ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Beginning during the second half of our fiscal year ended October 31, 2006, the U. S. housing market has been impacted by a declining consumer confidence, increasing home foreclosure rates and increasing supplies of resale and new home inventories. The result has been weakened demand for new homes, slower sales, higher than normal cancellation rates, and increased price discounts and other sales incentives to attract homebuyers. Additionally, the availability of certain mortgage financing products became more constrained starting in February 2007 when the mortgage industry began to more closely scrutinize subprime, Alt-A, and other non-prime mortgage products. The overall economy weakened significantly and fears of a prolonged economic weakness are still present due to high unemployment levels, further deterioration in consumer confidence and the reduction in extensions of credit and consumer spending. As a result, we experienced significant decreases in our revenues and gross margins during 2007, 2008 and 2009 compared with prior years. During 2010, the homebuilding market has exhibited a large degree of choppiness. Signs of this choppiness can be seen in key measures, such as our gross margin, cancellation rates and total deliveries. Although we continued to see declines in deliveries and revenues during the first and second quarters of fiscal 2010, both were relatively flat in the third quarter compared to the same period in the prior year. This occurred because we had a strong delivery quarter as we delivered a lot of homes for customers taking advantage of the federal homebuyer tax credit that expired June 30, 2010. Our gross margin percentage has increased to 16.8% for the nine months ended July 31, 2010 from 7.7% for the nine months ended July 31, 2009, and our contract cancellation rate of 23% in the third quarter of fiscal 2010 is consistent with more normalized levels, as seen in fiscal 2003 and 2004. Net contracts per active selling community decreased to 17.1 for the nine months ended July 31, 2010 compared to 20.1 in the same period in the prior year. Active selling communities decreased by 7.6% compared with the same period a year ago. Although we remain cautiously optimistic, several challenges such as persistently high unemployment levels, the expiration of the federal homebuyers' tax credit on April 30, 2010 and the threat of more foreclosures continue to hinder a recovery in the housing market.
We have exposure to additional impairments of our inventories, which, as of July 31, 2010, have a book value of $1.1 billion, net of $885.6 million of impairments recorded on 170 of our communities. We also have $76.7 million invested in 14,793 lots under option, including cash and letters of credit option deposits of $37.9 million as of July 31, 2010. We will record a write-off for the amounts associated with an option if we determine it is probable we will not exercise it. As of July 31, 2010, we have total investments in, and advances to, unconsolidated joint ventures of $37.6 million. Each of our joint ventures assesses its inventory and other long-lived assets for impairment and we separately assess our investment in joint ventures for recoverability, which has resulted in total reductions in our investment in joint ventures of $115.8 million from the second half of fiscal 2006, the first period in which we had impairments on our joint ventures, through July 31, 2010. We still have exposure to future write-downs of our investment in unconsolidated joint ventures if conditions deteriorate further in the markets in which our joint ventures operate.
As the market for new homes declined, we adjusted our approach to land acquisition and construction practices and shortened our land pipeline, reduced production volumes, and balanced home price and profitability with sales pace. We delayed and cancelled planned land purchases and renegotiated land prices and significantly reduced our total number of controlled lots owned and under option. Additionally, we significantly reduced our total number of speculative homes put into production over the past several years. Recently, however, we have begun to see more opportunities to purchase land at prices that make economic sense in light of the current sales prices and sales paces and plan to pursue such land acquisitions. New land purchases at pricing that will generate good investment returns and drive greater operating efficiencies are needed to return to profitability. During the first three quarters of fiscal 2010, we increased our controlled lots by 4,665 and we opened 53 new communities. During the third quarter of fiscal 2010, we purchased approximately 850 lots within 45 newly identified communities (communities that were controlled subsequent to January 31, 2009). In the third quarter of fiscal 2010 compared to the second quarter of fiscal 2010, we had an increase in active communities in consecutive quarters. This is the first consecutive quarter increase in community count since the second quarter of fiscal 2007. In addition, we put under option approximately 4,700 lots in 62 newly identified communities during the third quarter of 2010. We have also closely evaluated and made reductions in selling, general and administrative expenses, including corporate general and administrative expenses, reducing these expenses $138.3 million from $459.9 million in fiscal 2008 to $321.6 million in fiscal 2009 due in large part to a 74.5% reduction in head count at the end of fiscal 2009 from our peak in June 2006. Given the persistence of these difficult market conditions, improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus. For the nine months ended July 31, 2010, homebuilding selling, general and administrative costs declined 31.8% to $127.6 million compared to the nine months ended July 31, 2009.
CRITICAL ACCOUNTING POLICIES
Effective July 1, 2009, the Financial Accounting Standards Board ("FASB") established the Accounting Standards Codification ("ASC") as the primary source of accounting principles generally accepted in the United States of America ("US GAAP") recognized by the FASB to be applied by nongovernmental entities. Although the establishment of the ASC did not change US GAAP, it did change the way we refer to US GAAP throughout this document to reflect the updated referencing convention.
Management believes that the following critical accounting policies, which have not changed during fiscal 2010, require its most significant judgments and estimates used in the preparation of the consolidated financial statements:
Income Recognition from Home and Land Sales - We are primarily engaged in the development, construction, marketing and sale of residential single-family and multi-family homes where the planned construction cycle is less than 12 months. For these homes, in accordance with ASC 360-20, "Property, Plant and Equipment - Real Estate Sales" ("ASC 360-20"), revenue is recognized when title is conveyed to the buyer, adequate initial and continuing investments have been received and there is no continued involvement. In situations where the buyer's financing is originated by our mortgage subsidiary and the buyer has not made an adequate initial or continuing investment as prescribed by ASC 360-20, the profit on such sales is deferred until the sale of the related mortgage loan to a third-party investor has been completed.
Additionally, in certain markets, we sell lots to customers, transferring title, collecting proceeds, and entering into contracts to build homes on these lots. In these cases, we do not recognize the revenue from the lot sale until we deliver the completed home and have no continued involvement related to that home. The cash received on the lot is recorded as a reduction of inventory until the revenue is recognized.
Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage-backed securities ("MBS") to hedge our mortgage-related interest rate exposure on agency and government loans.
We elected the fair value option for our loans held for sale for mortgage loans originated subsequent to October 31, 2008 in accordance with ASC 825, "Financial Instruments" ("ASC 825"), which permits us to measure our loans held for sale at fair value. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. In addition, we recognize the fair value of our rights to service a mortgage loan as revenue upon entering into an interest rate lock loan commitment with a borrower. The fair value of these servicing rights is included in loans held for sale. Fair value of the servicing rights is determined based on values in the Company's servicing sales contracts.
Substantially all of the loans originated are sold within a short period in the secondary mortgage market on a servicing released, non-recourse basis although the Company remains liable for certain limited representations and warranties related to loan sales. Included in mortgage loans held for sale at July 31, 2010, is $2.2 million of mortgage loans that do not qualify for the secondary mortgage market. These loans are serviced by a third party until such time that they can be liquidated via alternative mortgage markets, foreclosure or repayment.
Inventories - Inventories consist of land, land development, home construction costs, capitalized interest and construction overhead. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type.
We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all cost related to specific performance options, variable interest entities, and other options, which consists primarily of our model homes financed by a third party and inventory related to structured lot options.
We have decided to mothball (or stop development on) certain communities where we determine the current performance does not justify further investment at this time. When we decide to mothball a community, the inventory is reclassified from "Sold and unsold homes and lots under development" to "Land and land options held for future development or sale". As of July 31, 2010, the net book value associated with the 61 mothballed communities was $234.8 million, net of impairment charges of $543.1 million. We continually review communities to determine if mothballing is appropriate.
The recoverability of inventories and other long-lived assets are assessed in accordance with the provisions of ASC 360-10, "Property, Plant and Equipment - Overall" ("ASC 360-10"). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure.
We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly, primarily by completing detailed budgets for all of our communities and identifying those communities with a projected operating loss for any projected fiscal year or for the entire projected community life. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable.
The projected operating profits, losses or cash flows of each community can be significantly impacted by our estimates of the following:
• future base selling prices; • future home sales incentives; • future home construction and land development costs; and • future sales absorption pace and cancellation rates.
These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include:
• the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors; • the current sales absorption pace for both our communities and competitor communities; • community-specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered; • potential for alternative product offerings to respond to local market conditions; • changes by management in the sales strategy of the community; and • current local market economic and demographic conditions and related trends and forecasts.
These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor.
If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written-down to its fair value. We determine the estimated fair value of each community by determining the present value of the estimated future cash flows at a discount rate commensurate with the risk of the respective community. Our discount rates used for all impairments recorded from October 31, 2006 to July 31, 2010 range from 13.5% to 20.3%. The estimated future cash flow assumptions are the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis.
From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed probable that the optioned property will not be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant.
Insurance Deductible Reserves - For homes delivered in fiscal 2010 and fiscal 2009, our deductible is $20 million per occurrence with an aggregate $20 million for liability claims and an aggregate $21.5 million for construction defect claims under our general liability insurance. Our worker's compensation insurance deductible is $0.5 million per occurrence in fiscal 2010 and fiscal 2009. Reserves for fiscal 2010 and fiscal 2009 have been established using the assistance of a third party actuary. We engage a third party actuary that uses our historical warranty data and other data to assist management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and workers compensation programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts.
Interest - Interest attributable to properties under development during the land development and home construction period is capitalized and expensed along with the associated cost of sales as the related inventories are sold. Interest incurred in excess of interest capitalized, which occurs when assets qualifying for interest capitalization are less than our outstanding debt balances, is expensed as incurred in "Other interest".
Land Options - Costs incurred to obtain options to acquire improved or unimproved home sites are capitalized. Such amounts are either included as part of the purchase price if the land is acquired or charged to operations if we determine we will not exercise the option. If the options are with variable interest entities and we are the primary beneficiary, we record the land under option on the Condensed Consolidated Balance Sheets under "Consolidated inventory not owned" with an offset under "Liabilities from inventory not owned". The evaluation of whether or not we are the primary beneficiary can require significant judgment. If the option obligation is to purchase under specific performance or has terms that require us to record it as financing, then we record the option on the Condensed Consolidated Balance Sheets under "Consolidated inventory not owned" with an offset under "Liabilities from inventory not owned". In accordance with ASC 810, "Consolidation" ("ASC 810"), we record costs associated with other options on the Condensed Consolidated Balance Sheets under "Land and land options held for future development or sale".
Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interest in joint ventures varies but is generally less than or equal to 50%. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, "Investments-Equity Method and Joint Ventures - Overall" ("ASC 323-10"), we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment is other than temporary, we write-down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture's projected cash flows. This process requires significant management judgment and estimate. During the first three quarters of 2010, we did not write down any of our joint venture investments based on this recoverability analysis.
Post-Development Completion and Warranty Costs - In those instances where a development is substantially completed and sold and we have additional construction work to be incurred, an estimated liability is provided to cover the cost of such work. In addition, we estimate and accrue warranty costs as part of cost of sales for repair costs under $5,000 per occurrence to homes, community amenities and land development infrastructure. In addition, we accrue and estimate for warranty costs over $5,000 per occurrence as part of our general liability insurance deductible expensed as selling, general and administrative costs. Warranty accruals require our management to make significant estimates about the cost of the future claims. Both of these liabilities are recorded in "Accounts payable and other liabilities" on the Condensed Consolidated Balance Sheets.
Income Taxes - Deferred income taxes or income tax benefits are provided for temporary differences between amounts recorded for financial reporting and for income tax purposes. If the combination of future years' income (or loss) combined with the reversal of the timing differences results in a loss, such losses can be carried back to prior years or carried forward to future years to recover the deferred tax assets. In accordance with ASC 740-10, "Income Taxes - Overall" ("ASC 740-10"), we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740-10 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a "more-likely-than-not" standard. See "Total Taxes" below under "Results of Operations" for further discussion of our valuation allowances.
We recognize tax liabilities in accordance with ASC 740-10, and we adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a liability that is materially different from our current estimate. These differences will be reflected as increases or decreases to income tax expense in the period in which they are determined.
Recent Accounting Pronouncements - See Note 18 to the Condensed Consolidated Financial Statements included elsewhere in this Form 10-Q.
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CAPITAL RESOURCES AND LIQUIDITY
We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our bank credit facilities and the issuance of new debt and equity securities. In light of the challenging homebuilding market conditions experienced over the past few years, which are continuing as reflected in our 1.7% and 12.1% decline in revenues during the three and nine months ended July 31, 2010, respectively, compared to the same period of 2009, we had been operating with a primary focus to generate cash flows from operations through reductions in assets. The generation of cash flow, together with debt repurchases and exchanges at prices below par, has allowed us to reduce net debt (debt less cash) over the past two years. However, recently we have begun to see more opportunities to purchase land at prices that make economic sense given current home sales prices and sales paces. As such, in 2010 we have acquired new land at higher levels than in the previous few years. As a result, our net debt increased slightly in the third quarter of 2010 compared to the second quarter of fiscal 2010.
Our cash uses during the nine months ended July 31, 2010 and 2009 were for operating expenses, land purchases, land deposits, construction spending, state income taxes, interest and debt repurchases. We provided for our cash requirements from available cash on hand, housing and land sales, financial service revenues, federal income tax refunds and other revenues. We believe that these sources of cash will be sufficient through fiscal 2011 to finance our working capital requirements and other needs, despite continued declines in total revenues, the termination of our revolving credit facility and the collateralization with cash in segregated accounts to support certain of our letters of credit. We may also enter into land sale agreements or joint ventures to generate cash from our existing balance sheet. Due to a change in tax legislation that became effective on November 6, 2009, we were able to carryback our 2009 net operating loss five years to previously profitable years. As a result, we received a $274.1 million federal income tax cash refund during our second quarter of fiscal 2010 and we expect to receive the remaining $17.2 million by the first quarter of fiscal 2011.
Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, interest and other accrued liabilities, deferred income taxes, accounts payable, mortgage loans and liabilities, and non-cash charges relating to depreciation, amortization of computer software costs, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, which is what happened during the last half of fiscal 2007 through 2009 allowing us to generate positive cash flow from operations over this three year period. Looking forward, given the depressed housing market, it will become more difficult to generate positive cash flow from operations until we return to profitability. However, we will continue to make adjustments to our structure and our business plans in order to maximize our liquidity while taking steps to return to profitability. We continue to focus on maximizing cash flow by limiting our investment in currently owned communities that we believe will not generate positive cash flow in the near term, and by seeking to identify and purchase new land parcels (primarily finished lots) on which homes can be built and delivered in a short period of time, generating acceptable returns based on our underwriting standards and positive cash flow.
On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. As of July 31, 2010, 3.4 million shares of Class A Common Stock have been purchased under this program (See Part II, Item 2 for information on equity purchases).
On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company's common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares beginning on the fifth anniversary of their issuance. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol "HOVNP". During the nine months ended July 31, 2010 and 2009, we did not make any dividend payments on our Series A Preferred Stock as a result of covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future.
In connection with the issuance of our senior secured first lien notes in the fourth quarter of fiscal 2009, we terminated our revolving credit facility and refinanced the borrowing capacity thereunder. Also in connection with the refinancing, we entered into certain stand alone cash collateralized letter of credit agreements and facilities under which there were a total of $97.3 million and $130.3 million of letters of credit outstanding as of July 31, 2010 and October 31, 2009, respectively. These agreements and facilities require us to maintain specified amounts of cash as collateral in segregated accounts to support the letters of credit issued thereunder, which will affect the amount of cash we have available for other uses. As of July 31, 2010 and October 31, 2009, the amount of cash collateral in these segregated accounts was $101.5 million and $135.2 million, respectively, which is reflected in "Restricted cash" on the Condensed Consolidated Balance Sheets.
Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC ("K. Hovnanian Mortgage"), originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. Our secured Master Repurchase Agreement with Citibank, N.A. ("Citibank Master Repurchase Agreement") is a short-term borrowing facility that provides up to $50 million through April 5, 2011. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable upon the sale of each mortgage loan to a permanent investor at LIBOR plus 4.00%. As of July 31, 2010, the aggregate principal amount of all borrowings under the Citibank Master Repurchase Agreement was $36.3 million. The Citibank Master Repurchase Agreement requires K. Hovnanian Mortgage to satisfy and maintain specified financial ratios and other financial condition tests. Because of the extremely short period of time mortgages are held by K. Hovnanian Mortgage before the mortgages are sold to investors (generally a period of a few weeks), the immateriality to us on a consolidated basis of the size of the facility, the levels required by these financial covenants, our ability based on our immediately available resources to contribute sufficient capital to cure any default, were such conditions to occur, and our right to cure any conditions of default based on the terms of the Citibank Master Repurchase Agreement, we do not consider any of these covenants to be substantive or material. As of July 31, 2010, we believe we were in compliance with the covenants of the Citibank Master Repurchase Agreement.
In addition to the Citibank Master Repurchase Agreement discussed above, on July 19, 2010, K. Hovnanian Mortgage executed a secured Master Repurchase Agreement with JPMorgan Chase Bank, N.A. ("Chase Master Repurchase Agreement") which is a short-term borrowing facility that provides up to $25 million through July 18, 2011. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly on outstanding advances at LIBOR floor of 2.00% plus applicable margin ranging from 2.50% to 3.00% based on the takeout investor and type of loan. As of July 31, 2010, the aggregate principal amount of all borrowings under the Chase Master Repurchase Agreement was $19.7 million. The Chase Master Repurchase Agreement requires K. Hovnanian Mortgage to satisfy and maintain specified financial ratios and other financial condition tests. Because of the extremely short period of time mortgages are held by K. Hovnanian Mortgage before the mortgages are sold to investors (generally a period of a few weeks), the immateriality to us on a consolidated basis of the size of the facility, the levels required by these financial covenants, our ability based on our immediately available resources to contribute sufficient capital to cure any default, were such conditions to occur, and our right to cure any conditions of default based on the terms of the Chase Master Repurchase Agreement, we do not consider any of these covenants to be substantive or material. As of July 31, 2010, we believe we were in compliance with the covenants of the Chase Master Repurchase Agreement.
At July 31, 2010, we had $797.2 million ($784.2 million net of discount) of outstanding senior secured notes, comprised of $0.5 million 11 1/2% Senior Secured Notes due 2013, $785.0 million 10 5/8% Senior Secured Notes due 2016 and $11.7 million 18% Senior Secured Notes due 2017. At July 31, 2010 we also had $713.2 million of outstanding senior notes ($711.5 million net of discount), comprised of $35.5 million 8% Senior Notes due 2012, $54.4 million 6 1/2% Senior Notes due 2014, $29.2 million 6 3/8% Senior Notes due 2014, $52.7 million 6 1/4% Senior Notes due 2015, $173.2 million 6 1/4% Senior Notes due 2016, $172.3 million 7 1/2% Senior Notes due 2016 and $195.9 million 8 5/8% Senior Notes due 2017. In addition, we had $120.2 million of outstanding senior subordinated notes, comprised of $66.7 million 8 7/8% Senior Subordinated Notes due 2012, and $53.5 million 7 3/4% Senior Subordinated Notes due 2013.
During the three months ended January 31, 2010, the remaining $13.6 million of our 6% Senior Subordinated Notes due 2010 matured and was paid. In addition, during the three and nine months ended July 31, 2010, we repurchased in open market transactions $2.0 million and $27.0 million principal amount of our 6 1/2% Senior Notes due 2014, respectively, $9.0 million and $54.5 million principal amount of our 6 3/8% Senior Notes due 2014, respectively, $13.6 million and $29.5 million principal amount of our 6 1/4% Senior Notes due 2015, respectively. Also, during the nine months ended July 31, 2010 we repurchased in open market transactions $1.4 million principal amount of 8 7/8% Senior Subordinated Notes due 2012, and $11.1 million principal amount of 7 3/4% Senior Subordinated Notes due 2013. The aggregate purchase price for these repurchases was $19.3 million and $97.9 million for the three and nine months ended July 31, 2010, respectively, plus accrued and unpaid interest. These repurchases resulted in a gain on extinguishment of debt of $5.3 million and $25.0 million for the three and nine months ended July 31, 2010, respectively, net of the write-off of unamortized discounts and fees. The gains from the repurchases are included in the Condensed Consolidated Statement of Operations for the three and nine months ended July 31, 2010 as "Gain on extinguishment of debt".
We and each of our subsidiaries are guarantors of the senior secured, senior and senior subordinated notes, except for K. Hovnanian, the issuer of the notes, certain of our financial services subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and our foreign subsidiary (see Note 20 to the Condensed Consolidated Financial Statements). The indentures governing the senior secured, senior and senior subordinated notes do not contain any financial maintenance covenants but do contain restrictive covenants that limit, among other things, the Company's ability and that of certain of its subsidiaries, including K. Hovnanian, the issuer of the senior secured, senior and senior subordinated notes, to incur additional indebtedness (other than certain permitted indebtedness, refinancing indebtedness and non-recourse indebtedness), pay dividends and make distributions on common and preferred stock, repurchase senior notes and senior subordinated notes (with respect to the senior secured first-lien notes indenture), make other restricted payments, make investments, sell certain assets, incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets and enter into certain transactions with affiliates. The indentures also contain events of default which would permit the holders of the senior secured, senior and senior subordinated notes to declare those notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the notes or other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy, and insolvency and, with respect to the indentures governing the senior secured notes, the failure of the documents granting security for the senior secured notes to be in full force and effect and the failure of the liens on any material portion of the collateral securing the senior secured notes to be valid and perfected. As of July 31, 2010, we believe we were in compliance with the covenants of the indentures governing our outstanding notes. Under the terms of the indentures, we have the right to make certain redemptions and, depending on market conditions and covenant restrictions, may do so from time to time. We may also continue to make debt purchases and/or exchanges from time to time through tender offers, open market purchases, private transactions, or otherwise depending on market conditions and covenant restrictions.
If our consolidated fixed charge coverage ratio, as defined in the indentures governing our senior secured, senior, and senior subordinated notes, is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness, and non-recourse indebtedness. As a result of this restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. If current market trends continue or worsen, we will continue to be restricted from paying dividends through fiscal 2010, and possibly beyond. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our bond indentures or otherwise affect compliance with any of the covenants contained in the bond indentures.
The 10 5/8% Senior Secured Notes due 2016 are secured by a first-priority lien, the 11 1/2% Senior Secured Notes due 2013 are secured by a second-priority lien and the 18% Senior Secured Notes due 2017 are secured by a third-priority lien, in each case, subject to permitted liens and other exceptions, on substantially all the assets owned by us, K. Hovnanian (the issuer of the senior secured notes) and the guarantors, in the case of the 11 1/2% Senior Secured Notes due 2013 and the 18% Senior Secured Notes due 2017, to the extent such assets secure obligations under the 10 5/8% Senior Secured Notes due 2016. At July 31, 2010, the aggregate book value of the real property collateral securing these notes was approximately $776.6 million, which does not include the impact of inventory investments, home deliveries, or impairments thereafter and which may differ from the appraised value. In addition, cash collateral securing these notes was $357.4 million as of July 31, 2010, which includes $101.5 million of restricted cash also collateralizing certain letters of credit. Subsequent to such date, cash uses include general business operations and real estate and other investments.
During the second quarter of fiscal 2009, our credit ratings were downgraded by Standard & Poor's ("S&P"), Moody's Investors Services ("Moody's") and Fitch Ratings ("Fitch"), as follows:
· S&P downgraded our corporate credit rating to CCC from B-,
· Moody's downgraded our corporate family rating to Caa1 from B3,
· Fitch downgraded our Issuer Default Rating ("IDR") to CCC from B- and
· S&P, Moody's and Fitch also downgraded our various senior secured notes,
senior notes and senior subordinated notes.
On October 5, 2009, S&P raised our corporate credit rating to CCC+ from CCC and revised our outlook to developing from negative.
Downgrades in our credit ratings do not accelerate the scheduled maturity dates of our debt or affect the interest rates charged on any of our debt issues or our debt covenant requirements or cause any other operating issue. The only potential risk from these negative changes in our credit ratings is that they may make it more difficult or costly for us to access capital. However, due to our available cash resources, the downgrades in our credit ratings in the second quarter of fiscal 2009 have not impacted management's operating plans, or our financial condition, results of operations or liquidity.
Total inventory decreased $3.3 million, excluding inventory not owned, during the nine months ended July 31, 2010. Total inventory, excluding inventory not owned, decreased in the Northeast $39.6 million, in the Mid-Atlantic $10.7 million, and in the Southeast $0.7 million. These decreases were offset by increases in the Midwest of $4.4 million, in the Southwest of $27.6 million, and in the West of $15.7 million. During the nine months of 2010, we incurred $54.1 million in write-downs primarily attributable to impairments as a result of a continued decline in sales pace, sales price and general market conditions. In addition, we wrote-off costs in the amount of $1.0 million during the nine months ended July 31, 2010, related to land options that expired or that we terminated. See "Notes to Condensed Consolidated Financial Statements" - Note 5 for additional information. Despite these write-downs and inventory reductions due to deliveries, total inventory only decreased $3.3 million, excluding inventory not owned, because we purchased $219.7 million of land during the nine months ended July 31, 2010. We have recently been able to identify new land parcels at prices that generate reasonable returns under the current homebuilding market conditions. Substantially all homes under construction or completed and included in inventory at July 31, 2010 are expected to be closed during the next 12 months. Most inventory completed or under development was/is partially financed through our line of credit and debt and equity issuances.
The total inventory decrease discussed above excluded the decrease in consolidated inventory not owned of $37.8 million consisting of specific performance options, options with variable interest entities, and other options that were added to our balance sheet in accordance with ASC 470-40, "Debt-Product Financing Arrangements", ASC 840-40, "Leases-Sales-Leaseback Transactions", and variable interest entities in accordance with ASC 810. See "Notes to Condensed Consolidated Financial Statements"-Note 16 for additional information on ASC 810. Specific performance options inventory decreased $9.9 million during the nine months ended July 31, 2010. This decrease was primarily due to the fact that some lots previously recorded as a future obligation in the Northeast were taken down during the first quarter. Variable interest entity options inventory decreased $10.6 million as we continue to take down land or walk away from deals previously consolidated. Other options inventory decreased $17.4 million for the period. Other options consist of inventory financed via a model home program and structured lot option agreements. Model home inventory financed through the model lease program decreased $14.5 million because we have terminated the use of these models in certain communities where the models were no longer needed and in conjunction therewith also terminated the option to purchase those models. Structured lot option inventory decreased $2.9 million. This decrease was primarily in the Mid-Atlantic where we walked away from a land purchase transaction during the first quarter of fiscal 2010.
We usually option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option. As a result, our commitment for major land acquisitions is reduced. However, our inventory representing "Land and land options held for future development or sale" at July 31, 2010, on the Condensed Consolidated Balance Sheets, increased by $61.7 million compared to October 31, 2009. The increase is due to the acquisition of new land in the Southeast, Southwest and West segments, as land prices became more attractive during the first three quarters of the fiscal year. Included in "Land and land options held for future development or sale inventory" are amounts associated with inventory in mothballed communities. We mothball (or stop development on) communities when we determine the current performance does not justify further investment at this time. That is, we believe we will generate higher returns if we avoid spending money to improve land today and save the raw land until such times as the markets improve. As of July 31, 2010, we have mothballed land in 61 communities. The net book value associated with these 61 communities at July 31, 2010 was $234.8 million, net of an impairment balance of $543.1 million. We continually review communities to determine if mothballing is appropriate or to re-activate previously mothballed communities as we did with one and eleven communities in the three and nine months ended July 31, 2010, respectively. Of the six communities mothballed in the third quarter of fiscal 2010, one community was re-activated and five communities were sold.
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The following table summarizes home sites included in our total residential real estate. Due to the recent land purchases discussed above, total home sites available at July 31, 2010 increased compared to October 31, 2009.
Active Proposed Active Communities Developable Communities(1) Homes Homes Total Homes July 31, 2010: Northeast 16 1,382 5,164 6,546 Mid-Atlantic 26 2,040 3,798 5,838 Midwest 22 2,201 526 2,727 Southeast 14 667 2,434 3,101 Southwest 88 4,017 1,737 5,754 West 17 1,760 6,944 8,704 Consolidated total 183 12,067 20,603 32,670 Unconsolidated joint ventures 1,594 565 2,159 Total including unconsolidated joint ventures 13,661 21,168 34,829 Owned 6,282 11,410 17,692 Optioned 5,600 9,193 14,793 Controlled lots 11,882 20,603 32,485 Construction to permanent financing lots 185 - 185 Consolidated total 12,067 20,603 32,670 Lots controlled by unconsolidated joint ventures 1,594 565 2,159 Total including unconsolidated joint ventures 13,661 21,168 34,829
(1) Active communities are open for sale communities with 10 or more home sites available.
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Active Proposed Active Communities Developable Communities(1) Homes Homes Total Homes October 31, 2009: Northeast 18 1,718 5,033 6,751 Mid-Atlantic 27 1,980 2,046 4,026 Midwest 21 3,005 102 3,107 Southeast 14 620 798 1,418 Southwest 78 4,115 1,144 5,259 West 21 2,507 4,890 7,397 Consolidated total 179 13,945 14,013 27,958 Unconsolidated joint ventures 2,200 376 2,576 Total including unconsolidated joint ventures 16,145 14,389 30,534 Owned 6,724 9,753 16,477 Optioned 7,083 4,260 11,343 Controlled lots 13,807 14,013 27,820 Construction to permanent financing lots 138 - 138 Consolidated total 13,945 14,013 27,958 Lots controlled by unconsolidated joint ventures 2,200 376 2,576 Total including unconsolidated joint ventures 16,145 14,389 30,534
(1) Active communities are open for sale communities with 10 or more home sites available.
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The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. July 31, 2010 October 31, 2009 Started Started Unsold Unsold Homes Models Total Homes Models Total Northeast 102 15 117 103 14 117 Mid-Atlantic 80 29 109 69 25 94 Midwest 48 19 67 40 19 59 Southeast 91 9 100 50 1 51 Southwest 475 101 576 364 82 446 West 41 69 110 33 83 116 Total 837 242 1,079 659 224 883 Started or completed unsold homes and models per active and substantially completed communities 4.6 1.3 5.9 3.7 1.2 4.9
The increase in total started unsold homes compared to the prior year end is primarily due to an increase in cancellations after the expiration of the tax credit, new community openings and a slower sales pace.
Investments in and advances to unconsolidated joint ventures decreased $3.7 million during the nine months ended July 31, 2010. This decrease is primarily due to distributions received from certain joint ventures during the nine months ended July 31, 2010. As of July 31, 2010, we have investments in eight homebuilding joint ventures and six land development joint ventures. Other than guarantees limited only to completion of development, environmental indemnification and standard indemnification for fraud and misrepresentation including voluntary bankruptcy, we have no guarantees associated with unconsolidated joint ventures.
Receivables, deposits and notes increased $7.1 million since October 31, 2009, to $51.5 million at July 31, 2010. The increase is primarily due to the purchase of a note in our Southwest segment which will allow us to acquire the property that collateralizes the note. The increase is also due to an increase in receivables for home closings as a result of cash in transit from various title companies at the end of the respective periods.
Property, plant and equipment decreased $7.8 million during the nine months ended July 31, 2010, primarily due to depreciation and a small amount of disposals, which were offset by minor additions for leasehold improvements during the period.
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Prepaid expenses and other assets were as follows:
July 31, October 31, Dollar (In thousands) 2010 2009 Change Prepaid insurance $3,354 $5,118 $(1,764)
Prepaid project costs 43,439 50,227 (6,788) Senior residential rental
properties 7,304 7,003 301 Other prepaids 23,899 25,832 (1,933) Other assets 9,848 9,979 (131) Total $87,844 $98,159 $(10,315)
Prepaid insurance decreased due to amortization of certain liability insurance premium costs during the nine months ended July 31, 2010. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs decreased for homes delivered and have not yet been replenished by spending on prepaids for new communities. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered. Other prepaids decreased mainly due to the amortization of the remaining prepaid debt costs. Also contributing to the decrease were debt repurchases during the nine months ended July 31, 2010, which resulted in the write-off of portions of the associated prepaid debt costs.
Financial Services - Mortgage loans held for sale consist primarily of residential mortgages receivable held for sale of $59.3 million and $66.0 million at July 31, 2010 and October 31, 2009, respectively, which are being temporarily warehoused and are awaiting sale in the secondary mortgage market. Also included are residential mortgages receivable held for sale of $2.2 million and $3.5 million at July 31, 2010 and October 31, 2009, respectively, which represent loans that cannot currently be sold at reasonable terms in the secondary mortgage market. We may incur risk with respect to mortgages that are delinquent, but only to the extent the losses are not covered by mortgage insurance or resale value of the house. Historically, we have incurred minimal credit losses. We have reserves for potential losses on mortgages we currently hold. The decrease in mortgage loans held for sale from October 31, 2009 is directly related to a decrease in the volume of loans originated during the third quarter of 2010 compared to the fourth quarter of 2009.
Nonrecourse land mortgages increased to $5.4 million at July 31, 2010 from zero at October 31, 2009. The increase is primarily due to three new mortgages recorded in the West segment during the nine months ended July 31, 2010.
Accounts payable and other liabilities are as follows:
July 31, October 31, Dollar (In thousands) 2010 2009 Change Accounts payable $76,378 $99,175 $(22,797) Reserves 132,239 136,481 (4,242) Accrued expenses 40,359 54,169 (13,810) Accrued compensation 18,253 17,237 1,016 Other liabilities 14,780 18,660 (3,880) Total $282,009 $325,722 $(43,713)
The decrease in accounts payable was primarily due to the lower volume of deliveries in the third quarter of fiscal 2010, compared to the fourth quarter of fiscal 2009. The decrease in the reserves is the result of an increase in use of the reserve for warranty claims for homes delivered in prior years when we were delivering two or three times as many homes as we are today. The decrease in accrued expenses is primarily due to decreases in property tax, payroll and advertising expenses paid in fiscal 2010 and amortization of abandoned lease space accruals. The increase in accrued compensation is due to certain markets generating profits in fiscal 2010, which therefore required an increase in bonus accruals. The decrease in other liabilities is primarily due to the payoff of a note on a community in the Northeast segment that was paid during the first quarter of fiscal 2010.
Customer deposits decreased $7.5 million from $18.8 million at October 31, 2009 to $11.3 million at July 31, 2010. This decrease is primarily due to lower average sales prices of homes in backlog and certain incentive programs in place that allow for lower deposit amounts. In addition, in some segments where we used to hold customer deposits in our own accounts, we are now using a third party escrow agent to hold customer deposits. We do not have the liability associated with the deposits held by third party escrow agents.
Liabilities from inventory not owned decreased $37.3 million, from $96.9 million at October 31, 2009 to $59.6 million at July 31, 2010. The decrease in these amounts is directly correlated to the change in "Consolidated inventory not owned" on the Condensed Consolidated Balance Sheets, which is explained in the discussion of inventory in this "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Accrued interest increased $7.0 million to $33.1 million at July 31, 2010. This increase is primarily attributed to higher accruals in the current quarter as a result of the issuance of the 10 5/8% Senior Secured Notes due 2016 during the end of the fourth quarter of 2009.
Income taxes payable of $62.4 million at October 31, 2009 decreased $43.2 million in the nine months ended July 31, 2010 to $19.2 million due to the payment of $19.3 million in taxes, including interest and penalties, during the period, as well as due to the change in tax legislation that became effective on November 6, 2009, which allowed us to carryback our 2009 net operating loss five years and record a tax benefit of $291.3 million during the first quarter of 2010. We received $274.1 million of that federal tax refund during the second quarter of 2010, and we expect to receive the remaining $17.2 million in the first quarter of fiscal 2011. Also, during the three months ended July 31, 2010, we reversed $7.0 million for certain state tax reserves that were no longer needed as the statute of limitations had lapsed for the tax years reserved.
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RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED JULY 31, 2010 COMPARED TO THE THREE AND NINE MONTHS ENDED JULY 31, 2009
Total revenues
Compared to the same prior period, revenues decreased as follows:
Three Months Ended Percentage (In thousands) July 31, 2010 July 31, 2009 Dollar Change Change Homebuilding: Sale of homes $368,077 $367,141 $936 0.3% Land sales and other revenues 3,770 11,044 (7,274) (65.9)% Financial services 8,753 8,929 (176) (2.0)% Total revenues $380,600 $387,114 $(6,514) (1.7)% Nine Months Ended Percentage (In thousands) July 31, 2010 July 31, 2009 Dollar Change Change Homebuilding: Sale of homes $987,923 $1,107,891 $(119,968) (10.8)% Land sales and other revenues 7,489 24,731 (17,242) (69.7)% Financial services 23,418 26,275 (2,857) (10.9)% Total revenues $1,018,830 $1,158,897 $(140,067) (12.1)% Homebuilding
For the three months ended July 31, 2010, sale of homes revenues increased $0.9 million, or 0.3%, as compared to the same period of the prior year. Although the number of home deliveries declined 0.5% for the three months ended July 31, 2010 compared to the three months ended July 31, 2009, the average price per home increased to $280,000 in the three months ended July 31, 2010 from $278,000 in the three months ended July 31, 2009. Compared to the same period last year, sale of homes revenues decreased $120.0 million, or 10.8%, during the nine months ended July 31, 2010. This decrease was primarily due to the number of home deliveries declining 10.0% for the nine months ended July 31, 2010, as well as the average price per home decreasing to $280,000 for the nine months ended July 31, 2010 compared to $283,000 for the same period of the prior year. The fluctuations in average prices are a result of geographic and community mix of our deliveries rather than price increases or decreases in individual communities. Land sales are ancillary to our homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. For further details on the decline in land sales and other revenues, see the section titled "Land Sales and Other Revenues" below.
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Information on homes delivered by segment is set forth below:
Three Months Ended July 31, Nine Months Ended July 31, (Dollars in 2010 2009 % Change 2010 2009 % Change thousands) Northeast: Dollars $91,740 $84,761 8.2% $217,409 $254,749 (14.7)% Homes 221 201 10.0% 538 586 (8.2)% Mid-Atlantic: Dollars $72,767 $75,631 (3.8)% $206,477 $215,513 (4.2)% Homes 194 200 (3.0)% 552 582 (5.2)% Midwest: Dollars $22,650 $29,925 (24.3)% $62,083 $80,685 (23.1)% Homes 110 128 (14.1)% 291 355 (18.0)% Southeast: Dollars $28,522 $23,152 23.2% $75,240 $90,001 (16.4)% Homes 121 95 27.4% 308 393 (21.6)% Southwest: Dollars $103,065 $105,518 (2.3)% $288,617 $305,637 (5.6)% Homes 472 500 (5.6)% 1,316 1,390 (5.3)% West: Dollars $49,333 $48,154 2.4% $138,097 $161,306 (14.4)% Homes 198 198 0% 520 612 (15.0)% Consolidated total: Dollars $368,077 $367,141 0.3% $987,923 $1,107,891 (10.8)% Homes 1,316 1,322 (0.5)% 3,525 3,918 (10.0)% Unconsolidated joint ventures: Dollars $34,609 $25,460 35.9% $88,615 $72,494 22.2% Homes 80 69 15.9% 197 215 (8.4)% Totals: Housing $402,686 $392,601 2.6% $1,076,538 $1,180,385 (8.8)% revenues Homes 1,396 1,391 0.4% 3,722 4,133 (9.9)% delivered
The decrease in housing revenues during the nine months ended July 31, 2010 was due to a continued decline in the number of open for sale communities from 198 at July 31, 2009 to 183 at July 31, 2010. During the three months ended July 31, 2010, housing revenues and deliveries were approximately flat with the three months ended July 31, 2009. This is the first quarter with increased revenues compared to the same quarter in the prior year since the fourth quarter of fiscal 2006. This occurred because we had a strong delivery quarter as we delivered a lot of homes for customers taking advantage of the federal homebuyer tax credit that expired June 30, 2010.
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An important indicator of our future results are recently signed contracts and our home contract backlog for future deliveries. Our sales contracts and homes in contract backlog primarily using base sales prices by segment are set forth below: Net Contracts (1) for the Contract Backlog as of Nine Months Ended July 31, July 31, (Dollars in thousands) 2010 2009 2010 2009 Northeast: Dollars $150,901 $254,091 $128,424 $205,966 Homes 381 568 300 479 Mid-Atlantic: Dollars $171,498 $214,819 $115,716 $165,218 Homes 465 615 299 418 Midwest: Dollars $60,235 $77,745 $48,680 $62,645 Homes 324 388 286 324 Southeast: Dollars $57,835 $78,796 $18,554 $34,600 Homes 248 361 75 131 Southwest: Dollars $282,183 $279,495 $76,721 $81,238 Homes 1,255 1,346 290 376 West: Dollars $113,210 $154,777 $31,374 $64,557 Homes 455 711 125 250 Consolidated total: Dollars $835,862 $1,059,723 $419,469 $614,224 Homes 3,128 3,989 1,375 1,978 Unconsolidated joint ventures: Dollars $92,489 $65,437 $80,968 $146,747 Homes 205 164 167 212 Totals: Dollars $928,351 $1,125,160 $500,437 $760,971 Homes 3,333 4,153 1,542 2,190
(1) Net contracts are defined as new contracts executed during the period for the purchase of homes,
less cancellations of prior contracts in the same period.
In the first three quarters of 2010, our open for sale community count has increased by four from our open for sale community count at October 31, 2009, which is the net result of opening 53 new communities and having closed 49 communities since the beginning of fiscal 2010. Our reported level of sales contracts (net of cancellations) has been impacted by the decrease in our average number of open for sale community count compared to the first three quarters of 2009, as we have focused on generating cash flow by selling inventory in our existing communities. Contracts per community for the nine months ended July 31, 2010 decreased to 17.1 compared to the same period in the prior year of 20.1, demonstrating a decrease in sales pace. This decrease in sales pace occurred in the three months ended July 31, 2010, which we believe was partially due to the expiration of the federal tax credit, continued high unemployment and a further decline in consumer confidence. However, we did see some improvement in sales pace in the latter part of July and in August.
Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures:
Quarter 2010 2009 2008 2007 2006
First 21% 31% 38% 36% 30% Second 17% 24% 29% 32% 32% Third 23% 23% 32% 35% 33% Fourth 24% 42% 40% 35%
Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures:
Quarter 2010 2009 2008 2007 2006
First 13% 22% 16% 17% 11% Second 17% 31% 24% 19% 15% Third 15% 23% 20% 18% 14% Fourth 20% 30% 26% 16%
Historically, most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of buyers' failures to qualify for a mortgage, which generally occurs during the first few weeks after signing. However, beginning in fiscal 2007, we experienced a higher than normal number of cancellations later in the construction process. These cancellations were related primarily to falling prices, sometimes due to new discounts offered by us and other builders, leading the buyer to lose confidence in their contract price and due to tighter mortgage underwriting criteria leading to some customers' inability to be approved for a mortgage loan. In some cases, the buyer will walk away from a significant nonrefundable deposit that we recognize as other revenues. While our cancellation rate based on gross sales contracts for the third quarter of fiscal 2010 increased over the prior two quarters, it is, however, what we view as a more normalized level, as seen in fiscal 2003 and 2004. It is difficult to predict if this trend will continue. The cancellation rate as a percentage of beginning backlog for the three quarters of fiscal 2010 has been lower than it has been for several prior quarters.
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Cost of sales includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as "land charges" in the tables below). A breakout of such expenses for housing sales and housing gross margin is set forth below:
Three Months Ended Nine Months Ended July 31, July 31, (Dollars in thousands) 2010 2009 2010 2009 Sale of homes $368,077 $367,141 $987,923 $1,107,891 Cost of sales, net of impairment reversals and excluding interest 305,054 333,887 821,776 1,022,496 Homebuilding gross margin, before cost of sales interest expense and land charges 63,023 33,254 166,147 85,395 Cost of sales interest expense, excluding land sales interest expense 20,918 20,363 59,290 67,752 Homebuilding gross margin, after cost of sales interest expense, before land charges 42,105 12,891 106,857 17,643 Land charges 48,959 101,130 55,111 521,505 Homebuilding gross margin, after cost of sales interest expense and land charges $(6,854) $(88,239) $51,746 $(503,862) Gross margin percentage, before cost of sales interest expense and land charges 17.1% 9.1% 16.8% 7.7% Gross margin percentage, after cost of sales interest expense, before land charges 11.4% 3.5% 10.8% 1.6% Gross margin percentage, after cost of sales interest expense and land charges (1.9)% (24.0)% 5.2% (45.5)%
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Cost of sales expenses as a percentage of home sales revenues are presented below: Three Months Ended Nine Months Ended July 31, July 31, 2010 2009 2010 2009 Sale of homes 100.0% 100.0% 100.0% 100.0% Cost of sales, net of impairment reversals and excluding interest: Housing, land and 69.5% 76.6% development costs 70.2% 75.6% Commissions 3.5% 3.4% 3.4% 3.3% Financing concessions 2.2% 2.3% 2.2% 2.4% Overheads 7.0% 9.6% 8.1% 10.0% Total cost of sales, before interest expense and land charges 82.9% 90.9% 83.2% 92.3% Gross margin percentage, before cost of sales interest expense and land charges 17.1% 9.1% 16.8% 7.7% Cost of sales interest 5.7% 5.6% 6.0% 6.1% Gross margin percentage, after cost of sales interest expense and before land charges 11.4% 3.5% 10.8% 1.6%
We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margins, before interest expense and land impairment and option write off charges, increased to 17.1 % during the three months ended July 31, 2010 compared to 9.1% for the same period last year and increased to 16.8% during the nine months ended July 31, 2010 compared to 7.7% for the same period last year. The increase in gross margin percentage is primarily due to the fact that the prior year included final deliveries in older communities with lower gross margins, while in 2010 we have increased the number of deliveries from new communities where we have acquired the land at more reasonable prices resulting in higher gross margins.
Reflected as inventory impairment loss and land option write-offs in cost of sales ("land charges"), we have written-off or written-down certain inventories totaling $49.0 million and $101.1 million during the three months ended July 31, 2010 and 2009, respectively, and $55.1 million and $521.5 million during the nine months ended July 31, 2010 and 2009, respectively, to their estimated fair value. During the three and nine months ended July 31, 2010, we wrote-off residential land options and approval and engineering costs amounting to $(0.7) million and $1.0 million, compared to $6.5 million and $30.1 million for the three and nine months ended July 31, 2009, which are included in the total adjustments mentioned above. When a community is redesigned, abandoned engineering costs are written-off. Option and approval and engineering costs are written-off when a community's proforma profitability is not projected to produce adequate returns on the investment commensurate with the risk and we believe it is probable we will cancel the option. Occasionally, as is the case in the third quarter of fiscal 2010, these write-offs are offset by recovered deposits (sometimes through legal action) that had been written off in a prior period as walk-away costs. We recorded inventory impairments of $49.7 million and $94.6 million during the three months ended July 31, 2010 and 2009 and $54.1 million and $491.4 million during the nine months ended July 31, 2010 and 2009, respectively. Inventory impairments for the nine months ended July 31, 2010 were lower than they have been in several years, as we have begun to see some stabilization in prices and sales pace in most of our segments. It is difficult to predict if this trend will continue and, should it become necessary to further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may be required to recognize additional impairments. See "Notes to Condensed Consolidated Financial Statements" - Note 5 for an additional information of segment impairments.
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Land Sales and Other Revenues:
Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below:
Three Months Ended Nine Months Ended July 31, July 31, (In thousands) 2010 2009 2010 2009 Land and lot sales $2,786 $8,488 $3,821 $14,388
Cost of sales, excluding interest 1,000 3,982 1,020 7,197 Land and lot sales gross margin,
excluding interest 1,786 4,506 2,801 7,191 Land sales interest expense 1,266 4,258 1,487 6,038
Land and lot sales gross margin,
including interest $520 $248 $1,314 $1,153
Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. For the three months ended July 31, 2010, the primary land sale was for a parcel of land in the Midwest where we were able to negotiate a favorable price significantly higher than its adjusted value. For the nine months ended July 31, 2010, the primary land sale was for commercially zoned property acquired as part of a land purchase for residential homes. We had no book value for this property, so the costs associated with the sale are commission and other closing costs.
Land sales and other revenues decreased $7.3 million and $17.2 million for the three and nine months ended July 31, 2010, respectively, compared to the same periods in the prior year. Other Revenues include income from contract cancellations, where the deposit has been forfeited due to contract terminations, interest income, cash discounts, buyer walk aways and miscellaneous one-time receipts. In addition to the $5.7 million and $10.6 million reduction in land sales revenue for the three and nine months ended July 31, 2010 shown above, the primary reason for the decrease was a reduction in interest income due to lower excess cash in interest bearing accounts, as well as lower interest rates for both the three and nine months of fiscal 2010 compared to 2009. Also contributing to the decrease is significantly less income from forfeited customer deposits as a result of less cancellations in fiscal 2010 compared to fiscal 2009.
Homebuilding Selling, General and Administrative
Homebuilding selling, general and administrative expenses as a percentage of homebuilding revenues decreased to 11.3% for the three months ended July 31, 2010, compared to 14.6% for the three months ended July 31, 2009, and decreased to 12.8% for the nine months ended July 31, 2010, compared to 16.5% for the nine months ended July 31, 2009. Expenses decreased $13.1 million and $59.5 million for the three and nine months ended July 31, 2010 compared to the same periods last year as we have reduced these costs through headcount reduction, administration consolidation, and other cost saving measures.
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HOMEBUILDING OPERATIONS BY SEGMENT
Segment Analysis
Three Months Ended July 31, (Dollars in thousands, except 2010 2009 Variance Variance % average sales price) Northeast Homebuilding revenue $92,179 $86,163 $6,016 7.0% Loss before taxes $(15,510) $(43,201) $27,691 (64.1)% Homes delivered 221 201 20 10.0% Average sales price $415,113 $421,697 $(6,584) (1.6)% Contract cancellation rate 19.8% 20.2% (0.4)% Mid-Atlantic Homebuilding revenue $72,876 $76,521 $(3,645) (4.8)% Income (loss) before taxes $3,248 $(16,834) $20,082 (119.3)% Homes delivered 194 200 (6) (3.0)% Average sales price $375,088 $378,155 $(3,067) (0.8)% Contract cancellation rate 28.6% 28.2% 0.4% Midwest Homebuilding revenue $24,437 $30,075 $(5,638) (18.7)% Loss before taxes $(1,190) $(3,806) $2,616 (68.7)% Homes delivered 110 128 (18) (14.1)% Average sales price $205,909 $233,789 $(27,880) (11.9)% Contract cancellation rate 24.4% 26.0% (1.6)% Southeast Homebuilding revenue $28,843 $23,617 $5,226 22.1% Loss before taxes $(1,352) $(7,900) $6,548 (82.9)% Homes delivered 121 95 26 27.4% Average sales price $235,719 $243,705 $(7,986) (3.3)% Contract cancellation rate 14.7% 18.2% (3.5)% Southwest Homebuilding revenue $103,597 $113,403 $(9,806) (8.6)% Income (loss) before taxes $7,033 $(16,036) $23,069 (143.9)% Homes delivered 472 500 (28) (5.6)% Average sales price $218,358 $211,036 $7,322 3.5% Contract cancellation rate 23.9% 23.6% 0.3% West Homebuilding revenue $49,966 $48,070 $1,896 3.9% Loss before taxes $(39,070) $(63,795) $24,725 (38.8)% Homes delivered 198 198 - 0.0% Average sales price $249,157 $243,200 $5,957 2.4% Contract cancellation rate 20.8% 17.9% 2.9%
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Nine Months Ended July 31, (Dollars in thousands, except 2010 2009 Variance Variance % average sales price) Northeast Homebuilding revenue $218,686 $259,610 $(40,924) (15.8)% Loss before taxes $(30,281) $(273,511) $243,230 (88.9)% Homes delivered 538 586 (48) (8.2)% Average sales price $404,106 $434,725 $(30,619) (7.0)% Contract cancellation rate 22.4% 24.2% (1.8)% Mid-Atlantic Homebuilding revenue $207,615 $217,362 $(9,747) (4.5)% Income (loss) before taxes $5,369 $(66,590) $71,959 (108.1)% Homes delivered 552 582 (30) (5.2)% Average sales price $374,053 $370,297 $3,756 1.0% Contract cancellation rate 24.6% 33.3% (8.7)% Midwest Homebuilding revenue $63,986 $81,069 $(17,083) (21.1)% Loss before taxes $(7,215) $(18,548) $11,333 (61.1)% Homes delivered 291 355 (64) (18.0)% Average sales price $213,344 $227,282 $(13,938) (6.1)% Contract cancellation rate 16.7% 22.2% (5.5)% Southeast Homebuilding revenue $76,003 $92,404 $(16,401) (17.7)% Loss before taxes $(6,307) $(47,933) $41,626 (86.8)% Homes delivered 308 393 (85) (21.6)% Average sales price $244,286 $229,010 $15,276 6.7% Contract cancellation rate 13.0% 22.5% (9.5)% Southwest Homebuilding revenue $289,968 $317,370 $(27,402) (8.6)% Income (loss) before taxes $17,969 $(55,760) $73,729 (132.2)% Homes delivered 1,316 1,390 (74) (5.3)% Average sales price $219,314 $219,883 $(569) (0.3)% Contract cancellation rate 20.5% 27.6% (7.1)% West Homebuilding revenue $138,936 $161,438 $(22,502) (13.9)% Loss before taxes $(49,477) $(259,582) $210,105 (80.9)% Homes delivered 520 612 (92) (15.0)% Average sales price $265,571 $263,571 $2,000 0.8% Contract cancellation rate 17.4% 17.2% 0.2%
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Homebuilding Results by Segment
Northeast - Homebuilding revenues increased 7.0% for the three months and decreased 15.8% for the nine months ended July 31, 2010, respectively, compared to the same periods of the prior year. The increase for the three months ended July 31, 2010 can be attributed to a 10.0% increase in homes delivered, offset by a 1.6% decrease in average sales price. The decrease for the nine months ended July 31, 2010 was primarily due to an 8.2% decrease in homes delivered and a 7.0% decrease in average sales price. Loss before income taxes decreased $27.7 million and $243.2 million to a loss of $15.5 million and $30.3 million for the three and nine months ended July 31, 2010. This decrease is mainly due to a $9.9 million and $173.4 million decrease in inventory impairment losses and land option write-offs recorded for the three and nine months ended July 31, 2010, respectively. In addition, gross margin percentage before interest expense increased for the three and nine months ended July 31, 2010, respectively.
Mid-Atlantic - Homebuilding revenues decreased 4.8% and 4.5% for the three and nine months ended July 31, 2010, respectively, compared to the same periods of the prior year. The decreases were primarily due to a 3.0% and 5.2% decrease in homes delivered which was further impacted by a 0.8% decrease in average sales price for the three months ended July 31, 2010 and was offset by a 1.0% increase in average sales price for the nine months ended July 31, 2010, as a result of the different mix of communities delivering in 2010 compared to 2009. Loss before income taxes decreased $20.1 million and $72.0 million to a profit of $3.2 million and $5.4 million for the three and nine months ended July 31, 2010, respectively, due partly to a $14.2 million and $48.4 million decrease in inventory impairment losses and land option write-offs for the three and nine months, as well as increased gross margin for the period.
Midwest - Homebuilding revenues decreased 18.7% and 21.1% for the three and nine months ended July 31, 2010, respectively, compared to the same periods of the prior year. The decreases were primarily due to a 14.1% and 18.0% decrease in homes delivered and an 11.9% decrease and 6.1% decrease in average sales price for the three and nine months ended July 31, 2010, respectively. The decreases in average sales prices were the result of the mix of communities delivering in the three and nine months ended July 31, 2010 compared to the same periods of 2009. Loss before income taxes decreased $2.6 million and $11.3 million to a loss of $1.2 million and $7.2 million for the three and nine months ended July 31, 2010, respectively. The decrease in the loss for the three and nine months ended July 31, 2010, was primarily due to a $1.4 million and $6.8 million decrease in inventory impairment losses and land option write-offs for the three and nine months, as well as increased gross margin for the period.
Southeast - Homebuilding revenues increased 22.1% for the three months and decreased 17.7% for the nine months ended July 31, 2010, respectively, compared to the same periods of the prior year. The increase for the three months ended July 31, 2010 can be attributed to the 27.4% increase in homes delivered, offset by a 3.3% decrease in average sales price. The decrease for the nine months ended July 31, 2010 was due to a 21.6% decrease in homes delivered, offset by a 6.7% increase in average sales price. The fluctuations in average sales price was primarily due to the different mix of communities delivering in 2010 compared to 2009. Loss before income taxes decreased $6.5 million and $41.6 million to a loss of $1.4 million and $6.3 million for the three and nine months ended July 31, 2010, respectively, due partly to a $2.4 million and $27.3 million decrease in inventory impairment losses and land option write-offs for the three and nine months ended July 31, 2010, as well as increased gross margin for the period.
Southwest - Homebuilding revenues decreased 8.6% for the three and nine months ended July 31, 2010 compared to the same periods of the prior year. The decreases were primarily due to a 5.6% and 5.3% decrease in homes delivered and a 3.5% increase and 0.3% decrease in average selling price for the three and nine months ended July 31, 2010, as a result of the different mix of communities delivering in the three and nine months ended July 31, 2010 compared to the same periods of 2009. Loss before income taxes decreased $23.1 million and $73.7 million to a profit of $7.0 million and $18.0 million for the three and nine months ended July 31, 2010, respectively. The return to profitability for the three and nine months ended July 31, 2010 was also partially due to a $9.5 million and $42.5 million decrease in inventory impairment losses and land option write-offs, as well as increased gross margin for the period.
West - Homebuilding revenues increased 3.9% and decreased 13.9% for the three and nine months ended July 31, 2010, respectively, compared to the same periods of the prior year. The increase for the three months ended July 31, 2010 can be attributed to the 2.4% increase in average sales price. The decrease for the nine months ended July 31, 2010 was primarily due to a 15.0% decrease in homes delivered, partially offset by a 0.8% increase in average selling price for the nine months ended July 31, 2010. The decrease in deliveries was the result of the continued slowing of the housing market in California and reduced active communities as nearly half of our mothballed communities are in the West. Loss before income taxes decreased $24.7 million and $210.1 million to a loss of $39.1 million and $49.5 million for the three and nine months ended July 31, 2010. The decreased loss for the three and nine months ended July 31, 2010 was primarily due to an $14.7 million and $167.9 million decrease in inventory impairments and land option write-offs taken in the three and nine months ended July 31, 2010, respectively, compared to the same periods in the prior year. In addition, gross margin before interest expense increased for the three and nine months ended July 31, 2010, as we are starting to see signs of price stabilization in this market and the benefit of impairment reserve reversals as homes are delivered.
Financial Services
Financial services consist primarily of originating mortgages from our homebuyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of mortgage-backed securities ("MBS") to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. In an effort to reduce our exposure to the marketability and disposal of non-agency and non-governmental loans, including Alt-A (FICO scores below 680 and depending on credit criteria) and sub-prime loans (FICO scores below 580 and depending on credit criteria), we require our Financial Services segment to either presell or broker all of these loans, on an individual loan basis as soon as they are committed to by the customer. However, because of the tightening standards by mortgage lenders, none of the loans we originated during fiscal 2009 and the first three quarters of 2010 were Alt-A or sub-prime. As Alt-A and sub-prime originations declined, we have seen an increase in our level of Federal Housing Administration and Veterans Administration ("FHA/VA") loan origination. FHA/VA loans represented 54.8% and 45.1% for the first three quarters of fiscal 2010 and 2009, respectively, of our total loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected.
During the three and nine months ended July 31, 2010, financial services provided a $2.6 million and $6.2 million pretax profit, respectively, compared to $2.6 million and $6.7 million of pretax profit for the same period of fiscal 2009. While revenues were down 10.9% for the first three quarters of fiscal 2010, costs were down 12.1% for such period. This was due primarily to headcount reductions during fiscal 2009. There were severance payments resulting from personnel reduction in the first quarter of 2009 which did not re-occur in 2010. In addition, we amortized the applicable portion of an accrual for vacant lease space during the first three quarters of 2010. Also, mortgage settlements decreased for the nine months ended July 31, 2010 compared to the same period in the prior year. In the market areas served by our wholly owned mortgage banking subsidiaries, approximately 83.2% and 81.1% of our non-cash homebuyers obtained mortgages originated by these subsidiaries during the three months ended July 31, 2010 and 2009, respectively, and 80.8% and 78.9% during the nine months ended July 31, 2010 and 2009, respectively. Servicing rights on new mortgages originated by us will be sold with the loans.
Corporate General and Administrative
Corporate general and administrative expenses include the operations at our headquarters in Red Bank, New Jersey. These expenses include payroll, stock compensation, facility and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services and administration of insurance, quality and safety. Corporate general and administrative expenses decreased to $14.8 million for the three months ended July 31, 2010, compared to $15.5 million for the three months ended July 31, 2009, and decreased to $45.2 million for the nine months ended July 31, 2010, compared to $64.8 million for the nine months ended July 31, 2009. During the first quarter of fiscal 2009, the Chief Executive Officer, Chief Financial Officer and each of the non-executive members of the Board of Directors consented to the cancellation of certain of their options (with the full understanding that the Company made no commitment to provide them with any other form of consideration in respect of the cancelled options) in order to reduce a portion of the equity reserve "overhang" under the Company's equity compensation plans represented by the number of shares of the Company's common stock remaining available for future issuance under such plans (including shares that may be issued upon the exercise or vesting of outstanding options and other rights). As a result of this cancellation, we recorded an additional expense of $12.3 million in the first half of 2009. This charge to operations was offset by a credit to paid in capital. Excluding this option cancellation expense, corporate, general and administrative expenses decreased $0.7 million and $7.2 million for the three and nine months ended July 31, 2010 compared to the same period of 2009, primarily due to reduced salaries resulting from headcount reduction, and continued tightening of variable spending.
Other Interest
Other interest decreased $1.3 million and increased $4.9 million for the three and nine months ended July 31, 2010, respectively, compared to the three and nine months ended July 31, 2009. Our assets that qualify for interest capitalization (inventory under development) do not exceed our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. For the nine months ended July 31, 2010, our qualifying assets have declined enough to cause the amount of interest required to be directly expensed to have increased. However, in the three months ended July 31, 2010, our qualifying assets increased compared to the prior period thus resulting in less directly expensed interest.
Other Operations
Other operations consist primarily of miscellaneous residential housing operations expenses, senior rental residential property operations, rent expense for commercial office space, amortization of prepaid bond fees, minority interest relating to consolidated joint ventures, and corporate owned life insurance. Other operations decreased to $1.8 million and $5.5 million for the three and nine months ended July 31, 2010, respectively, compared to $2.0 million and $8.6 million for the three and nine months ended July 31, 2009, respectively. The decreases were primarily due to decreased prepaid bond fees amortization as our debt has been reduced and decreased rent expenses from amortization of abandoned lease accruals. In addition, we previously announced in March of this year that we were considering investing approximately $40.0 million on a newly formed company, "Newco", that would have provided finished lots to us and other homebuilders. We have decided not to make this investment in Newco and in the third quarter of fiscal 2010 we wrote-off our costs related to this investment which were to be reimbursed by Newco.
Gain on Extinguishment of Debt
During the three and nine months ended July 31, 2010, we repurchased in the open market a total of $24.6 million principal amount and $123.5 million principal amount, respectively, of various issues of our unsecured senior and senior subordinated notes due 2010 through 2017 for an aggregate purchase price of $19.3 million and $97.9 million, respectively, plus accrued and unpaid interest. We recognized a gain of $5.3 million and $25.0 million for the three and nine months ended July 31, 2010, respectively, net of the write-off of unamortized discounts and fees related to these purchases which represents the difference between the aggregate principal amount of the notes purchased and the total purchase price. During the nine months ended July 31, 2009, we repurchased in the open market a total of $578.3 million principal amount of various issues of our unsecured senior and senior subordinated notes due 2010 through 2017 for an aggregate purchase price of $223.1 million, plus accrued and unpaid interest. We recognized a gain of $349.5 million net of the write-off of unamortized discounts and fees, related to these purchases which represents the difference between the principal amounts of the notes and the aggregate purchase price. In addition, on December 3, 2008, we exchanged a total of $71.4 million principal amount of various issues of our unsecured senior notes due 2012 through 2017 for $29.3 million in senior secured 18% notes due 2017. This exchange resulted in a recognized gain of $41.3 million. During the three months ended July 31, 2009, we completed cash tender offers whereby we purchased an aggregate of approximately $119.2 million principal amount of various issues of our unsecured senior and senior subordinated notes due 2010 through 2017 for an aggregate purchase price of approximately $80.5 million, plus accrued unpaid interest. As a result of the tender offers we recognized a gain of $37.0 million in the third quarter, net of the write-off of unamortized discounts and fees. We may continue to make additional debt purchases and/or exchanges through tender offers, open market purchases, private transactions or otherwise from time to time depending on market conditions and covenant restrictions.
Loss From Unconsolidated Joint Ventures
Loss from unconsolidated joint ventures was $0.9 million for both the three and nine months ended July 31, 2010, compared to losses of $5.5 million and $38.2 million for the three and nine months ended July 31, 2009, respectively. The decrease in the loss is mainly due to significant charges in the three and nine months ended July 31, 2009 for the write down of our investment in one of our joint ventures where the full amount of the investment is deemed to be other-than temporarily impaired, as well as for our share of the losses from inventory impairments from another of our joint ventures. We did not have any investment write-downs or impairments in our joint ventures during the first three quarters of 2010.
Total Taxes
Total income tax benefit was $7.0 million for the three months ended July 31, 2010, primarily due to a decrease in tax reserves for uncertain tax positions. The total income tax benefit was $297.5 million for the nine months ended July 31, 2010, primarily due to the benefit recognized for a federal net operating loss carryback. On November 6, 2009, President Obama signed the Worker, Homeownership, and Business Assistance Act of 2009, under which, the Company was able to carryback its 2009 net operating loss five years to previously profitable years that were not available to the Company for carryback prior to this tax legislation. We recorded the benefit for the carryback of $291.3 million in the first quarter of fiscal 2010. We received $274.1 million of the federal income tax refund in the second quarter of 2010 and expect to receive the remaining $17.2 million in the first quarter of fiscal 2011.
Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years' income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried back to income in prior years, if available, or carried forward to future years to recover the deferred tax assets. In accordance with ASC 740, we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a "more likely than not" standard. Given the continued downturn in the homebuilding industry during 2007, 2008 and 2009, resulting in additional inventory and intangible impairments, we are in a three year cumulative loss position as of October 31, 2009. According to ASC 740, a three-year cumulative loss is significant negative evidence in considering whether deferred tax assets are realizable. Our valuation allowance for current and deferred tax assets increased $33.0 million during the three months ended July 31, 2010 due to reserving for the tax benefit generated from the losses during the period. However, allowance decreased $240.9 million during the nine months ended July 31, 2010 primarily due to the impact of a federal net operating loss carryback recorded in the first quarter of 2010, partially offset by additional reserves recorded for the federal tax benefit generated from the losses during the first nine months of fiscal 2010. At July 31, 2010, our total valuation allowance amounted to $746.6 million.
Inflation
Inflation has a long-term effect, because increasing costs of land, materials and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers.
Inflation has a lesser short-term effect, because we generally negotiate fixed price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. Construction costs for residential buildings represent approximately 60.8% of our homebuilding cost of sales.
Safe Harbor Statement
All statements in this Form 10-Q that are not historical facts should be considered "Forward-Looking Statements" within the meaning of the "Safe Harbor" provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions, or expectations will be achieved. Such risks, uncertainties and other factors include, but are not limited to:
. Changes in general and local economic and industry and business conditions; . Adverse weather conditions and natural disasters; . Changes in market conditions and seasonality of the Company's business; . Changes in home prices and sales activity in the markets where the Company builds homes; . Government regulation, including regulations concerning development of land, the home
building, sales and customer financing processes, and the environment; . Fluctuations in interest rates and the availability of mortgage financing; . Shortages in, and price fluctuations of, raw materials and labor; . The availability and cost of suitable land and improved lots; . Levels of competition; . Availability of financing to the Company; . Utility shortages and outages or rate fluctuations; . Levels of indebtedness and restrictions on the Company's operations and activities imposed
by the agreements governing the Company's outstanding indebtedness; . Operations through joint ventures with third parties; . Product liability litigation and warranty claims; . Successful identification and integration of acquisitions; . Significant influence of the Company's controlling stockholders; and . Geopolitical risks, terrorist acts and other acts of war.
Certain risks, uncertainties, and other factors are described in detail in Part I, Item 1 "Business" and Item 1A "Risk Factors" in our Form 10-K for the year ended October 31, 2009. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Form 10-Q.
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