Transcript:
Dean Wehrli:
Hey listeners, this is Dean, welcome to New Home Insights. Today we have our guest with CR Herro of Meritage Homes and he was so brilliant and full of so much great information that we actually are going to cut it into two parts. So right now let’s listen to part one and next week we’ll have part two.
Dean Wehrli:
Okay. Welcome to our latest episode of New Home Insights with John Burns Real Estate Consulting. I’m your host Dean Wehrli. Today we have another extraordinarily special guest is CR Herro. He’s the vice president of innovation at Meritage Homes. CR.
CR Herro:
Hi Dean. How are you?
Dean Wehrli:
I’m good. I hope you’re well too.
CR Herro:
I as well.
Dean Wehrli:
Let me give you a quick background on CR. He’s a really, you’re a building scientist, right, who joined Meritage in 2009 and you lead their innovations and their performance initiatives and materials for really for making a better home. I mean, that’s kind of your goal, isn’t it?
CR Herro:
It is. I’ve got graduate degrees in biology, chemistry, engineering and philosophy. So it’s either this or I guess a chalk painting outside.
Dean Wehrli:
That’s a lot of schooling as they say.
CR Herro:
Yeah. It kept me out of the bars when I was a kid. So it was probably a good thing.
Dean Wehrli:
Was it? I don’t know.
CR Herro:
Yeah, that’s fair.
Dean Wehrli:
So essentially though, you’re a building scientist with his background in biology and philosophy, et cetera. So what we’re going to talk today is kind of innovation from three strains really. We’re going to talk first about sort of energy and energy efficiency. Then we’re going to talk about the disruption in the industry going on, particularly with respect to offsite construction. And then we’re going to touch on kind of the automation and kind of smart home and how that’s going to play out in the future over time. So CR, let’s talk about energy first. I think this is very, very near and dear to you. I’ve heard you talk about it in the past. How critical is a home being energy smart now and going forward?
CR Herro:
I think all three of these things represented disruption and by that, I mean that there is a change in the way buyers are presented a product. And in doing so it’s changing the way that they think about quality and the choices they make. And that disruption means that buyers are going to change the way builders build to be relevant. And the way I challenged myself and our team at Meritage to think about it is in 10 years, imagine what a relevant builder looks like. How do they build, what are the materials they use with, what are their processes, how do they go to market, how do they interact with consumers, and do we look like that today? And pretty holistically, I hear no. We recognize that the market is changing and that in order for us to be relevant, we have to change with it. And energy efficiency is probably the tip of the spear that for the last 10 years has really been pushing the industry to improve the value it brings back to its buyers.
CR Herro:
And so we’ve been looking at better insulation and better windows and better heating and cooling system and lighting and appliances and all just around one key metric. Can we invest a dollar to save a buyer five? And most buyers when exposed to that opportunity would preferentially choose that in the marketplace. And therefore it’s a very smart business decision to create value for our buyers, to leverage our expertise and the abilities of our trades to present something that’s a better choice in the marketplace.
Dean Wehrli:
Is energy a so important part of this disruption, this new builder, new home because it’s so clearly associated with cost? Is that really why it’s all about money and that’s the key consideration?
CR Herro:
It absolutely does. If you think about the three keys to buying a house, it’s going to be cost or affordability, the zip code is, and then the overall kind of design, the dimensions and the bedroom counts and everything else. And so it’s one of the key three and it’s probably one of the most pragmatic of those three. And the operating cost of a home represents about $200,000 over a 30 year mortgage for an average home in the US. And so if you can reduce that, there’s tens of thousands of dollars of potential benefit that a buyer can either use to buy a bigger house than they thought they could or have more disposable income to live a better quality of life. So I do think it does boil down to a very pragmatic energy efficiency.
Dean Wehrli:
I want to get into more the nuts and bolts of how you do it and how we’ll be doing it, efficiency down the road. But first I do want to, here’s the key question, right? How do you get folks to look at kind of a longer time horizon than they’re used to in terms of buying a home, right? The upfront costs, we’ve talked about before, the upfront cost versus the total cost, the longterm costs, you just mentioned that, how do you get them to sort of change that time horizon when they’re going into it?
CR Herro:
The answer is, not well. We’ve been doing it for 10 years and I think we’re penetrating maybe 25% of what we should in the marketplace. And what I mean by that is, as somebody in this space, I buy differently than my buyers buy. And the only reason I buy differently is because I’m aware of other facets that are different than first costs, right, I’m aware of total cost, which is, what does it cost me every month to own a home? And that includes both what I have to serve in my mortgage, but also what am I utilities costs and what does my maintenance cost? And because I know that, I make a slightly different value choice than the average buyer and energy efficiency is an opportunity to inspire consumers to say, hey, let’s give you some sort of indicator of this total cost and let’s inspire you that total cost is the more important variable, not the price tag when you first buy the house because of the potential for that to swing $200,000 in true cost, buyers often can save $10,000 and spend $80,000 in operating costs because of that “deal”.
Dean Wehrli:
Yeah. You’re right though, that’s a tough sell because it does push up. I mean it costs more. The better, more efficient homes are going to be a little bit more of an upfront cost. So will it be a harder sell? Are has it been for you folks, a harder sell at the entry level because the upfront cost is so much a bigger part of the equation for that buyer?
CR Herro:
I think so. I think California is going to be the test bed for all of these because one, California has the most need for affordable entry-level housing and two, they have the most progressive requirements and building code. They’ve now adopted not only a very significant energy efficiency, but the requirement to put in renewable energy as a part of their code. So those costs will be borne by the market, there’s no choice. And so buyers are going to have a marketplace where they’ve got 1970s construction that will cost them maybe $100,000 more in operating costs, but in the marketplace can sell for $20,000 cheaper than a new home. And so that market is going to have to become educated in order for the requirements of the state and Title 24 to take effect. And I’ve build in California and I’ve been really pushing for some reform that if you’re going to improve the energy efficiency by requirement, you have to improve the transaction, which means that a buyer has to be aware of total costs.
CR Herro:
For example, if you buy in France, the transaction tells you what the average cost for an average family is going to cost every month. And so it’s not just your mortgage, there’s an energy efficiency label that translates into this affordability. It distills it down to the dollars and cents and I think that’s going to be a necessary component for California to really realize its intentions. It’s going to have to have a labeling process so that buyers can differentiate the true cost between a 20 year old home, a 10 year old home and a brand new home built to this new code. And inevitably that’s going to pull in appraisals and that’s going to have to pull in underwriting because if you can save somebody $150,000 in operating costs, you should have a different underwriting ratio. You should be able to qualify for $10,000 more mortgage if you’re going to save $100,000 over that mortgage service.
Dean Wehrli:
So if I’m hearing you right, I think you mean that in sort of a truth in labeling or at least an education on labeling in both the resale and the new environment to kind of heighten that discrepancy. Am I hearing that right?
CR Herro:
I absolutely think that that is the biggest remaining piece to transform the marketplace and to create the true value in the marketplace for energy efficiency. And it does have to include resale because if you’ve got a 1985 home and you replace the windows and improve them today, even though you may have a better home that’s more comfortable and costs less to operate, there’s no mechanism in the transaction for the next buyer to be aware and to value that investment in better windows or pulling out the old HVAC system and upgrading it or even putting on solar panels. All of these upgrades have an economic value and they’re very difficult for the next buyer to monetize. And so we, as an industry, really needed to support changes to create mechanisms to properly value everything included, not just the mortgage.
Dean Wehrli:
And that really will kind of heighten that difference between new and existing. I mean I think that’s something that… I think we’ve talked about this, I’m forgetting the guests on this podcast where we’re seeing a bigger gap between new home pricing and resell pricing and a lot of markets across the country. And a big driver of that is that the new home are continually innovating and building better homes, but it’s tough to still make that that connection to a buyer who’s looking at a price they may or may not be able to afford.
CR Herro:
Well, and that’s the irony is that for an average buyer, they’re going to perceive it as a lack of affordability of new homes. But that $10,000 really in your mortgage is 50 bucks a month and it may represent $150 of reduced operating costs. And so new homes very often to a sophisticated buyer represent the least total cost when you’re investing in a home.
CR Herro:
It’s very similar to when you buy a new car, it had a larger price tag, but you may be able to avoid a tremendous amount of maintenance in those first five years that may actually make the total cost better than buying something that is used and requires new tires after a year and then requires a new transmission after two years. And so it’s the way I would tell my grandma to buy a home. So it’s a very defined strategy based on truly trying to improve people’s choices in value in the marketplace. But it is a change and we have to inspire the market to change along with us to create acknowledgement and use of that value.
Dean Wehrli:
Tell me if this is unfair. But is it a little bit like saying, “Look, the Mercedes really is a far, far better car than the, and I shouldn’t say, how about Yugo. I don’t want to say a current existing car company and upset them, but that expensive, clearly better and superior in terms of technology and cost and maintenance, et cetera. Versus a car that you may be able to afford because that’s all you can afford. Is it kind of like making that sales pitch or am I being too rough?
CR Herro:
I think it’s an exact correct comparison. If you look at why Japanese auto manufacturers displaced the American auto manufacturers in the 80s it wasn’t because their product was cheaper to purchase, but a Honda was cheaper to operate and buyers quickly increase their sophistication, changed the way they bought, looking at, hey, I can buy something that’s going to make it 200,000 miles and not have as much maintenance as the Chevy I used to own, and it changed the marketplace. Right now when you buy a Chevy, it is going to last 200,000 miles as well.
CR Herro:
And that’s the sort of market disruption I think energy efficiency provides in the marketplace is that once buyers understand that there’s more than just the first cost of a home and that translates into the benefits, right, the less maintenance in a car, the less maintenance in a home. An energy efficient home also tends to be much more comfortable because it’s just not as leaky and it’s not as exposed to the outside elements. And so as buyers start to equate energy efficiency and quality and resale value, and in lower operating costs, it’s going to put pressure on all of the market to update its inventory to meet those new needs.
Dean Wehrli:
So you think the more innovative builders are going to be pushing the other folks to match them over the long… the way Honda did with Chevy.
CR Herro:
Yeah. We’ve been working with California to adopt supportive components to their new energy efficiency code to enable buyers to make those fisc aid decisions. So whether it’s energy labeling at the transaction or expanding the appraisal process to demonstrate to buyers the additional features that come in a new home that aren’t available in used or honestly simply working with mortgage underwriters to say, hey, if you can demonstrate there’s $100,000 less of operating costs, you can borrow $50,000 more in your home. And those sorts of bits of information is going to inevitably change the buyer’s perspective about value and that the influencer of buyers, right, it’s going to change the real estate industry to help buyers differentiate between good, better, and best.
Dean Wehrli:
Yeah. And maybe that’s why the energy part of that is so important because back to the car analogy, it wasn’t a big part of buying the Honda, it wasn’t just that it costs you less over time and then it lasted longer. It was also that it saved you money on gas right upfront immediately relative to that land yacht that you had in the driveway.
CR Herro:
Exactly. Once people started getting $3 a gallon gas, they started making different valued judgements, right. And look at Germany. In Germany, the reason there’s so much pervasive energy efficiency and renewable energy isn’t because that culture values energy efficiency more than Europe. It’s because it’s got $1 a kilowatt power when we have 10 cents a kilowatt power and you make very different decisions when your power costs that much.
Dean Wehrli:
Yeah. Can we talk about, you mentioned solar just a bit ago. Can we talk about solar for a second? I know that’s solar, it’s a lot more than solar in this equation we’re talking about here, but how important is solar and how do you get people to take that mindset of, hey, this is going to pay for itself over the midterm?
CR Herro:
Yeah. There’s three really important things when you think about renewable energy, especially solar renewable energy is one, is that there is more cost effective techniques to reduce your utility bill initially and so that’s when you hear the phrase reduce before you renew. Put good insulation in your house, put good windows in your house, upgrade your lights, upgrade your heating, cooling. For every dollar you’re spending on those upgrades, you’re creating more dollars in offsets or utility costs than if you invested in solar. But at some point you get to a point where your house is really energy efficient and solar does make a lot of sense to continue to progress.
CR Herro:
And solar today, the install cost, when you finance it, the monthly finance charges is less than the benefit solar provides. So solar absolutely has come of age and is a smart economic decision all the way down to zero energy. So as long as you’re above what most utilities provide, what they call net metering, which is they give you credit for the solar that you’re making, as long as you’re not going negative, where you’re actually looking for them to pay you for energy, as long as you’re positive in your energy production, your solar credit from your utilities is worth more than the cost to have bought that solar installed it in your house. So solar today is a great decision.
Dean Wehrli:
Wow. So in a sense solar is paying for itself upfront if what you just described is true for your situation. Is that fair?
CR Herro:
Absolutely, and it has for the last time several years. It’s the last piece, just like all the rest of this energy efficiency is consumer awareness. The average consumer still thinks about solar like it was 1990 and you invest in it to feel good, but it wasn’t necessarily cost effective.
Dean Wehrli:
Yeah. I think the average consumer probably still thinks that mindset of okay, it’ll pay for itself in five to seven years, but I may not be in this house for five to seven years.
CR Herro:
Yeah, and as long as you’re financing it now if you pay for it in cash, then you have to do some sort of ROI analysis and solar is about a seven year ROI, but if you’re financing it, it’s cashflow positive day one because you’re creating more benefit than cost and the minute that solar gets turned out.
Dean Wehrli:
Okay. That’s interesting. How about on this topic, it sounds like it’s going to take, you mentioned underwriters and it’s going to take a lot of folks sort of swimming in the same direction to have the movement we need on energy, energy efficiency and smarter homes. Who are the main actors going to be?
CR Herro:
The main actors are the influencer to your 36 year old mom who’s buying the house. So the first one is realtors. The inventory that they’re normally transacting, 90% is still resale. And so all the things that are happening in new codes aren’t reflected in 90% of those realtors transactions. And then the really good progressive energy efficiency is voluntary. So those represent less than 10% of the new home transactions. So you’re talking about less than 1% of the transactions are being impacted. And so realtors really haven’t done the education or have the skill sets and the nuances to be able to direct buyers between good, better and best in the marketplace.
CR Herro:
So as California has adopted these new standards, I once again think it’s going to be a test bed for realtors to become educated to understand this value equation differently than they have before. And then it’s a great opportunity for realtors in the marketplace to differentiate themselves from competition to be able to do this, to be able to understand, hey, what is the value of buying from a home builder that certifies their homes to energy star, what should I expect is inappropriate premium in that marketplace for these better window or this home was renewable energy because buyers ultimately are the ones who benefit. And I’m sure you’ve seen how much the real estate industry is being challenged from outside with the internet now you can look for location, design and price. What realtors used to do and provide to customers is changing. And so they need to figure out a new value equation back to buyers. And I think this sits in a really smart place, which is realtors need to be that trusted expert to help buyers make better choices in the market.
Dean Wehrli:
So you think that you’ll see a time in probably in the not too distant future where agents will be saying things like, okay, here’s the 10 homes you’re looking at in your price range location. Now let’s look at their HERS scores and look at the kind of insulation they have. Do you think that’ll be routine?
CR Herro:
I think so because if there’s 50 realtors in the marketplace, what are they telling their buyers? Hey, I can do a Google search for you, or hey, I can be your expert to help you understand total cost. And it’s the realtors that get there and understand that they can differentiate themselves and create. Real estate is a job of referrals and the more they can create substance and value to their buyers, the greater opportunity they’re going to have to out compete in the marketplace.
Dean Wehrli:
Until Zillow and Redfin make that a standard field on their home valuation and then back to the same situation again.
CR Herro:
The good news is that they’re probably not going to get there quick.
Dean Wehrli:
Okay. So agents, who else is going to is going to be important in this process?
CR Herro:
So the mortgage for sure. There has been what they’ve called an energy efficient mortgage or a green mortgage for decades and nobody uses it. And it’s basically, think about the transaction. If you have income based property when you buy something that if there’s rental property associated with the property, you can take that income stream and leverage it as part of your ratio for underwriting. That offsets and adds to your income. Well, energy efficiency conceivably is the same thing. If you reduce the cost of your home by $150 a month because of superior components and more efficient appliances, that is an interesting way to think about it, revenue right? It’s $150 every month that you don’t have to spend that, that is available to serve your mortgage. And when they do tests on these, energy efficient mortgages have significantly less default than a conventional mortgage because these buyers don’t have the same disposable income. They have greater disposable income because they’re not utilizing it to service their utility costs.
CR Herro:
So I think that’s an evolution that is important. And the good news is once you show banks a way to risk mitigate or increase their business because they can underwrite more efficiently by taking credit for a true savings. I think there’s a lot of opportunity there for banks once again to create better products to serve these energy efficient homes.
Dean Wehrli:
Do you see any movement yet from underwriters on that?
CR Herro:
There was a piece of legislation called the Save Act, a sensible act to value energy. And it was bipartisan. It was Bennet and Isakson, so Bennet’s in Denver and Isakson’s in Georgia, and it went to the Senate floor and it was part of the big energy bill and it would have compelled all government underwritten mortgages to include total cost of operation in the underwriting ratios and would have absolutely transformed the market to value energy efficiency. But unfortunately the Senate hasn’t been really good at getting anything done off the floor.
Dean Wehrli:
So it just sort of died on the vine but…
CR Herro:
It’s still out there. It’s still a part of their agenda. But nothing’s really kind of gotten through the energy committee in the Senate for 10 years.
Dean Wehrli:
That’s not a good track record. So we have agents, we have underwriters, who else might be part of this process?
CR Herro:
And then the last, I think big influencers are appraisers, right? The market values what the market values. And the comp analysis is not an appropriate use to say, hey, this 1974 home with 20 year old HVAC and 50 year old windows is the same as a brand new home with this high series HVAC and LED lights and polyurethanes spray foam insulation and solar panels. So it’s a very apples and orange comparison and the appraisal process, the comp analysis hasn’t evolved to differentiate that.
CR Herro:
So there is an addendum. It’s the AI 820.04, the energy efficient addendum that appraisers can use to add value because of renewable energy to add value because of third party certifications like energy star or add value because it’s got energy efficient appliances. But once again, the same math that we are doing for realtors, it occurs to appraisers, it’s 1% of the transactions they see. And so not everyone is an expert and has the skillset to do that kind of differentiation, but hopefully the market solves it, right. Hopefully it’s yet another opportunity for appraisers to add value by being able to properly capture the value that the average appraiser can’t.
Dean Wehrli:
It sounds like it’s one of those critical mass or adoption curve kind of situations, isn’t it, where once you get it to be… we’re probably going to go from a dribble dribble dribble to just an explosion and where everybody, underwriters, appraisers, everyone will be kind of again swimming in the same direction, but we’re not quite to that critical mass yet.
CR Herro:
Yeah, I certainly hope so. It has been dribble dribble for a decade now and I was hoping that that Save Act would have been the explosion that’s needed to mature the market, but quite possibly this new Title 24 in California that’s so significantly more aggressive than conventional code will provide that on the West Coast and that explosion will happen and then move East.
Dean Wehrli:
So should we add government as a fourth actor to this scenario? I know billers don’t always want to hear that, but can they be a big part of this?
CR Herro:
It would absolutely solve the problem. I’m always cautious when I say the government should help us, but the, the opportunity is a no cost challenge. It’s just a government policy to recognize value. And if that’s the extent of it, then I fully support legislative pieces to do those three things we’ve talked about is to create consistent labeling at the transaction on total cost, to promote appraisals and to promote underwriting to value those savings in the transaction for buyers, and that will create a mechanism both for buyers to make good choices, but also to take the existing inventory, invest in improving its function and realize it in the subsequent transaction. So it’s the only mechanism I’m aware of to improve our existing inventory in a predictable way because right now you wouldn’t be necessarily wise to put a bunch of energy efficient features in an existing home because you can’t count on the market giving you credit for it, but once you can on the market responding properly to that value, then it triggers an entire industry of retrofit.
Dean Wehrli:
Yeah, it’s true. I mean sometimes for good, sometimes for bad that government actions like that, it can really speed things up. I mean look at solar where without a lot of the subsidies for solar where we’re probably five or 10 years further behind in that technology than we are now.
CR Herro:
Agreed.
Dean Wehrli:
All right, that was the first part of our conversation with CR Herro. Please join us for our next episode. We’ll bring you part two and talk about home automation and about offsite construction and other disruptive factors in the building process. See you then.
