Toll Brothers, Inc. (NYSE: TOL) Q3 2022 earnings call dated Aug. 24, 2022
Corporate Participants:
Douglas C. Yearley — Chairman and Chief Executive Officer
Martin P. Connor — Chief Financial Officer
Analysts:
Alan Ratner — Zelman & Associates — Analyst
Michael Rehaut — J.P. Morgan — Analyst
Daniel Oppenheim — Credit Suisse — Analyst
Spencer Kaufman — UBS — Analyst
Matthew Bouley — Barclays — Analyst
Susan Maklari — Goldman Sachs — Analyst
Mike Dahl — RBC Capital Markets — Analyst
Presentation:
Operator
Good morning, and welcome to the Toll Brothers’ Third Quarter Earnings Conference Call. [Operator Instructions] The company is planning to end the call at 9:30 when the market opens. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Douglas Yearley, CEO. Please go ahead.
Douglas C. Yearley — Chairman and Chief Executive Officer
Thank you, Jason. Good morning. Welcome, and thank you for joining us.
With me today are Marty Connor, Chief Financial Officer; Rob Parahus, President and Chief Operating Officer; Fred Cooper, Senior VP of Finance and Investor Relations; Wendy Marlett, Chief Marketing Officer; and Gregg Ziegler, Senior VP and Treasurer.
Before I begin, I ask you to read the statement on forward-looking information in our earnings release of last night and on our website. I caution you that many statements on this call are forward-looking based on assumptions about the economy, world events, housing and financial markets, interest rates, the availability of labor and materials, inflation, pandemic impacts and many other factors beyond our control that could significantly affect future results.
In our fiscal third quarter ended July 31, we reported earnings of $2.35 per share, up 26% compared to the third quarter of 2021 and driven by continued gross margin expansion. Our third quarter adjusted gross margin was 27.9%, an improvement of 230 basis points compared to last year and 90 basis points better than guidance. SG&A expense was 10.3% of homebuilding revenues, which was 20 basis points better than both our guidance and last year’s third quarter.
We delivered 2,414 homes in the quarter at an average price of approximately $935,000, generating $2.3 billion in homebuilding revenues. Although we achieved record third quarter revenues, net income and EPS and our revenues were lower than anticipated due to fewer deliveries than projected. The shortfall resulted from the combined impact of unforeseen delays with municipal inspections, continued labor shortages, ongoing supply chain disruptions and a softer demand environment.
We missed our deliveries guidance by 336 homes. Most of these deliveries were concentrated in a handful of communities and markets. For example in California, we had 200 homes that were completed at quarter end, but due to delays with city inspectors and with utility companies, we simply could not get the final inspections or the electricity needed to obtain certificate of occupancy.
The change in the demand environment also impacted Q3 deliveries. The combination of fewer spec sales, outsized lender delays, a modest uptick in cancellations and customers taking more time to sell their existing homes, all resulted in fewer deliveries. Due to these challenges, we are lowering our deliveries guidance. We now expect to deliver between 3,250 homes and 3,550 homes in our fourth quarter and between 10,000 homes and 10,300 homes for the full year.
Our adjusted gross margin in the third quarter at 27.9% was 90 basis points better than projected, primarily due to favorable mix and effective management of costs. We ended the quarter with a solid backlog of 10,725 homes, worth $11.2 billion. We had a total of 190 cancellations in the third quarter, equal to just 1.6% of the 11,768 homes in backlog at the beginning of the quarter and comparable to our cancellation rate of 1.2% in the first half of 2022.
For context since 2010, our average cancellation rate as a percentage of backlog has been 2.3%. And yes, we think looking at cancellations as a percentage of backlog is much better than as a percentage of current orders. We have not seen any change in cancellation rates in the first few weeks of August. We have consistently had the lowest cancellation rate in the industry for many decades, which speaks to the financial strength of our customers and our build-to-order model where buyers personalize their homes and become emotionally invested. They make a non-refundable down payment averaging $80,000. So, they are also financially invested.
As our low backlog cancellation rate in the third quarter attests, our buyers have remained committed to their new homes even in this uncertain environment. Our backlog consists of homes sold in the very strong pricing environment of the past year, which puts us in a great position to continue to expand our gross margin in the fourth quarter and into fiscal year 2023. We project an adjusted gross margin of 29.2% for the fourth quarter and we are reaffirming our full-year guidance of 27.5%.
Turning to market conditions. As our third quarter progressed, we saw a significant decline in demand, as many prospective buyers stepped to the sidelines in the face of steep increases in mortgage rates, significantly higher home prices, a volatile stock market and rising inflation. Buyer confidence was also impacted by the non-stop headlines about a softening housing market and by a general sense of uncertainty regarding the future direction of the economy.
All of these factors led to a market change in psychology, and buyers remain cautious through the summer months. As a result, our net signed contracts were down approximately 60% in units compared to last year’s historically strong third quarter. On a dollar basis, signed contracts were down 44% year-over-year as contracts in the third quarter benefited from price increases we had steadily applied throughout the year.
For most of the third quarter, we purposely did not chase buyers with incentives as we felt demand was very inelastic. Buyers were on the sidelines. They were not looking for a better deal. On average, incentives in our third quarter contracts were approximately $16,000 per home, up only $5,000 from the average over the first half of 2022.
In more recent weeks, we have seen signs of increased demand as sentiment appears to be improving and buyers are returning to the market. With higher quality traffic, we have also started to modestly increase incentives, which buyers are responding to. August sales included an average incentive of about $30,000. In the first three weeks of August, our average weekly non-binding deposits were up 25% compared to July. We have also seen digital leads and foot traffic to our model homes increase.
Our sales teams are reporting higher quality traffic and in several recently opened new communities, we have seen great deposit activity. Although we are only talking about a few weeks, these are encouraging signs and we are cautiously optimistic that the housing market is settling into a more normal seasonal cadence. Despite the near-term uncertainty, we believe that many fundamental drivers that have supported the housing market in recent years remain firmly in place.
These include favorable demographics, with more and more millennials reaching their prime homebuying years and baby boomers relocating as they embrace new lifestyles, the undersupply of new homes over the past decade, which has led to a large deficit and tight supply of homes for sale, migration trends driven by more workplace flexibility and the greater appreciation for home that Americans have embraced in the past few years. We believe these long-term secular trends will continue to support demand for homeownership well into the future.
In the current environment, we believe it is important — excuse me, more important than ever to remain disciplined and capital efficient in our operations and our land acquisition strategy. We are even more focused on controlling SG&A costs and becoming more efficient as we manage headcount and reduce SG&A expenditures. We have also become more conservative in our underwriting of new land deals, and we’ll continue to renegotiate or terminate optioned land if a project no longer meets our stricter underwriting standards.
At the end of the third quarter, we owned or controlled approximately 82,100 lots, 3,700 fewer lots than at the end of the second quarter. Approximately 51% of these lots were optioned, a decline from 53% at second quarter end, due in part to our terminating option of over 3,000 lots in the quarter. Longer term, we continue to target an overall mix of 60% optioned and 40% owned lots. As a reminder, nearly 11,000 of our total owned lots are committed to buyers in our backlog. When you exclude these lots, 59% of our land is controlled through options.
We also remain focused on our return on equity. In the third quarter, we repurchased $92 million of our common stock. Since the beginning of the fiscal year, we have repurchased approximately $385 million, or 5.8% of our diluted share count at the end of fiscal year 2021. We have also paid $67 million in dividends year-to-date and we retired $410 million of long-term debt in our first quarter. We expect share repurchases to remain an important part of our capital allocation priorities for the foreseeable future. Additionally, we continue to employ capital efficient strategies in our land buy.
Last week, we announced a new joint venture between our City Living division and Sculptor Real Estate to develop two luxury condominium communities in the New York City market, including the latest addition to our Provost Square development in Jersey City, where we have sold 60 units at an average price of $1.1 million over the past three months. We will act as a managing member and development lead overseeing approvals, design, construction and sales. We hope to add future properties to this venture. The structure of these transactions and our strategic partnership with a seasoned team at Sculptor demonstrate our commitment to maximizing the capital efficiency of our City Living operation.
With that, I’ll turn it over to Marty.
Martin P. Connor — Chief Financial Officer
Thanks, Doug.
Before we jump into the income statement, let me address the average sales price for our new signed contracts in the quarter. The average selling price attributed to contracts signed in fiscal year ’22’s third quarter was $1.3 million. It’s important to point out that this average contract value was skewed higher this quarter due to the lower number of contracts we signed.
Consistent with our normal practice, our total contract value for the quarter includes both the dollar value of new contracts signed in the quarter and the dollar value of option sales that occurred in the quarter on homes sold in prior quarters. Remember, it’s not unusual for our buyers to select finishing options a quarter or two after they signed the initial contract of sales. And while this practice typically does not skew the quoted average sale price for new orders, it did this quarter because of the much smaller denominator from fewer contracts in Q3 versus Q2 and Q1.
On a normalized basis, we estimate that the Q3 contracts average selling price was closer to $1.15 million, which was still up approximately 7% compared to Q2. This 7% increase was attributable to our pricing strategy throughout the previous year, including our decision not to incentivize through much of the third quarter and also by positive mix. In our third quarter, we generated homebuilding revenues of $2.3 billion, down 7% in units and up 1% in dollars from one year ago.
We also reported pre-tax income of $366 million compared to $303 million in the third quarter of fiscal ’21. Net income was $273.5 million, or $2.35 per share diluted, compared to $235 million and $1.87 per share diluted one year ago. The increase in pre-tax and net income compared to last year was primarily driven by the significant year-over-year expansion in gross margin.
Our third quarter adjusted gross margin was 27.9% compared to 25.6% in the third quarter of ’21, a 90 basis points better than projected. As Doug mentioned, the outperformance relative to our guide was due primarily to favorable mix and effective management of costs. We expect adjusted gross margin to be 29.2% in the fourth quarter and therefore, we continue to project 27.5% gross margin for the full year.
The estimated gross margin of homes in our backlog is high, reflecting the strong and improving price environment that held through most of our third quarter. With 10,725 homes in backlog and approximately 3,400 deliveries projected for our fourth quarter at our midpoint, we have more than 7,000 homes in backlog that will form the foundation of our deliveries in fiscal year 2023.
The estimated gross margin that is embedded in these deliveries is better than our projected full-year 2022 margin. SG&A as a percentage of revenue in our third quarter was 10.3% compared to 10.5% in Q3 of last year, and 20 basis points better than projected despite lower than projected revenue. This was primarily due to lower-than-anticipated selling and marketing expenses.
Third quarter joint venture, land sales and other income was $13.2 million, exceeding our breakeven guidance, mostly due to gains on land sold into joint ventures that we had originally projected would occur later in the year. We had previously expected to sell several of our stabilized apartment living and student housing properties in our fourth quarter, which were projected to generate approximately $50 million in income from unconsolidated entities. However, we are pushing these sales into fiscal year 2023, when we expect to see better pricing from buyers. As a result, we are lowering our 2022 full-year joint venture, land sales and other income to $60 million.
Overall, our total investment in Apartment Living at the end of our fiscal third quarter was $565 million. It consisted of a $133 million in 18 properties that were either stabilized or in lease-up, where we believe we have unrealized gains of approximately $400 million. In addition to the $133 million, we have $289 million invested in 23 properties that are currently in joint venture and under construction, and another $143 million in land and projects, 28 in total that are 100% on our balance sheet, but slated for future development in joint ventures. This pipeline should allow us to produce a consistent series of gains from apartment sales in future years. We expect the earnings from these gains on apartment sales will continue to be a nice complement to our core homebuilding business.
Turning back to our results. Impairments and write-offs were $6.2 million in the quarter, primarily reflecting some due diligence cost or lost deposits on land that we are no longer pursuing because it doesn’t meet our stricter underwriting standards. Our tax rate in the third quarter was 25.3%, 70 basis points better than projected. We now project the tax rate of approximately 24.8% for the fourth quarter and 25% for the full year. This is a slight improvement over our prior guide as we now expect approximately $10 million in Section 45 energy tax credits that were reinstated in the recently signed Inflation Reduction Act.
We finished the quarter with a net debt-to-capital ratio of 34.3%. We had $316.5 million in cash and equivalents and $1.8 billion available on our — under our $1.9 billion revolving bank credit facility, which doesn’t mature for over four years. This provides us with ample flexibility to both grow and return capital to our shareholders. At quarter end, our book value per share was $48.74. We expect this to be approximately $52.50 at fiscal year end.
Let me cover the additional items in our guidance that we have not already touched on. Based on the strong pricing in our backlog, we expect our fourth quarter average delivered price to be between $935,000 and $955,000. We’ve increased the full-year average to $920,000 at the midpoint. We expect interest and cost of sales to be approximately 1.8% of home sales revenues in the fourth quarter and for the full year, representing a 40 basis point decline compared to full-year 2021. This decline is primarily due to the retirement of higher interest rate debt over the past few years, which has also decreased leverage. We expect to further reduce interest and cost of sales in fiscal year 2023.
We project SG&A as a percentage of home sales revenues to be approximately 8.7% in our fourth quarter and 10.5% for the full year. Our weighted average share count is expected to be 118.5 million for the full year. We expect community count to be approximately 350 at fiscal year end. We’ve lowered this community count projection due to the impact of entitlement delays and supply chain disruptions impacting land development and our strategy to intentionally deferred the opening of some communities until 2023.
Over the past two years, we are able to open communities earlier than normal without models and out of sale trailers or even offsite due to frenzied buyer demand. We do not see that continuing into the near future and we will shift back to our normal practice of opening communities with finished model homes and sales centers that are fully complete. Importantly, we own or control sufficient land for a significant increase in community count in fiscal year 2023.
And now let me turn it back to Doug.
Douglas C. Yearley — Chairman and Chief Executive Officer
Thank you, Marty.
I want to take this opportunity to thank our incredible Toll Brothers team members who continue to work tirelessly on behalf of our clients in these unprecedented times. It is their dedication and passion for our business that make us all so excited for the future.
Jason, now let’s open it up for questions.
Questions and Answers:
Operator
Thank you. [Operator Instructions] Our first question comes from Alan Ratner from Zelman & Associates. Please go ahead.
Alan Ratner — Zelman & Associates — Analyst
Hey, guys. Good morning. Thanks for taking the questions and all the color. Appreciate it. So I guess, first question just on the delivery guidance. I think you reduced it by about 1,000 homes for the year. I’m curious if you’re able to give a rough split, how much of that is kind of the supply chain challenges you guys referenced in terms of, hey, these homes are not going to get delivered or completed before year end like we previously thought versus how much of that is maybe just more of a conservative view on demand for you guys had been building more specs? And I assume there had been some assumption that you would sell and deliver some of those homes before year end. How much of the reduction is just conservatism around not having those homes sold and delivered in time for year end?
Douglas C. Yearley — Chairman and Chief Executive Officer
Thanks. Good question. Our model is about 80% build-to-order, 20% spec. And so the reduced guidance is probably, Alan, around 10% to 15% due to less spec sales that we’ll sell and deliver, what I call, same quarter or in a short period of time, since that’s not the primary part of our business model. And so the balance of, let’s call it 85% to 90% is primarily, I’d say, two-thirds of that balance is being driven by supply chain.
We’ve recently and the industry has recently run into these incredible problems with getting transformers from utility companies so we can get houses fired up with electricity that were completed and getting electric meters that you put on the outside of the house and things that — this is a new one for us, but it can be significant, as I mentioned with the issues in California. And then the balance of a third, I’d say is a combination of township issues with the inability to get inspections and to get certificates of occupancy and then some buyer delays, right?
There is more mortgage issues we have today, as the mortgage rates are a bit higher and there may be some more time for qualification. There could be a longer timeframe because buyers now find it a bit harder to sell their existing home, and then we’ve had this modest increase in cancellations, which we have certainly budgeted in, I said that August cancels are not up.
Historically, our cancels are still low, but they have moved up a little bit. So when you combine all of it, very little is due to the sell-and-deliver spec strategy since that’s not our primary business and more of it is just that bucket of items I just described, which really goes to primarily production and municipality-related production issues and utility company production issues. But that’s the bulk of it.
Alan Ratner — Zelman & Associates — Analyst
Got it. No, that’s really helpful. Thanks for walking through all that, Doug. Second, on the incentive environment, I think — I appreciate your comments there just in terms of the inelasticity of demand through the quarter. So it’s the easiest way to think about the incentives that you’re offering in August, $30,000. So that’s roughly double from where you were before, pretty modest overall. It’s about 1.5%, I guess, in terms of, I guess, the potential margin impact.
When you’re talking about your margin in backlog and kind of the expectation for improvement in ’23, recognizing that these incentives are on new orders today, what are the conversations like in terms of your buyers in backlog? Are they coming to you expecting a similar incentive? Are you prepared to offer that type of incentive to a buyer to keep them in backlog? And ultimately, how aggressive are you willing to get on the incentive front before kind of just taking a backseat and letting other builders compete in that area because traditionally you have not been very aggressive there?
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure. So, I’m going to give a little bit of a longer answer here because I know it’s on everybody’s mind. Our Q2 incentive was $11,000, which on a $1.1 million house, let’s call it 1%. May, it was $12,000. June, it was $15,000. July, it was $22,000 and August, it was $30,000. That’s $30,000 on a $1.1 million house. We’re still below 3% incentive, which historically, through good times is a very low incentive. When you sell $1.1 million house even in a great market, you tend to give the buyer $10,000, $15,000, $20,000, $30,000 to spend at our design studio or to finish their basement or help them with closing costs. It’s a normal incentive and we’re still in that range. We saw early on in May and June, and I talked about it a bit on the May call that we expected a slow summer.
We think buyers with not only the rise in home prices, but the doubling of mortgage rates and all the chatter about inflation, the headlines were starting to hit about a softening market, we knew they were headed to the sidelines. They were going to take the summer off, and we were not going to chase those buyers down with incentives. We have $11 billion in backlog. We’re going to focus on that backlog and it just wasn’t smart business for us with our business model to do that. We didn’t have finished spec inventory that we had to move out, and we made the business decision, I think, correctly to not chase that buyer down. It was inelastic. They were on the sidelines. They were not coming in asking what is this week’s deal. They weren’t negotiating.
From the 4th of July forward, we started seeing signs of better traffic. We survey our 350 sales teams around the country every week. I’m involved in calls for hours every Monday, and we started hearing the traffic is better. They’re interested, they’re back, they’ve absorbed the new market. Summer is moving on. They’re starting to think through their plans. And so we felt demand was getting a bit more elastic, meaning that buyers were interested. They knew it was more of a buyers market than it had been, but they were at the negotiating table interested in buying and so we moved the incentive up modestly and we’ve seen some pretty good results from that. Does that mean we’re done with incentivizing? It’s community by community.
We will continue to react to what we hear from the sales teams, and I think as summer is winding down, we’re going to continue to see better traffic, higher quality traffic, but we recognize it is certainly more of a buyer’ market and we will act accordingly. So, I’m not suggesting that the $30,000 of August is — I’m not calling the bottom here. We don’t know what lies ahead, but we certainly do feel better and we will act accordingly. But we’re not going to chase the incentives to a big number, and we don’t think we need to do that with our business model.
With respect to the backlog, which was another one of your questions, no, we do not negotiate with the backlog. We have about $80,000 in down payment. Do not underestimate the emotional connection our client has to the home. 80% of our buyers are custom designing the home out of the gate. It is their lot. It is their architecture. It is their structural changes and then they go to our design studio and they spend another $100,000, $200,000 on all the finishes. They have become emotionally attached. It is a move-up family primarily. This is about lifestyle changes for them. The kids are moving into a new school. This is the dream house.
And historically, we have not seen cancels rates anything close to the industry for all of those reasons. And so right now, the rates are low. We do not negotiate with the backlog. We work with them, if they need a little bit more time because of the house to sell, if we need to help them with different mortgage programs, there’s lots of different things we can do to help. But we — our backlog right now is secure and we are not going back and negotiating with that backlog. They are committed for the most part and moving forward.
Sorry for the long answer. But I know it’s on everyone’s mind.
Alan Ratner — Zelman & Associates — Analyst
No, I appreciate that. Thanks again.
Operator
The next question comes from Michael Rehaut from J.P. Morgan. Please go ahead.
Michael Rehaut — J.P. Morgan — Analyst
Great. Thanks. Good morning, and thanks for taking my questions.
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure, Michael.
Michael Rehaut — J.P. Morgan — Analyst
Good morning, Doug. First, I just wanted to hit on — to see if I can get a little more clarity on the statistic around average weekly deposits for the first three weeks of August, up 25% from July. It’s a very helpful number and obviously, around the narrative of the improvement that you’re starting to see. I was just curious for context, if we could kind of get that number on a year-over-year basis, in other words, August, first three weeks average weekly deposits versus the first three weeks or roughly, let’s say, August of ’21, as well as what the year-over-year was for July?
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure. So yes — and again, it’s only three weeks. I’m not — while I say we’re cautiously optimistic, I’m going to — a disclaimer here is we’re talking about three weeks. It’s a short window of time, but we are encouraged that deposits are up about 25% over July. When you look year-over-year, the three weeks of this July are down about 45% to the three….
Martin P. Connor — Chief Financial Officer
It’s August.
Douglas C. Yearley — Chairman and Chief Executive Officer
Through the August, my apologies. Thank you, Marty. The three weeks of this August are down about 45% to the same three weeks of last August. In terms of cadence, we talk about the same contracts in each month of May, June, July this year, which was about 420 agreements or orders per month. Now when you look at last year, July was elevated significantly over the last 2021’s May end of June. But this year, it was more level.
And so if you consider the deposits being up 25%, you just do the normal math on conversion ratios, it would be fair to say for the next week or so until this month is over, that 420 sales that we saw in July would be about 500, if you do that math. And I’m not going to guess at all as to what September and October may hold, except that I think we are encouraged by what we see and we’ve certainly loosened the strings, as I just mentioned to Alan, in terms of the incentives and we’re getting out of the summer doldrums. So we, again, have that cautious optimism as to where we’re headed.
Does that answer your questions?
Michael Rehaut — J.P. Morgan — Analyst
Yeah. The second part of that was what — was July down year-over-year? But you may even not have that in front of you. I guess the second question I had was just kind of drilling into the comments around gross margins. Last couple of calls, you talked about an expectation for fiscal ’23 gross margins to be up over fiscal ’22. I’m not sure if I heard it slightly different, but this call so far, what you’ve said is the gross margins in backlog are above what you expect for the overall fiscal ’22, and you expect expansion into fiscal ’23. I was wondering if you still feel what your level of confidence is that as you look at overall fiscal ’23, that might still be up over fiscal ’22?
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure. So on your — I do have the answer to your July. So, July ’22 deposits were down 56% over July 2021 deposits and July 2022 agreements were down 66% against July 2021 agreements. With respect to 2023’s gross margin, I think Marty laid it out in really good detail, which is, we have over 7,000 homes in backlog that we project will deliver in 2023. And that’s just taken the math of the total backlog, what we think we’ll deliver in this fourth quarter and the balance of it — or almost the entire balance of it is projected to deliver next year.
That, of course, is not our full-year deliveries because we still have homes we can sell in the fourth quarter and even into early 2023 that we’ll still deliver by October 31 of ’23, and that includes build-to-orders and that, of course, includes many of those 20% spec homes that I talked about, which is part of our strategy. It is that bucket that I can’t — and I’m not prepared right now on this call to give any guidance on. We usually do that in December. That is still our intention. But our point was simply that a significant portion of 2023’s deliveries are in backlog with very high margins. And so that part of the year is pretty well baked. But as for the balance that needs to be sold, we’ll have to see how the market evolves, and we’ll give more updates in December.
Michael Rehaut — J.P. Morgan — Analyst
All right. Perfect. Thanks so much. Appreciate it.
Douglas C. Yearley — Chairman and Chief Executive Officer
Very welcome.
Operator
The next question comes from Dan Oppenheim from Credit Suisse. Please go ahead.
Daniel Oppenheim — Credit Suisse — Analyst
Thanks very much. I was wondering in terms of the timing of community openings, you talked about delaying some openings to have them fully set. Given that some of the new communities when they come online, kind of strong orders, does that impact what you would think about in terms of overall order trends for the fourth quarter of the year?
Douglas C. Yearley — Chairman and Chief Executive Officer
Dan, we’re pretty well split with new community openings quarter-by-quarter. If we see the market improving or if we have a specific location where we have a lot of pent-up demand, we may go back to the COVID style open out of the back of a station wagon on a farm field. But that is not our intention right now. This company is always white-gloved to every opening. We are the Ritz-Carlton. We don’t open until everything is perfect, and that’s how we like to launch.
But when you get into a hot market, when you have a lot of pent-up demand, if we can get roads in and get houses built, right, which is the other part of it, we don’t want to be opening if we can’t pull permits and start construction. But if all of that falls together in certain locations, there will certainly be exceptions to our older and now current strategy of get the entrance in, get the flowers planted, get the model home perfect and off we go.
But in terms of the cadence, go ahead, Marty.
Martin P. Connor — Chief Financial Officer
Dan, we opened 20 to 25 communities in each of the first three quarters of this year, and we project to open 35 to 40 in the fourth quarter of this year. Now while that number is down compared to what we had previously thought, it is still up significantly over the first three quarters. So, we do expect a boost in the fourth quarter from new community openings compared to the most recent quarters, right?
Douglas C. Yearley — Chairman and Chief Executive Officer
And then next year, as we mentioned in our prepared comments, we are in a great position and that we have the land controlled for significant community count growth next year. And so we will open those communities. When and for the reasons I have described, well, again, it will be somewhat market dependent. I’m very encouraged that based on the openings that we continue to have and those that we’ve had over the last month, we have had significant success at the initial launch with a lot of pent-up demand and in some cases, we’ve sold 5, 10, 15, 20 homes in the first couple of weeks of a new launch. So the buyers are out there.
And if you have the right offerings in the right locations, we are seeing success. I mentioned 60 sales in three months in New York City at $1.1 million. New York didn’t get as soft as other markets — excuse me, wasn’t as hot as other markets over the last couple of years as people left the cities. And so there wasn’t quite the sticker shock and the community has — continues to be very successful with hundreds of qualified buyers on a list that we’re just working through to continue to sell there. So, there are certainly bright spots around the country with new openings, which we’re encouraged by.
Daniel Oppenheim — Credit Suisse — Analyst
Great. Thanks. And then just a quick follow-up. You mentioned the expectation of book value at year-end. I was jut wondering how you’re thinking about allocating capital given the discount to book sort of relative to this environment where you’re sort of reassessing, sort of putting more into land and touch?
Martin P. Connor — Chief Financial Officer
Well, Dan, we’ve demonstrated a commitment to returning capital to shareholders through the dividends that we paid this year as well as the buybacks. And we’ve done that as we’ve grown the company. I think we will continue to look at balancing buybacks. We’ll pay the dividends. And we will continue to pursue new land deals. Many of those new land purchases are from old land contracts, and they still work. It is increasingly difficult for new land deals to meet our underwriting standards. So the balance will continue to exist. We will see what the opportunity set is and what the cash flow is.
Daniel Oppenheim — Credit Suisse — Analyst
Great. Thank you.
Operator
The next question comes from John Lovallo from UBS. Please go ahead.
Spencer Kaufman — UBS — Analyst
Hey, guys. Good morning. This is actually Spencer Kaufman on for John. Thank you for the questions. Maybe just piggybacking off of some of the comments from the last question. Can you just talk about what you’re seeing across your various markets? Which markets are more challenged today? Which markets are hanging in better than most? And are you seeing any difference in buyer activity between your affordable luxury product and your more traditional homes?
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure. So the move up and the active adults have performed better than affordable luxury. And I think that’s because the buyers are wealthier and mortgage rates aren’t quite as important to them. It’s not a monthly payment affordability issue as you move up in price. So, we’ve seen that in the past in times like this, and it’s proving to be the case again. The best markets for us right now are our home turf here in Philadelphia, New Jersey, Southern California, I mentioned New York City, Atlanta, Denver, Dallas, the Southeast Coast of Florida, Raleigh.
The weakest markets, which happens every cycle are those that were the hottest. Because when the price goes up a lot, those markets tend to take a little longer to adjust. And that would include Phoenix; Austin, Texas; Boise, Idaho and Reno. And I think, again, it’s just an adjustment that’s occurring because of the prices being higher and the affordability. Those locations also tend to be a little bit lower priced for us in many cases. And so I think they probably fit a little bit more into that affordable luxury group that I mentioned, where as rates have gone up, there’s a bit more pressure.
Spencer Kaufman — UBS — Analyst
Okay. That’s helpful. Appreciate the color. And maybe can you just talk a little bit as to what would need to happen in order for you guys to see widespread impairments?
Douglas C. Yearley — Chairman and Chief Executive Officer
I’m sorry, I didn’t…
Martin P. Connor — Chief Financial Officer
Widespread impairments.
Douglas C. Yearley — Chairman and Chief Executive Officer
Oh.
Martin P. Connor — Chief Financial Officer
Yes. I think things would have to go a lot worse than they’re going right now for widespread impairments. And just to kind of reiterate the breakdown of our inventory that I gave last quarter, it hasn’t moved too much. We have about $9.4 billion of inventory. $6.25 billion of that is construction and progress associated with our backlog. So, there shouldn’t be much concern at all about that backlog. The backlog has upper-20s gross margin to it. We’re seeing very low cancellation rates.
So, there’s not too much to that. About $2.5 billion of our inventory is owned land that also has strong margins associated with it. And around $450 million of our inventory is land deposits and about $80 million of that is refundable. And those are four pieces of land that we have not acquired, that we have under optioned. So with a close to 30% gross margin and a 20% operating margin from home sales, we’d have to see dramatic reductions in price for impairments to be of concern.
And as you have that dramatic reduction in volume or price, you’re also going to have reductions in costs. So it would have to be much more significant than a 25% or 30% decline in price to trigger any impairments. And those impairments would be associated with those smaller buckets of inventory, land and deposits, not so much associated with our homes under construction and backlog.
Spencer Kaufman — UBS — Analyst
Thanks, Marty.
Operator
The next question comes from Matthew Bouley from Barclays. Please go ahead.
Matthew Bouley — Barclays — Analyst
Hey. Good morning, everyone. Thanks for taking the questions, and thanks for all the detail. So a question on ASP and pricing power in light of all these communities you’ve got coming online. I appreciate that detail you gave around the order ASP in Q3. So that’s helpful. But as we think about these future community openings, I mean, how should we think about sort of the opening price points and margins on that? Is that an area where you might flex a little bit, given current market conditions? Thank you.
Douglas C. Yearley — Chairman and Chief Executive Officer
Again, it’s very specific to the location and the interest. We hope not to flex. We like a 30% gross margin. But if we have to flex, we will. But that decision is made very locally. But we are very confident and comfortable with the underwriting we have in place now for these new openings that continue to show significant outsized gross margins. So again, it will — we go through a pricing analysis before every community opens, and that analysis is based on detailed market comps, the number of VIP buyers we have that are interested in buying. And we do a full analysis and make decisions on where to open. And of course, we have a keen eye on what those returns are when we do that. But right now, I’m very comfortable that the communities we have slated to open over the next year will all perform well.
Matthew Bouley — Barclays — Analyst
Got it. No — thank you for that. And then just second one on, I guess, sales pace and underwritings. Presumably, if the sales pace, at this level, is maybe a little bit less than what you had sort of underwrote to in the past. I guess the question is, kind of how do you balance the — where you want inventory turns to get or to be versus just that potential pressure on returns? Or is the result of all that simply just reducing your acquisition of owned land? Like how do you kind of balance those points? Thank you.
Douglas C. Yearley — Chairman and Chief Executive Officer
Well, as we’ve been talking about for a few years, it’s not just profit margin, it’s also capital efficiency and ROE. So, we are absolutely balancing price with pace. The fact that we had a very slow quarter does not mean that our head is in the sand, and we’re not going to sell because we’re trying to maintain a margin. We recognize there is a balance. And the reason we didn’t have sales is what I described. In May, June and into the early summer, the buyers were on the sidelines, and we didn’t think it was about price unless you wanted to really drop the price to go grab those few buyers that might have been out there.
As that is changing, I think we will do a good job of balancing the incentive necessary to drive an absorption that will still have an eye on ROE and being capital efficient. So, we recognize the need and as part of our strategy to focus on driving strong margins, but also being capital efficient and having good returns. With respect to the land, our underwriting has gotten even tighter. I talked on the last call that we are now up to 60% combined gross margin and what we call internally IRR. So if you had a 30% gross margin, you needed a 30% IRR, that’s now 65%.
And on top of it being 65%, we are building in today’s sales pieces and today’s pricing. So that’s a bit of a double whammy because sales pace is down a bit and price with more incentives is down a bit. And on top of that, you’ve layered in the higher threshold that you have to hit. So, we’re going to continue to be disciplined. And by the way, when we exit due diligence, we’re doing that new analysis and deciding whether we want to go forward. And we’re going back to land sellers to renegotiate. And if they don’t come around, then we will drop deals.
The only reason our optioned lots went up modestly — excuse me, went down modestly this quarter is because we dropped 3,000 optioned lots, because they no longer penciled with our tighter underwriting. And the quarter before that, we dropped a couple of thousand lots for the same reason. So, I’m very happy with the discipline we’re bringing to land buying. We have a great land portfolio that allows us to grow community count significantly next year and we will continue operating this way into the future.
Matthew Bouley — Barclays — Analyst
Great. Thanks for all the detail, Doug.
Douglas C. Yearley — Chairman and Chief Executive Officer
You’re very welcome. Thank you.
Operator
The next question comes from Susan Maklari from Goldman Sachs. Please go ahead.
Susan Maklari — Goldman Sachs — Analyst
Thank you. Good morning, everyone.
Douglas C. Yearley — Chairman and Chief Executive Officer
Good morning.
Susan Maklari — Goldman Sachs — Analyst
My first question is, can you just talk a little bit about the supply chain and build times? And as we are seeing the market shift, how you’re thinking about the forward trajectory for the construction cycles as we go into the back half of this year and then into next year?
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure. So right now, our cycle time from agreement is about 13 months on average, 380 days. That’s not pure construction because the front end — it takes a while for the client to fix their finishes, their options and for us to get a building permit. So the actual build cycle time is not that full 380. Affordable luxury is about 60 days less than that because the houses are smaller and a bit simpler. It is up. It continues to climb. Right now, the stress I mentioned is on things we took for granted like transformer boxes.
You guys have all seen those green boxes in the front yard of houses that generally handle about four homes to six homes on a street. You have to put a transformer down, which gets the electricity to those four to six houses. And utility companies have apparently run out of them at the moment or are having a hard time finding them. And this is just the whack-a-mole issue that the industry is dealing with. Finished trades right now, our houses are a bit more complicated when you get beyond Toll Brothers — when you get beyond drywall with the Toll Brother’s home, there’s a lot more that goes into those finishes, with tile and millwork and cabinets and things like that.
And on the finish end right now, we’re feeling a bit of pressure with the late — with trades. And so I think that’s pushed out. If you look at drywall to delivery, we’ve added a couple of weeks from what we used to have. So that’s the latest issue that we are addressing. There are some encouraging signs that I have for next year, when it comes to supply chain. We are on the phone regularly with our biggest suppliers, and I’m hearing some encouraging words in that regard. But we’re not building that into any of the projections we’re making internally or to you.
Susan Maklari — Goldman Sachs — Analyst
Okay. That’s helpful. And then following up, understanding that spec is only about 20% of the business, but can you talk about where you are in terms of the spec inventory and how you’re thinking about adding to that as we go forward?
Douglas C. Yearley — Chairman and Chief Executive Officer
Yeah. We’re in really good shape right now with spec. We have about 1,800 what we define as spec, which means the homes have a footing, which is a foundation in the ground. So spec doesn’t mean it’s finished. Internally, it means we have started a home. We have poured concrete. We have a footing in place for a home that has not yet sold. And sometimes we’ll sell that house at frame because now you can get it in five months instead of getting it in 13 months, and sometimes we’ll hold that house until finishes. So, we are in very good shape now.
Not every one of those specs that sits at footing is moving forward right now. We are making some decisions to move houses forward on a full cadence, and we’re making decisions in other locations to sit and wait to see where the market goes. Behind those 1,800, we have many houses that have permits in place and in some municipalities, that can be a couple of months to get a permit. So, we will decide when that permit gets to go, which means we’re going to move forward with footings and build the house.
But last year, our spec inventory was depleted because the market was so hot. We were selling very rapidly, and I’m very happy now to have the 1,800 at footing or beyond, with more permit behind that because now we can pull levers in certain locations based on market conditions as to when and how quickly we move forward with this. But overall, the strategy, we think, is the right one at our price point to be 80% build-to-order, which is what most people want with Toll Brothers, but then 20% are houses that are available in a quicker turn time. Now many of these specs, you are allowed to have finishes because we’ll put the house on the market, let’s say, at drywall, so you can still pick your kitchen cabinets, your countertops, your flooring, which our clients want.
Susan Maklari — Goldman Sachs — Analyst
Okay. That’s very helpful color. Thank you.
Operator
We have time for one last question. That’s from Mike Dahl from RBC Capital Markets. Please go ahead.
Mike Dahl — RBC Capital Markets — Analyst
Thanks for squeezing me in last minute.
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure, Mike.
Mike Dahl — RBC Capital Markets — Analyst
Just quick, Doug, on the — just going back to the deposits and the orders in August. When you make that comment on kind of all else equal tracking to about 500 orders in August, if you just look at deposit trends, how have the conversion rates from the positive contracts been trending the last couple of months and what does that comment kind of imply for conversion in order to hit, let’s say, a 500 order number in August?
Douglas C. Yearley — Chairman and Chief Executive Officer
Sure. So, we’re trending at about 70% of our deposits convert to agreement, and it’s consistent with what we’ve had over the last couple of quarters. In fact, I just — Gregg Ziegler just sent me a piece of paper that says our five-year average conversion ratio was 71%. And we’re right on that now last month, last quarter, last year.
Mike Dahl — RBC Capital Markets — Analyst
Okay. That’s very helpful. And then my follow-up. Just given what you articulated around the build cycle or the order-to-close cycle, what are you finding is the right balance of incentives for your buyer right now? And I don’t mean magnitude, but I mean kind of site because it’s easy to see where if there’s something that’s quicker close or financing incentive, where you could have visibility on kind of cost of locking and buying down the rate that could be affected. But with your volume cycle, what’s making the most sense for you or your buyers?
Douglas C. Yearley — Chairman and Chief Executive Officer
Right. So mortgage buydown would be number one. We have programs that allow our clients to get the mortgage rate under 5. Now that may not apply to long term. We can’t lock a sub-5 for 13 months. But there are opportunities as the house gets closer to delivery that we have that opportunity. Closing costs always help people. We recently ran a kitchen-and-bath weekend, where there were upgrades to your kitchen and your master bathroom, which is — that’s where people want to put the money. You can get second, third level cabinets, countertops, appliances and that’s always very effective. We move the incentives around regularly.
This weekend, it’s a finished basement. Next weekend, it’s $25,000 credit at our beautiful design studio when you go do finishes. So, there’s not one thing. But in today’s market where rates are on everybody’s mind, that’s generally where the incentive starts. But we do have 20% cash buyers, right? So there’s an example right away, we’re going to give them money at the design studio, or we’re going to lure them into the kitchen-and-bath sales event. So it’s constantly moving on purpose. We do not touch the price sheet. And we try to — the local teams have the authority to try to adapt their incentive that they’ve been given to what they think will be most effective for their clients.
Mike Dahl — RBC Capital Markets — Analyst
Okay. Thanks, Doug. Really helpful.
Douglas C. Yearley — Chairman and Chief Executive Officer
You’re very welcome. Thank you. Okay, Jason, I think our — the time is up. And thanks, everyone. So Jason, thank you, and thanks, everyone, for your interest and your support. We are always here to answer any questions you may have, offline. And have a wonderful end of summer. Take care.
Operator
[Operator Closing Remarks]