest rate fluctuations. We may obtain in the future one or more forms of interest rate protection in the form of swap agreements, interest rate cap contracts or similar agreements to hedge against the possible negative effects of interest rate fluctuations. However, we cannot assure that any hedging will adequately relieve the adverse effects of interest rate increases or that counterparties under these agreements will honor their obligations thereunder. In addition, we may be subject to risks of default by hedging counterparties. Adverse economic conditions could also cause the terms on which we borrow to be unfavorable. We could be required to liquidate one or more of our assets at times which may not permit us to receive an attractive return on our assets in order to meet our debt service obligations.
RISKS RELATED TO OUR ORGANIZATION AND STRUCTURE
Our only material asset is our interest in UCP, LLC, and we are accordingly dependent upon distributions from UCP, LLC to pay dividends, if any, taxes and other expenses.
UCP, Inc. is a holding company and has no material assets other than its ownership of membership interests in UCP, LLC. UCP, Inc. has no independent means of generating revenue other than the operations of UCP, LLC that it owns and controls. We intend to cause UCP, LLC to make distributions to its members in an amount sufficient to cover all applicable taxes payable and dividends, if any, declared by us, as well as any payments due under the TRA, as described below. Future financing arrangements may contain negative covenants, limiting the ability of our operating subsidiaries to declare or pay dividends or make distributions. To the extent that UCP, Inc. needs funds, and UCP, LLC and/or its subsidiaries are restricted from making such distributions under applicable law or regulations, or otherwise unable to provide such funds, for example, due to restrictions contained in the indenture governing our 2017 Notes, certain of our subsidiary level project financings or in future financing arrangements that limit the ability of our operating subsidiaries to distribute funds, our liquidity and financial condition could be materially harmed.
We are required to pay PICO for a portion of the benefits relating to any additional tax depreciation or amortization deductions we may claim as a result of tax basis step-ups we receive in connection with future exchanges by PICO of its UCP, LLC Series A Units for shares of our Class A common stock.
The UCP, LLC Series A Units held by PICO may in the future be exchanged for shares of our Class A common stock. The exchanges may result in increases in the tax basis of the assets of UCP, LLC that otherwise would not have been available. These increases in tax basis may reduce the amount of tax that we would otherwise be required to pay in the future, although the IRS may challenge all or part of the tax basis increases, and a court could sustain such a challenge.
We entered into a TRA with PICO that provides for the payment by us to PICO of 85.0% of the amount of cash savings, if any, in U.S. federal, state and local income tax or franchise tax that we actually realize as a result of any such increases in tax basis (or are deemed to realize in the case of certain events, as discussed below). Any actual increases in tax basis, as well as the amount and timing of any payments under the TRA, cannot be predicted reliably at this time.
The increase in tax basis, as well as the amount and timing of any payments under this agreement, will vary depending upon a number of factors, including the timing of exchanges, the price of shares of our Class A common stock at the time of the exchange, the extent to which such exchanges are taxable, and the amount and timing of our income. As a result of the size of the increases in the tax basis of the tangible and intangible assets of UCP, LLC attributable to our interest in UCP, LLC, during the expected term of the TRA, we expect that the payments that we may make to PICO could be substantial.
We are not aware of any issue that would cause the IRS to challenge a tax basis increase; however, if the IRS were successful in making such a challenge, PICO would not reimburse us for any payments that may previously have been made under the TRA if it is later determined that we did not receive the anticipated corresponding tax benefit. As a result, in certain circumstances we could make payments to PICO under the TRA in excess of our cash tax savings. In addition, our ability to achieve benefits from any tax basis increase, and the payments to be made under the TRA, will depend upon a number of factors, as discussed above, including the timing and amount of our future income.
In certain cases, payments by us under the Tax Receivable Agreement may be accelerated and/or significantly exceed the benefits we realize in respect of the tax attributes subject to the Tax Receivable Agreement.
The TRA provides that upon certain changes of control, or if, at any time, we either materially breach our obligations under the TRA or elect an early termination of the TRA, our (or our successor’s) obligations with respect to UCP, LLC Series A Units would be based on certain assumptions, including that (a) all the UCP, LLC Series A Units are deemed exchanged for their fair value, (b) we would have sufficient taxable income to fully utilize the deductions arising from the increased tax deductions and tax basis and other benefits related to entering into the TRA and (c) the subsidiaries of UCP, LLC will sell certain non-amortizable assets (and realize certain related tax benefits) no later than a specified date. In each of these instances (based on the foregoing assumptions), we would be required to make an immediate payment to the holders of such UCP, LLC Series A Units equal to the present value of the anticipated future tax benefits (discounted over the applicable amortization and depreciation periods for the assets the tax bases of which are stepped up (which could be as long as fifteen years in respect of intangibles and goodwill) at a uniform discount rate equal to LIBOR plus 100 basis points). The benefits would be payable even though, in certain circumstances, no UCP, LLC Series A Units are actually exchanged at the time of the accelerated payment under the TRA, thereby resulting in no corresponding tax basis step up at the time of such accelerated payment under the TRA. Accordingly, payments under the TRA may be made years in advance of the actual realization, if any, of the anticipated future tax benefits and may be significantly greater than the benefits we realize in respect of the tax attributes subject to the TRA. In these situations, our obligations under the TRA could have a substantial negative impact on our liquidity. We may not be able to finance our obligations under the TRA and our existing indebtedness may limit our subsidiaries’ ability to make distributions to us to pay these obligations.
In addition, our obligations under the TRA could have the effect of delaying, deferring or preventing certain mergers, asset sales, other forms of business combinations or other changes of control that could be in the best interests of our public stockholders.
We may not be able to realize all or a portion of the tax benefits that are expected to result from exchanges of UCP LLC Series A Units for shares of our Class A common stock and payments made under the Tax Receivable Agreement itself.
Our ability to benefit from any depreciation or amortization deductions or to realize other tax benefits that we currently expect to be available as a result of the increases in tax basis created by exchanges of UCP LLC Series A Units for shares of our Class A common stock and our ability to realize certain other tax benefits attributable to payments under the TRA itself, depend on a number of assumptions, including that we earn sufficient taxable income each year during the period over which such deductions are available and that there are no adverse changes in applicable law or regulations. If our actual taxable income were insufficient and/or there were adverse changes in applicable law or regulations, we may be unable to realize all or a portion of these expected benefits and our cash flows and stockholders’ equity could be negatively affected.
In the event we acquire more than 50% of all outstanding units of UCP, LLC, we may become subject to additional state and local real estate taxes due to a reassessment of the value of our land holdings for California real estate tax purposes. We may also become subject to California and Washington state and local real estate transfer taxes.
We are subject to state and local real estate taxes in California on an annual basis, which are assessed on the basis of the value of our land holdings in the relevant counties. Under Article XIIIA of the California Constitution (known as Proposition 13), California real estate taxes are generally based upon a property’s historic cost (subject to an inflationary increase in value not to exceed 2.0% per year) until the property undergoes a change in ownership or the entity owning the property undergoes a change in control.
Because we have acquired our lots over time, the values currently used for assessing these real estate taxes (generally, the price we paid for the lots subject to the allowable inflationary increase in value described in the preceding paragraph) may not fully reflect current market values.
If we acquire more than 50.0% of all outstanding units of UCP, LLC (which might occur, for instance, upon an exchange of UCP, LLC Series A Units by PICO pursuant to the Exchange Agreement) it may be treated as triggering a “change in ownership” for such real estate tax purposes, which, in turn, will result in a reassessment of the values of our lots in California for purposes of our annual real estate tax payments. In such case, the values of our California lots would be reassessed at, and our California real estate taxes would be based on, the then current market value of such lots, which may significantly exceed the price we paid for such lots plus any previously allowed inflationary increase in value. If such reassessment results in an upward adjustment of the values of our California lots, our annual California real estate tax payments will increase. In addition, if we acquire more than 50.0% of the units in UCP, LLC, we may also become subject to one-time California and Washington State and local real estate transfer taxes in respect of our lots in such state. Such additional tax payments would have a negative impact on our earnings, cash flows and liquidity.
Termination of the employment agreements with the members of our management team could be costly and prevent a change in control of our Company.
The employment agreements entered into with our key management team members provide that if their employment with us terminates under certain circumstances, we may be required to pay them significant amounts of severance compensation, thereby making it costly to terminate their employment. Furthermore, these provisions could delay or prevent a transaction or a change in control of our Company that might involve a premium paid for shares of our Class A common stock or otherwise be in the best interests of our stockholders, which could adversely affect the market price of our Class A common stock.
Certain anti-takeover defenses, applicable law, and provisions of our Registration Rights Agreement, Tax Receivable
Agreement, Investor Rights Agreement and the indenture relating to our 2017 Notes may limit the ability of a third party to acquire control of us.
Our charter and bylaws and Delaware law contain provisions that may delay or prevent a transaction or a change in control of our Company that might involve a premium paid for shares of our Class A common stock or otherwise be in the best interests of our stockholders, which could adversely affect the market price of our Class A common stock. Certain of these provisions are described below.
Selected
provisions of our charter and/or bylaws:
Our charter and/or bylaws contain anti-takeover provisions that:
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divide our directors into three classes, with the term of one class expiring each year, which could delay a change in our control;
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authorize our board of directors, without further action by the stockholders, to issue up to 50,000,000 shares of preferred stock in one or more series, and with respect to each series, to fix the number of shares constituting that series and establish the rights and other terms of that series;
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require that actions to be taken by our stockholders may be taken only at an annual or special meeting of our stockholders and not by written consent;
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specify that special meetings of our stockholders can be called only by our board of directors, the chairman of our board of directors or our chief executive officer;
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establish advance notice procedures for stockholders to submit nominations of candidates for election to our board of directors and other proposals to be brought before a stockholders meeting;
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provide that our bylaws may be amended by our board of directors without stockholder approval;
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allow our directors to establish the size of our board of directors by action of our board of directors, subject to a minimum of three members;
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provide that vacancies on our board of directors or newly created directorships resulting from an increase in the number of our directors may be filled only by a majority of directors then in office, even though less than a quorum;
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do not give the holders of our common stock cumulative voting rights with respect to the election of directors; and
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prohibit us from engaging in certain business combinations with any “interested stockholder” unless specified conditions are satisfied.
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Selected provisions of Delaware law:
We have opted out of Section 203 of the Delaware General Corporation Law (the “DGCL”), which regulates corporate takeovers. However, our charter contains provisions that are similar to Section 203 of the DGCL. Specifically, our charter provides that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the person became an interested stockholder, unless:
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prior to the time that person became an interested stockholder, our board of directors approved either the business combination or the transaction which resulted in the person becoming an interested stockholder;
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upon consummation of the transaction which resulted in the person becoming an interested stockholder, the interested stockholder owned at least 85.0% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding certain shares; or
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at or subsequent to the time the person became an interested stockholder, the business combination is approved by our board of directors and by the affirmative vote of at least 66 2/3% of the outstanding voting stock which is not owned by the interested stockholder.
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Generally, a business combination includes a merger, consolidation, asset or stock sale or other transaction resulting in a financial benefit to the interested stockholder. Subject to certain exceptions, an interested stockholder is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our voting stock. However, in the case of our Company, PICO and any of its affiliates and subsidiaries and any of their permitted transferees receiving 15% or more of our voting stock will not be deemed to be interested stockholders regardless of the percentage of our voting stock owned by them. This provision could prohibit or delay mergers or other takeover or change in control attempts with respect to us and, accordingly, may discourage attempts to acquire us.
Registration Rights Agreement, Investor Rights Agreement and Tax Receivable Agreement.
We entered into a Registration Rights Agreement, an Investor Rights Agreement and a TRA with PICO. Pursuant to the Registration Rights Agreement and the Investor Rights Agreement, PICO may require us to file a registration statement with the SEC relating to the offer and sale of any Class A common stock PICO may receive pursuant to the Exchange Agreement, and PICO has the right to nominate two individuals for election to our board of directors for as long as PICO owns 25.0% or more of the combined voting power of our outstanding Class A and Class B common stock and one individual for as long as it owns at least 10.0%. In the event that any board member nominated by PICO shall for any reason cease to serve as a member of our board of directors during his or her term of office, the resulting vacancy on the board will be filled by an individual selected by PICO. The TRA provides that upon certain changes of control, PICO may be entitled to a significant early termination payment. These agreements could discourage someone from making a significant investment in us or discourage transactions involving a change in control.
Indenture Relating to Our Senior Notes.
The indenture governing our 2017 Notes, with an aggregate outstanding principal amount of $75 million as of
December 31, 2016
, provides the holders thereof the right to require us to repurchase all or any part of their securities at a purchase price in cash equal to 101% of the principal amount of such securities plus accrued and unpaid interest to the date of purchase in the event a change of control occurs (which the indenture generally defines as certain persons (excluding PICO) having the right to acquire more than 35% of the voting power of our voting stock). This provision, which could result in a significant cash payment obligation, could discourage someone from making a significant investment in us or discourage a transaction involving a change in control.
We may change our operational policies, investment guidelines and our business and growth strategies without stockholder approval, which may subject us to different and more significant risks in the future.
Our board of directors determines our operational policies, investment guidelines and our business and growth strategies. Our board of directors may make changes to, or approve transactions that deviate from, those policies, guidelines and strategies without a vote of, or notice to, our stockholders. This could result in us conducting operational matters, making investments or pursuing different business or growth strategies. Under any of these circumstances, we may expose ourselves to different and more significant risks in the future, which could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
The obligations associated with being a public company require significant resources and management attention.
As a public company with listed equity securities, we must comply with numerous laws, regulations and requirements, including the requirements of the Exchange Act, certain corporate governance provisions of the Sarbanes-Oxley Act of 2002, or the “Sarbanes-Oxley Act,” related regulations of the SEC and requirements of the NYSE. The Exchange Act requires that we file annual, quarterly
and current reports with respect to our business and financial condition. The Sarbanes-Oxley Act requires, among other things, that we establish and maintain effective internal controls and procedures for financial reporting.
These reporting and other compliance obligations place significant demands on our management, administrative, operational and accounting resources and will cause us to incur significant expenses. We may need to upgrade our systems or create new systems, implement additional financial and management controls, reporting systems and procedures, create or outsource an internal audit function, and hire additional accounting and finance staff. If we are unable to accomplish these objectives in a timely and effective fashion, our ability to comply with the financial reporting requirements and other rules that apply to reporting companies could be impaired. Any failure to maintain effective internal control over financial reporting could have a material adverse effect on our business, prospects, liquidity, financial condition and results of operations.
If we fail to implement and maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, our stockholders could lose confidence in our financial results, which could materially and adversely affect us.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. We may in the future discover areas of our internal controls that need improvement. We cannot be certain that we will be successful in implementing or maintaining adequate internal control over our financial reporting and financial processes. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weakness or significant deficiency and management may not be able to remediate any such material weakness or significant deficiency in a timely manner. The existence of any material weakness in our internal control over financial reporting could also result in errors in our financial statements that could require us to restate our financial statements, cause us to fail to meet our reporting obligations and cause stockholders to lose confidence in our reported financial information, all of which could materially and adversely affect us.
We are an “emerging growth company,” and, as a result of the reduced disclosure and governance requirements applicable to emerging growth companies, our Class A common stock may be less attractive to investors.
We are an “emerging growth company,” as defined in the JOBS Act, and we are eligible to take advantage of certain exemptions from various reporting requirements applicable to other public companies but not to emerging growth companies, including reduced disclosure about executive compensation arrangements pursuant to the rules applicable to smaller reporting companies and no requirement to seek non‑binding advisory votes on executive compensation or golden parachute arrangements. We have elected to adopt these reduced disclosure requirements.
We could be an emerging growth company until the last day of the fiscal year following the fifth anniversary of the completion of our IPO, although a variety of circumstances could cause us to lose that status earlier. We cannot predict if investors will find our Class A common stock less attractive as a result of our taking advantage of these exemptions. If some investors find our Class A common stock less attractive as a result of our choices, there may be a less active trading market for our Class A common stock and our stock price may be more volatile.
Any joint venture investments that we make could be adversely affected by our lack of sole decision making authority, our reliance on co-venturers’ financial condition and disputes between us and our co-venturers.
We may co-invest in the future with third parties through partnerships, joint ventures or other entities, acquiring non‑controlling interests in or sharing responsibility for managing the affairs of a land acquisition and/or a development. In this event, we would not be in a position to exercise sole decision-making authority regarding the acquisition and/or development, and our investment may be illiquid due to our lack of control. Investments in partnerships, joint ventures, or other entities may, under certain circumstances, involve risks not present were a third-party not involved, including the possibility that partners or co-venturers might become bankrupt, fail to fund their share of required capital contributions, make poor business decisions or block or delay necessary decisions. Partners or co-venturers may have economic or other business interests or goals which are inconsistent with our business interests or goals, and may be in a position to take actions contrary to our policies or objectives. Such investments may also have the potential risk of impasses on decisions, such as a sale, because neither we nor the partner or co-venturer would have full control over the partnership or joint venture. Disputes between us and partners or co-venturers may result in litigation or arbitration that would increase our expenses and prevent our officers and/or directors from focusing their time and effort on our business. In addition, we may in certain circumstances be liable for the actions of our third-party partners or co-venturers.
RISKS RELATED TO OUR OWNERSHIP OF OUR CLASS A COMMON STOCK
We do not intend to pay dividends on our Class A common stock for the foreseeable future.
We currently intend to retain our future earnings, if any, to finance the development and expansion of our business and, therefore, do not intend to pay cash dividends on our Class A common stock for the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements, restrictions contained in the indenture governing our 2017 and any other financing instruments and such other factors as our board of directors deems relevant. Accordingly, investors may need to sell their shares of our Class A common stock to realize a return on their investment, and they may not be able to sell their shares at or above the price paid for.
Future sales of our Class A common stock or other securities convertible into our Class A common stock could cause the market value of our Class A common stock to decline and could result in dilution of your shares.
Our board of directors is authorized, without stockholder approval, to cause us to issue additional shares of our Class A common stock or to raise capital through the issuance of preferred stock (including equity or debt securities convertible into Class A common stock), options, warrants and other rights, on terms and for consideration as our board of directors in its sole discretion may determine. Sales of substantial amounts of our Class A common stock could cause the market price of our Class A common stock to decrease significantly. We cannot predict the effect, if any, of future sales of our Class A common stock, or the availability of our Class A common stock for future sales, on the value of our Class A common stock. Sales of substantial amounts of our Class A common stock by PICO or another large stockholder or otherwise, or the perception that such sales could occur, may also adversely affect the market price of our Class A common stock.
Future offerings of debt securities, which would rank senior to our Class A common stock upon our bankruptcy or liquidation, and future offerings of equity securities that may be senior to our Class A common stock for the purposes of dividend and liquidating distributions, may adversely affect the market price of our Class A common stock.
In the future, we may attempt to increase our capital resources by making offerings of debt securities or additional offerings of equity securities. Upon bankruptcy or liquidation, our creditors including holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings, and holders of any outstanding preferred stock will receive a distribution of our available assets prior to the holders of our Class A common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the market price of our Class A common stock, or both. Our preferred stock, if issued, could have a preference on liquidating distributions or a preference on dividend payments or both that could limit our ability to make a dividend distribution to the holders of our Class A common stock. Our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control. As a result, we cannot predict or estimate the amount, timing or nature of our future offerings, and Class A common stock owners bear the risk of our future offerings reducing the market price of our Class A common stock and diluting their ownership interest in our Company.
Non-U.S. holders may be subject to United States federal income tax on gain realized on the sale or disposition of shares of our Class A common stock.
Because of our holdings in United States real property interests, we believe we are and will remain a “United States real property holding corporation” for United States federal income tax purposes. As a result, a non‑U.S. holder generally will be subject to United States federal income tax on any gain realized on a sale or disposition of shares of our Class A common stock unless our Class A common stock is regularly traded on an established securities market (such as the NYSE) and such non‑U.S. holder did not actually or constructively hold more than 5.0% of our Class A common stock at any time during the shorter of (a) the five-year period preceding the date of the sale or disposition and (b) the non-U.S. holder’s holding period in such stock. In addition, if our Class A common stock is not regularly traded on an established securities market, a purchaser of the stock generally will be required to withhold and remit to the IRS 10.0% of the purchase price. A non‑U.S. holder also will be required to file a United States federal income tax return for any taxable year in which it realizes a gain from the disposition of our Class A common stock that is subject to United States federal income tax. We believe that our Class A common stock is regularly traded on an established securities market. However, no assurance can be given in this regard and no assurance can be given that our Class A common stock will remain regularly traded in the future. Non-U.S. holders should consult their tax advisors concerning the consequences of disposing of shares of our Class A common stock.
THE FOREGOING FACTORS, INDIVIDUALLY OR IN AGGREGATE, COULD MATERIALLY ADVERSELY AFFECT OUR FINANCIAL CONDITION, RESULTS OF OPERATIONS, CASH FLOW, LIQUIDITY AND THE MARKET PRICE OF OUR CLASS A COMMON STOCK.