The information called for by Item 13 is incorporated herein by reference to our definitive proxy statement to be filed pursuant to Regulation 14A in connection with our annual meeting of shareholders to be held on March 28, 2023.
HOVNANIAN ENTERPRISES, INC.
Notes to Consolidated Financial Statements
1. Basis of Presentation
The accompanying Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and include Hovnanian Enterprises, Inc.’s (“HEI”) accounts and those of all its consolidated subsidiaries, after elimination of all intercompany balances and transactions. HEI’s fiscal year ends October 31. Noncontrolling interest represents the proportionate equity interest in a consolidated joint venture that is not 100% owned by HEI, directly or indirectly. One of HEI's subsidiaries owned a 99% controlling interest in a consolidated joint venture and therefore HEI was required to consolidate the joint venture within its Consolidated Financial Statements. The 1% that we did not own was accounted for as a noncontrolling interest. On October 31, 2022, HEI purchased the 1% interest from the equity partner, resulting in 100% ownership as of October 31, 2022. Another one of HEI's subsidiaries owns an 80% controlling interest in a consolidated joint venture, and therefore HEI is required to consolidate the joint venture within its Consolidated Financial Statements. The 20% that HEI does not own is accounted for as a noncontrolling interest.
2. Business
HEI conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). Our operations consist of homebuilding, financial services and corporate. Historically, the Company had seven reportable segments consisting of six homebuilding segments (Northeast, Mid-Atlantic, Midwest, Southeast, Southwest and West) and its financial services segment. During the fourth quarter of fiscal 2022, we reevaluated our reportable segments as a result of changes in the business and our management thereof. In particular, we considered the fact that, since our segments were last established, the Company had exited the Minnesota, North Carolina and Tampa markets and is currently in the process of exiting the Chicago market. Applying the principles set forth under ASC 280 "Segment Reporting", including that our business trends are reflective of economic conditions in markets with general geographic proximity, we realigned our homebuilding operating segments and determined that, in addition to our financial services segment, we now had three reportable homebuilding segments comprised of (1) Northeast, (2) Southeast and (3) West. All prior period amounts related to the segment change have been retrospectively reclassified to conform to the new presentation. Homebuilding operations comprise the substantial part of our business, representing approximately 98% of consolidated revenues for the year ended October 31, 2022 and 97% for each of the years ended October 31, 2021 and 2020. HEI is a Delaware corporation, which through its subsidiaries, was building and selling homes in Arizona, California, Delaware, Florida, Georgia, Illinois, Maryland, New Jersey, Ohio, Pennsylvania, South Carolina, Texas, Virginia and West Virginia, including in 121 consolidated active selling communities at October 31, 2022. Our homebuilding subsidiaries offer a wide variety of homes that are designed to appeal to first-time buyers, first and second-time move-up buyers, luxury buyers, active lifestyle buyers and empty nesters. Our financial services operations, which are a reportable segment, provide mortgage banking and title services to the homebuilding operations’ customers. Our financial services subsidiaries do not typically retain or service the mortgages that they originate but rather sell the mortgages and related servicing rights to investors. Corporate primarily includes the operations of our corporate office whose primary purpose is to provide executive services, accounting, information services, human resources, management reporting, training, cash management, internal audit, risk management, and administration of process redesign, quality, and safety.
See Note 10 “Operating and Reporting Segments” for further disclosure of our reportable segments.
3. Summary of Significant Accounting Policies
Use of Estimates - The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and these differences could have a significant impact on 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 606, “Revenue from Contracts with Customers,” revenue is recognized when control is transferred to the buyer, which occurs when the buyer takes title to and possession of the home and there is no continuing involvement. From time to time as market conditions warrant, the Company offers sales incentives which enable customers to reduce the base price of a home or to reduce the price of options. These incentives are recorded as a reduction of revenue in accordance with ASC 606.
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 mortgage loans held for sale in accordance with ASC 825, “Financial Instruments,” 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 because it mitigates volatility in reported earnings and by measuring the fair value of loans and the derivative instruments used to economically hedge them, we do not have to apply complex hedge accounting provisions.
Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We have established reserves for probable losses.
Cash and Cash Equivalents - Cash equivalents include certificates of deposit, U.S. Treasury bills and government money–market funds with maturities of 90 days or less when purchased. Our cash balances are held at a few financial institutions and may, at times, exceed insurable amounts. We believe we help to mitigate this risk by depositing our cash in major financial institutions. At October 31, 2022 and 2021, $13.4 million and $15.7 million, respectively, of the total cash and cash equivalents was in cash equivalents and restricted cash equivalents.
Fair Value of Financial Instruments - The fair value of financial instruments is determined by reference to various market data and other valuation techniques as appropriate. Our financial instruments consist of cash and cash equivalents, restricted cash and cash equivalents, receivables, deposits and notes, accounts payable and other liabilities, customers' deposits, mortgage loans held for sale, nonrecourse mortgages, mortgage warehouse lines of credit, senior secured revolving credit facility, accrued interest, senior secured term loan, senior unsecured term loan credit facility, senior secured notes and senior notes. The fair value of the senior secured revolving credit facility, senior secured term loan, senior unsecured term loan credit facility, senior secured notes and senior notes is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to us for debt of the same remaining maturities or when not available, are estimated based on third-party broker quotes or management's estimate of the fair value based on available trades for similar debt instruments. The fair value of all of our other financial instruments approximates their carrying amounts.
Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under the specific identification method. 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 for each product type.
We record inventories on 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 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 consists of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings.
We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” During fiscal 2022, we re-activated four previously mothballed communities. As of October 31, 2022 and 2021, the net book value associated with our two and six total mothballed communities were $1.4 million and $4.3 million, respectively, which was net of impairment charges recorded in prior periods of $20.3 million and $57.5 million, respectively.
We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third-party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 606, these sale and leaseback transactions are considered a financing rather than a sale. Our Consolidated Balance Sheets, at October 31, 2022 and 2021, included inventory of $48.5 million and $32.5 million, respectively, recorded to “Consolidated inventory not owned” with a corresponding amount of $51.2 million and $31.5 million, respectively, recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.
We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 606, these transactions are considered a financing rather than a sale. Our Consolidated Balance Sheets, at October 31, 2022 and 2021, included inventory of $260.1 million and $66.2 million, respectively, recorded to “Consolidated inventory not owned” with a corresponding amount of $151.3 million (net of debt issuance costs) and $31.3 million, respectively, recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.
The recoverability of inventories and other long-lived assets is assessed in accordance with ASC 360, “Property, Plant and Equipment.” ASC 360 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on the undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. We evaluate impairment at the individual community level, which is the lowest level of discrete cash flows that are available.
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. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. 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 each quarter, 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; |
| | ● | current local market economic and demographic conditions and related trends and forecasts; and |
| | ● | existing home inventory supplies, including foreclosures and short sales. |
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, sales 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 is recorded. 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 calculating the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from third parties. The estimated future cash flow assumptions are virtually 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, 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 not probable that the optioned property will 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 in comparison to the total costs written off.
Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing the land. Land held for sale is recorded at the lower of carrying amount or fair value less costs to sell. There were no inventories held for sale at October 31, 2022 and 2021. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from third parties.
Warranty Costs and Construction Defect Reserves - We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general and administrative costs. For homes delivered in fiscal 2022 and 2021, our deductible under our general liability insurance was $25.0 million and $20.0 million, respectively, aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2022 and 2021 was $0.5 million, up to a $5.0 million limit in California and $0.25 million, up to a $5.0 million limit in all other states. Our aggregate retention for construction defect, warranty and bodily injury claims was $25.0 million for fiscal 2022 and $20.0 million for fiscal 2021. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. The third-party actuary uses our historical warranty and construction defect 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 construction defect 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 liabilities, actual future costs could differ significantly from our currently estimated amounts. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and control is transferred to the buyer.
Interest - Interest attributable to properties under development during the land development and home construction period is capitalized and then expensed in cost of sales as the related inventories are sold. Interest that does not qualify for capitalization is expensed as incurred in “Other interest.”
Interest costs incurred, expensed and capitalized were as follows:
| | | Year Ended | |
| | | October 31, | | | October 31, | | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Interest capitalized at beginning of year | | $ | 58,159 | | | $ | 65,010 | | | $ | 71,264 | |
| Plus interest incurred(1) | | | 134,024 | | | | 155,514 | | | | 176,457 | |
| Less cost of sales interest expensed | | | (85,240 | ) | | | (84,100 | ) | | | (74,330 | ) |
| Less other interest expensed(2)(3) | | | (47,343 | ) | | | (77,716 | ) | | | (103,801 | ) |
| Less interest contributed to unconsolidated joint venture(4) | | | - | | | | (3,667 | ) | | | (4,580 | ) |
| Plus interest acquired from unconsolidated joint venture(5) | | | - | | | | 3,118 | | | | - | |
| Interest capitalized at end of year(6) | | $ | 59,600 | | | $ | 58,159 | | | $ | 65,010 | |
| (1) | Data does not include interest incurred by our mortgage and finance subsidiaries. |
| (2) | Other interest expensed includes interest that does not qualify for interest capitalization because our assets that qualify for interest capitalization (inventory under development) do not exceed our debt, which amounted to $28.6 million, $57.1 million and $61.9 million for the years ended October 31, 2022, 2021 and 2020, respectively. Other interest also includes interest on completed homes, land in planning and fully developed lots without homes under construction, which does not qualify for capitalization, and therefore, is expensed as incurred. This component of other interest was $18.8 million, $20.6 million and $41.9 million for the years ended October 31, 2022, 2021 and 2020, respectively. |
| (3) | Cash paid for interest, net of capitalized interest, is the sum of other interest expensed, as defined above, and interest paid by our mortgage and finance subsidiaries adjusted for the change in accrued interest on notes payable, which is calculated as follows: |
| | | Year Ended | |
| | | October 31, | | | October 31, | | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Other interest expensed | | $ | 47,343 | | | $ | 77,716 | | | $ | 103,801 | |
| Interest paid by our mortgage and finance subsidiaries | | | 1,790 | | | | 2,102 | | | | 2,165 | |
| (Increase) decrease in accrued interest | | | (4,261 | ) | | | 7,409 | | | | (16,482 | ) |
| Cash paid for interest, net of capitalized interest | | $ | 44,872 | | | $ | 87,227 | | | $ | 89,484 | |
| (4) | Represents capitalized interest which was included as part of the assets contributed to joint ventures, as discussed in Note 20. There was no impact to the Consolidated Statement of Operations as a result of these transactions. |
| (5) | Represents capitalized interest which was included as part of the assets purchased from joint ventures, as discussed in Note 20. There was no impact to the Consolidated Statement of Operations as a result of these transactions. |
| (6) | Capitalized interest amounts are shown gross before allocating any portion of impairments, if any, to capitalized 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 “Inventory impairments and land option write-offs” if we determine we will not exercise the option. In accordance with ASC 810, “Consolidation,” we record costs associated with other options on the Consolidated Balance Sheets under “Land and land options held for future development or sale.” If the options are with variable interest entities ("VIEs") and we are the primary beneficiary or the options have terms that require us to record it as financing, then we record the land under option on the Consolidated Balance Sheets under “Consolidated inventory not owned” with an offset under “Liabilities from inventory not owned.”
Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method. 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 interests in the joint ventures vary but our voting interests are generally 50% or less. 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 joint venture can require significant judgment. In accordance with ASC 323, “Investments - Equity Method and Joint Ventures,” we assess our investments in unconsolidated joint ventures for recoverability quarterly, and if it is determined that a loss in value of the investment below its carrying amount 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 estimates. There were no write-downs for any periods presented.
Debt Issuance Costs - Costs associated with borrowings under our credit facilities and term loans and the issuance of senior secured and senior notes are capitalized and amortized over the term of each note’s issuance. The capitalized costs are recorded as a contra liability within our debt balances, except for the revolving credit facility costs, which are recorded as a prepaid expense.
Debt Issued at a Discount/Premium - Debt issued at a discount or premium to the face amount is amortized utilizing the effective interest method over the term of the note and recorded as a component of "Other interest" in the Consolidated Statements of Operations.
Advertising Costs - Advertising costs are expensed as incurred, primarily to "Selling, general and administrative" homebuilding expense in the Consolidated Statements of Operations. During the years ended October 31, 2022, 2021 and 2020, advertising expenses totaled $10.6 million, $9.8 million and $12.9 million, respectively.
Deferred Income Taxes - Deferred income taxes are provided for temporary differences between amounts recorded for financial reporting and 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 forward to future years to recover deferred tax assets. In accordance with ASC 740, “Income Taxes,” we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740 requires an assessment of whether valuation allowances should be established based on the consideration of all available evidence using a “more-likely-than-not” standard.
In evaluating the exposures associated with our various tax filing positions, we recognize tax liabilities in accordance with ASC 740, for more-likely-than-not exposures. We re-evaluate the exposures associated with our tax positions on a quarterly basis. This evaluation is based on factors such as changes in facts or circumstances, changes in tax law, new audit activity by taxing authorities and effectively settled issues. Determining whether an uncertain tax position is effectively settled requires judgment. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision. A number of years may elapse before a particular matter for which we have established a liability is audited and fully resolved or clarified. We adjust our liability for unrecognized tax benefits and the income tax provision in the period in which an uncertain tax position is effectively settled, or the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes 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. Any such changes will be reflected as increases or decreases to "Income taxes" in the Consolidated Statement of Operations for the period in which they are determined. In addition, we record interest and penalties related to unrecognized tax benefits as a component of income tax expense.
Prepaid Expenses - Prepaid expenses that relate to specific housing communities (model setup, architectural fees, homeowner warranty program fees, interest rate buydowns, etc.) are amortized to cost of sales as the applicable inventories are sold. All other prepaid expenses are amortized over a specific time period or as used and charged to overhead expense.
Allowance for Credit Losses – We regularly review our receivable balances, which are included in "Receivables, deposits and notes" on the Consolidated Balance Sheets, for collectability. These receivables include receivables from our insurance carriers, receivables from municipalities related to the development of utilities or other infrastructure, and other miscellaneous receivables. Allowances are maintained for potential credit losses based on historical experience, present economic conditions and other factors considered relevant by the Company. The allowance for credit losses were $12.7 million and $10.5 million at October 31, 2022 and 2021, respectively, which primarily related to allowances for receivables from municipalities and an allowance for a receivable for a prior year land sale. During fiscal 2022 and 2021, we recorded $0.3 million and $1.5 million, respectively, in recoveries. During fiscal 2022, we recorded $2.5 million of additional reserves. There were no additional reserves recorded in fiscal 2021. There were no write-offs in fiscal 2022 and 2021.
Stock-Based Compensation - We account for our stock-based awards under ASC 718, “Compensation - Stock Compensation,” which requires a fair-value based method to determine the estimated cost of an award. Compensation cost for stock-based awards is measured on the grant date. We recognize compensation cost for time-based awards ratably over the vesting period and performance-based awards ratably over the vesting period when it is probable that the stated performance target will be achieved. Forfeitures of stock-based awards are recognized as they occur.
Per Share Calculations - Basic earnings per share is computed by dividing net income (loss) (the "numerator") by the weighted-average number of common shares outstanding, adjusted for participating securities (the "denominator") for the period. Contingently issuable shares are included in basic earnings per share as of the date that all necessary vesting conditions have been satisfied. Computing diluted earnings per share is similar to computing basic earnings per share, except that the denominator is increased to include the dilutive effects of stock options and nonvested shares of restricted stock units ("RSUs"). Any stock options that have an exercise price greater than the average market price are considered to be anti-dilutive and are excluded from the diluted earnings per share calculation.
All shares that contain non-forfeitable rights to dividends or dividend equivalents that participate in undistributed earnings with common stock are considered participating securities and are included in earnings per share pursuant to the two-class method. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating securities according to dividends or dividend equivalents and participation rights in undistributed earnings in periods where we have net income.
Recent Accounting Pronouncements - In March 2020, the Financial Accounting Standards Board issued Accounting Standards Update ("ASU") 2020-04, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting” (“ASU 2020-04”). ASU 2020-04 provides companies with optional expedients to ease the potential accounting burden on contracts affected by the discontinuation of the London Interbank Offered Rate ("LIBOR") or another reference rate expected to be discontinued. This guidance was effective for the Company beginning on March 12, 2020, and we may elect to apply the amendments prospectively from now through December 31, 2022. The Company is currently evaluating the potential impact, but we do not expect the adoption of this guidance to have material impact on our Consolidated Financial Statements.
We rent certain office space for use in our operations. We assess each of these contracts to determine whether the arrangement contains a lease as defined by ASC 842. In order to meet the definition of a lease under ASC 842, the contractual arrangement must convey to us the right to control the use of an identifiable asset for a period of time in exchange for consideration. We recognize lease expense on a straight-line basis over the lease term and combine lease and non-lease components for all leases. Our office lease terms are typically from three to five years and generally contain renewal options. In accordance with ASC 842, our lease terms include renewals only to the extent that they are reasonably certain to be exercised. The exercise of these lease renewal options is generally at our discretion. In accordance with ASC 842, the lease liability is equal to the present value of the remaining lease payments while the ROU asset is based on the lease liability, subject to adjustment, such as for lease incentives. Our leases do not provide a readily determinable implicit interest rate and therefore, we must estimate our incremental borrowing rate. In determining the incremental borrowing rate, we consider the lease period and our collateralized borrowing rates.
Our lease population at October 31, 2022 is comprised of operating leases where we are the lessee, primarily for our corporate office and division offices. As allowed by ASC 842, we made an accounting policy election to not record leases with an initial term of 12 months or less on our Consolidated Balance Sheets.
Lease costs are included in our Consolidated Statements of Operations, primarily in "Selling, general and administrative" homebuilding expenses and payments on our lease liabilities are presented in the table below. Our short-term lease costs and sublease income are de minimis.
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Operating lease costs | | $ | 10,483 | | | $ | 10,521 | | | $ | 10,507 | |
| Cash payments on lease liabilities | | $ | 9,605 | | | $ | 9,598 | | | $ | 9,257 | |
ROU assets are classified within "Prepaid expenses and other assets" on our Consolidated Balance Sheets, while lease liabilities are classified within "Accounts payable and other liabilities." The Company recorded a net increase to both its ROU assets and lease liabilities of $9.9 million as a result of new leases and lease renewals that commenced during the year ended October 31, 2022. The following table contains additional information about our leases:
| (In thousands) | | 2022 | | | 2021 | |
| ROU assets | | $ | 17,899 | | | $ | 17,844 | |
| Lease liabilities | | $ | 18,862 | | | $ | 18,952 | |
| Weighted-average remaining lease term (in years) | | | 3.5 | | | | 3.1 | |
| Weighted-average discount rate | | | 9.5 | % | | | 9.4 | % |
Maturities of our operating lease liabilities as of October 31, 2022 are as follows:
| Fiscal Year Ended October 31, | | (In thousands) | |
| 2023 | | $ | 8,075 | |
| 2024 | | | 5,892 | |
| 2025 | | | 4,805 | |
| 2026 | | | 3,161 | |
| 2027 and thereafter | | | 1,820 | |
| Total operating lease payments (1) | | | 23,753 | |
| Less: imputed interest | | | (4,891 | ) |
| Present value of operating lease liabilities | | $ | 18,862 | |
(1) Lease payments exclude $13.7 million of legally binding minimum lease payments for office leases signed but not yet commenced as of October 31, 2022. The related ROU asset and operating lease liability are not reflected on the Company's balance sheet as of October 31, 2022.
5. Property and Equipment
Homebuilding property and equipment consists of land and land improvements, buildings, building improvements, furniture and equipment used to conduct day-to-day business and are recorded at cost less accumulated depreciation.
Property and equipment balances as of October 31, 2022 and 2021 were as follows:
| | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| | | | | | | | | |
| Land and land improvements | | $ | 1,639 | | | $ | 1,639 | |
| Buildings | | | 9,497 | | | | 9,497 | |
| Building improvements | | | 22,220 | | | | 15,478 | |
| Furniture | | | 4,363 | | | | 4,214 | |
| Equipment, including capitalized software | | | 40,002 | | | | 36,467 | |
| Property and equipment | | | 77,721 | | | | 67,295 | |
| Less: accumulated depreciation | | | (51,902 | ) | | | (48,559 | ) |
| Property and equipment, net | | $ | 25,819 | | | $ | 18,736 | |
6. Restricted Cash and Customers' Deposits
Homebuilding "Restricted cash and cash equivalents" on the Consolidated Balance Sheets totaled $13.4 million and $16.1 million as of October 31, 2022 and 2021, respectively, which primarily consists of cash collateralizing our letter of credit agreements and facilities (see Note 9).
Financial services restricted cash and cash equivalents, which are included in "Financial services" assets on the Consolidated Balance Sheets, totaled $36.1 million and $43.5 million as of October 31, 2022 and 2021, respectively. Included in these balances were (1) financial services customers’ deposits of $29.7 million and $40.7 million as of October 31, 2022 and 2021, respectively, which are subject to restrictions on our use, and (2) restricted cash under the terms of our mortgage warehouse lines of credit of $6.4 million and $2.8 million as of October 31, 2022 and 2021, respectively.
Homebuilding "Customers’ deposits" are shown as a liability on the Consolidated Balance Sheets. These liabilities are significantly more than the applicable periods’ restricted cash balances because in some states the deposits are not restricted from use and, in other states, we are able to release the majority of these customer deposits to cash by pledging letters of credit and surety bonds.
7. Mortgage Loans Held for Sale
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 are sold in the secondary mortgage market within a short period of time of origination. Mortgage loans held for sale consist primarily of single-family residential loans collateralized by the underlying property. Loans held for sale are recorded at fair value with the changes in the value recognized in the Consolidated Statements of Operations in “Financial services” revenue. We currently use forward sales of MBS, interest rate commitments from borrowers and mandatory and/or best-efforts forward commitments to sell loans to third-party purchasers to protect us from interest rate fluctuations. These short-term instruments do not require any payments to be made to the counterparty or purchaser in connection with the execution of the commitments.
At October 31, 2022 and 2021, $92.5 million and $136.5 million, respectively, of mortgage loans held for sale were pledged against our mortgage warehouse lines of credit (see Note 8). We may incur losses with respect to mortgages that were previously sold that are delinquent and which had underwriting defects, but only to the extent the losses are not covered by mortgage insurance or the resale value of the home. The reserves for these estimated losses are included in “Financial services” liabilities on the Consolidated Balance Sheets. At both October 31, 2022 and 2021, we had reserves specifically for 14 identified mortgage loans, as well as reserves for an estimate of future losses on mortgages sold but not yet identified to us.
The activity in our loan origination reserves in fiscal 2022 and 2021 was as follows:
| | | Year Ended | |
| | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| | | | | | | | | |
| Loan origination reserves, beginning of period | | $ | 1,632 | | | $ | 1,458 | |
| Provisions for losses during the period | | | 181 | | | | 228 | |
| Adjustments to pre-existing provisions for losses from changes in estimates | | | (18 | ) | | | (54 | ) |
| Loan origination reserves, end of period | | $ | 1,795 | | | $ | 1,632 | |
8. Mortgages
Nonrecourse
We have nonrecourse mortgage loans for certain communities totaling $144.8 million and $125.1 million, net of debt issuance costs, at October 31, 2022 and 2021, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $418.9 million and $448.5 million, respectively. The weighted-average interest rate on these obligations was 6.7% and 4.4% at October 31, 2022 and 2021, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries.
Mortgage Loans
K. Hovnanian Mortgage originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are generally sold in the secondary mortgage market within a short period of time. K. Hovnanian Mortgage finances the origination of mortgage loans through various master repurchase agreements, which are recorded in "Financial services" liabilities on the Consolidated Balance Sheets.
Our secured Master Repurchase Agreement with JPMorgan Chase Bank, N.A. (“Chase Master Repurchase Agreement”) is a short-term borrowing facility that provides up to $50.0 million through its maturity on July 31, 2023. 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 an adjusted Secured Overnight Financing Rate ("SOFR"), which was 3.81% at October 31, 2022, plus the applicable margin of 2.25% to 2.375%. As of October 31, 2022 and 2021, the aggregate principal amount of all borrowings outstanding under the Chase Master Repurchase Agreement was $14.1 million and $45.7 million, respectively.
K. Hovnanian Mortgage has another secured Master Repurchase Agreement with Customers Bank (“Customers Master Repurchase Agreement”) which is a short-term borrowing facility that provides up to $50.0 million through its maturity on March 8, 2023. 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 daily or as loans are sold to permanent investors on outstanding advances at the current Bloomberg Short Term Bank Yield Index ("BSBY") rate, plus the applicable margin ranging from 2.125% to 4.5% based on the type of loan and the number of days outstanding on the warehouse line. As of October 31, 2022 and 2021, the aggregate principal amount of all borrowings outstanding under the Customers Master Repurchase Agreement was $43.1 million and $40.5 million, respectively.
K. Hovnanian Mortgage also has a secured Master Repurchase Agreement with Comerica Bank (“Comerica Master Repurchase Agreement”) which was amended on August 8, 2022 to extend the maturity date and is a short-term borrowing facility through its maturity on July 7, 2023. The Comerica Master Repurchase Agreement provides up to $60.0 million on the 15th day of the last month of the Company's fiscal quarters and reverts back to up to $50.0 million 30 days thereafter. 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 at the daily adjusting BSBY rate, subject to a floor of 0.50%, plus the applicable margin of 1.875% or 3.25% based upon the type of loan. As of October 31, 2022 and 2021, the aggregate principal amount of all borrowings outstanding under the Comerica Master Repurchase Agreement was $37.1 million and $48.7 million, respectively.
The Chase Master Repurchase Agreement, Customers Master Repurchase Agreement and Comerica Master Repurchase Agreement (together, the “Master Repurchase Agreements”) require 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 Master Repurchase Agreements, 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 applicable agreement, we do not consider any of these covenants to be substantive or material. As of October 31, 2022, we believe we were in compliance with the covenants under the Master Repurchase Agreements.
9. Senior Notes and Credit Facilities
Senior notes and credit facilities balances as of October 31, 2022 and October 31, 2021, were as follows:
| | | October 31, | | | October 31, | |
| (In thousands) | | | 2022 | | | | 2021 | |
| Senior Secured Notes: | | | | | | | | |
| 10.0% Senior Secured 1.75 Lien Notes due November 15, 2025 | | $ | 158,502 | | | $ | 158,502 | |
| 7.75% Senior Secured 1.125 Lien Notes due February 15, 2026 | | | 250,000 | | | | 350,000 | |
| 10.5% Senior Secured 1.25 Lien Notes due February 15, 2026 | | | 282,322 | | | | 282,322 | |
| 11.25% Senior Secured 1.5 Lien Notes due February 15, 2026 | | | 162,269 | | | | 162,269 | |
| Total Senior Secured Notes | | $ | 853,093 | | | $ | 953,093 | |
| Senior Notes: | | | | | | | | |
| 8.0% Senior Notes due November 1, 2027 (1) | | $ | - | | | $ | - | |
| 13.5% Senior Notes due February 1, 2026 | | | 90,590 | | | | 90,590 | |
| 5.0% Senior Notes due February 1, 2040 | | | 90,120 | | | | 90,120 | |
| Total Senior Notes | | $ | 180,710 | | | $ | 180,710 | |
| Senior Unsecured Term Loan Credit Facility due February 1, 2027 | | $ | 39,551 | | | $ | 39,551 | |
| Senior Secured 1.75 Lien Term Loan Credit Facility due January 31, 2028 | | $ | 81,498 | | | $ | 81,498 | |
| Senior Secured Revolving Credit Facility (2) | | $ | - | | | $ | - | |
| Subtotal senior notes and credit facilities | | $ | 1,154,852 | | | $ | 1,254,852 | |
| Net (discounts) premiums | | $ | 4,079 | | | $ | 10,769 | |
| Unamortized debt issuance costs | | $ | (12,384 | ) | | $ | (17,248 | ) |
| Total senior notes and credit facilities, net of discounts, premiums and unamortized debt issuance costs | | $ | 1,146,547 | | | $ | 1,248,373 | |
(1) $26.0 million of 8.0% Senior Notes due 2027 (the "8.0% 2027 Notes") are owned by a wholly owned consolidated subsidiary of HEI. Therefore, in accordance with U.S. GAAP, such notes are not reflected on the Consolidated Balance Sheets of HEI.
(2) At October 31, 2022, provides for up to $125.0 million in aggregate senior secured first lien revolving loans. In the fourth quarter of fiscal 2022, we amended our Secured Credit Facility, which amendments became effective in the first quarter of fiscal 2023. As amended, the revolving loans thereunder have a maturity of June 30, 2024 and borrowings bear interest, at K. Hovnanian’s option, at either (i) a term secured overnight financing rate (subject to a floor of 1.00%) plus an applicable margin of 4.50% or (ii) an alternate base rate plus an applicable margin of 3.50%. In addition, K. Hovnanian will pay an unused commitment fee on the undrawn revolving commitments at a rate of 1.00% per annum.
As of October 31, 2022, future maturities of our borrowings were as follows (in thousands):
| Fiscal Year Ended October 31, (1) | | | | |
| 2023 | | $ | - | |
| 2024 | | | - | |
| 2025 | | | - | |
| 2026 | | | 943,683 | |
| 2027 | | | 39,551 | |
| Thereafter | | | 171,618 | |
| Total | | $ | 1,154,852 | |
(1) Does not include our $125.0 million Senior Secured Revolving Credit Facility under which there were no borrowings outstanding as of October 31, 2022.
General
Except for K. Hovnanian, the issuer of the notes and borrower under the Credit Facilities (as defined below), our home mortgage subsidiaries, certain of our title insurance subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures, we and each of our subsidiaries are guarantors of the Credit Facilities, the senior secured notes and senior notes outstanding (except for the 8.0% 2027 Notes which are not guaranteed by K. Hovnanian at Sunrise Trail III, LLC, a wholly-owned subsidiary of the Company) at October 31, 2022 (collectively, the “Notes Guarantors”).
The credit agreements governing the Credit Facilities and the indentures governing the senior secured and senior notes (together, the “Debt Instruments”) outstanding at October 31, 2022 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the ability of HEI and certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness, pay dividends and make distributions on common and preferred stock, repay/repurchase certain indebtedness prior to its respective stated maturity, repurchase (including through exchanges) common and preferred stock, make other restricted payments (including investments), sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all of their assets and enter into certain transactions with affiliates. The Debt Instruments also contain customary events of default which would permit the lenders or holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Unsecured Term Loan Facility (defined below) (the “Unsecured Term Loans”), loans made under the Secured Term Loan Facility (defined below) (the “Secured Term Loans”) and loans made under the Secured Credit Agreement (as defined below) (the “Secured Revolving Loans”) or notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Unsecured Term Loans, Secured Term Loans, Secured Revolving Loans or notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Unsecured Term Loans, Secured Term Loans and Secured Revolving Loans, material inaccuracy of representations and warranties and with respect to the Unsecured Term Loans, Secured Term Loans and Secured Revolving Loans, a change of control, and, with respect to the Secured Term Loans, Secured Revolving Loans and senior secured notes, the failure of the documents granting security for the obligations under the secured Debt Instruments to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the obligations under the secured Debt Instruments to be valid and perfected. As of October 31, 2022, we believe we were in compliance with the covenants of the Debt Instruments.
If our consolidated fixed charge coverage ratio is less than 2.0 to 1.0, as defined in the applicable Debt Instrument, we are restricted from making certain payments, including dividends (in each such case, our secured debt leverage ratio must also be less than 4.0 to 1.0), and from incurring indebtedness other than certain permitted indebtedness and nonrecourse indebtedness. Beginning as of October 31, 2021, as a result of our improved operating results, our fixed coverage ratio was above 2.0 to 1.0 and our secured debt leverage ratio was below 4.0 to 1.0, therefore we were no longer restricted from paying dividends. As such, we made dividend payments of $2.7 million to preferred shareholders in each quarter of fiscal 2022.
Under the terms of our Debt Instruments, we have the right to make certain redemptions and prepayments and, depending on market conditions, our strategic priorities and covenant restrictions, may do so from time to time. We also continue to actively analyze and evaluate our capital structure and explore transactions to simplify our capital structure and to strengthen our balance sheet, including those that reduce leverage, interest rates and/or extend maturities, and will seek to do so with the right opportunity. We may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, exchange offers, redemptions, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions.
Fiscal 2022
On April 29, 2022, K. Hovnanian redeemed $100.0 million aggregate principal amount of its 7.75% Senior Secured 1.125 Lien Notes due 2026 (the "1.125 Lien Notes"). The aggregate purchase price for this redemption was $105.5 million, which included accrued and unpaid interest and which was funded with cash on hand. This redemption resulted in a loss on extinguishment of debt of $6.8 million for the year ended October 31, 2022, net of the write-off of unamortized financing costs and fees. The loss from the redemption is included in the Consolidated Statement of Operations as "(Loss) gain on extinguishment of debt, net".
On August 19, 2022, the Company, K. Hovnanian, and other subsidiaries of the Company as guarantors entered into the Second Amendment (the “Second Amendment”) to the Credit Agreement, dated as of October 31, 2019, as amended by the First Amendment, dated as of November 27, 2019, by and among K. Hovnanian, the Company, the other guarantors party thereto, Wilmington Trust, National Association, as administrative agent, and the lenders party thereto, which provides for up to $125.0 million in aggregate amount of senior secured first lien revolving loans (the “Revolving Credit Facility”). The Second Amendment became effective in the first quarter of fiscal 2023 and (i) extends the final scheduled maturity of the Revolving Credit Facility from December 28, 2022 to June 30, 2024, (ii) replaces the 7.75% fixed interest rate with a floating interest rate based on the SOFR and (iii) provides for certain technical and clarifying amendments. Borrowings under the Revolving Credit Facility will bear interest, at K. Hovnanian’s option, at either (i) a term SOFR rate (subject to a floor of 1.00%) plus an applicable margin of 4.50% or (ii) an alternate base rate plus an applicable margin of 3.50%. In addition, K. Hovnanian will pay an unused commitment fee on the undrawn revolving commitments at a rate of 1.00% per annum.
Fiscal 2021
On July 30, 2021, K. Hovnanian redeemed in full all of the $111.2 million aggregate principal amount of 10.0% Senior Secured Notes due 2022 (the "10.0% 2022 Notes"). The aggregate purchase price for this redemption was $111.7 million, which included accrued and unpaid interest that was funded with cash on hand. This redemption resulted in a loss on extinguishment of debt of $0.3 million for the year ended October 31, 2021, net of the write-off of unamortized financing costs and fees. The loss from the redemption is included in the Consolidated Statement of Operations as "(Loss) gain on extinguishment of debt, net".
On August 2, 2021, K. Hovnanian redeemed in full all of the $69.7 million aggregate principal amount of 10.5% Senior Secured Notes due 2024 (the "10.5% 2024 Notes"). The aggregate purchase price for this redemption was $71.9 million, which included accrued and unpaid interest that was funded with cash on hand. This redemption resulted in a loss on extinguishment of debt of $3.4 million for the year ended October 31, 2021, net of the write-off of unamortized discounts, financing costs and fees. The loss from the redemption is included in the Consolidated Statement of Operations as "(Loss) gain on extinguishment of debt, net".
Fiscal 2020
On December 10, 2019, K. Hovnanian consummated an exchange offer (the "1.75 Lien Exchange Offer") pursuant to which it issued $158.5 million aggregate principal amount of 10.0% 1.75 Lien Notes due 2025 (the “1.75 Lien Notes”) in exchange for certain of its then outstanding second lien notes. K. Hovnanian also exchanged $163.0 million in aggregate principal amount of its Unsecured Term Loans for $81.5 million in aggregate principal amount of Secured Term Loans made under a new Senior Secured 1.75 Lien Term Loan Credit Facility due January 31, 2028 (the “Secured Term Loan Facility”). There was no cash consideration in these exchanges. These secured notes and term loan exchanges were accounted for in accordance with ASC 470-60, resulting in a carrying value of $164.9 million and $148.8 million, respectively, for the $158.5 million of 1.75 Lien Notes and $81.5 million of Secured Term Loans, respectively, and a net gain on extinguishment of debt of $9.2 million, which is included in “(Loss) gain on extinguishment of debt, net” on the Consolidated Statement of Operations. The effect of this gain on a per share basis, assuming dilution, for the year ended October 31, 2020 was $1.40, excluding the impact of taxes, as our deferred tax assets were fully reserved by a valuation allowance.
The 1.75 Lien Notes were issued under an Indenture, dated as of December 10, 2019, among HEI, K. Hovnanian, the guarantors party thereto and Wilmington Trust, National Association, as trustee and collateral agent. The 1.75 Lien Notes are guaranteed by HEI and the Notes Guarantors and are secured by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, subject to permitted liens and certain exceptions. Interest on the 1.75 Lien Notes is payable semi-annually on May 15 and November 15 of each year, to holders of record at the close of business on May 1 or November 1, as the case may be, immediately preceding each such interest payment date. The 1.75 Lien Notes have a maturity of November 15, 2025.
At any time and from time to time after November 15, 2022 and prior to November 15, 2023, K. Hovnanian may redeem some or all of the 1.75 Lien Notes at a redemption price equal to 102.50% of their principal amount and at any time and from time to time after November 15, 2023, K. Hovnanian may redeem some or all of the 1.75 Lien Notes at a redemption price equal to 100.0% of their principal amount.
The Secured Term Loans and the guarantees thereof are secured on a pari passu basis with the 1.75 Lien Notes by the same assets that secure the 1.75 Lien Notes, subject to permitted liens and certain exceptions. The Secured Term Loans bear interest at a rate equal to 10.0% per annum and will mature on January 31, 2028, with interest payable in arrears on the last business day of each fiscal quarter. At any time and from time to time after November 15, 2022 and prior to November 15, 2023, K. Hovnanian may voluntarily prepay some or all of the Secured Term Loans at a prepayment price equal to 102.50% of their principal amount and at any time and from time to time after November 15, 2023, K. Hovnanian may voluntarily prepay some or all of the Secured Term Loans at a prepayment price equal to 100.0% of their principal amount.
On March 25, 2020, K. Hovnanian consummated a private exchange (the “Exchange”) pursuant to which it issued $59.1 million aggregate principal amount of additional 1.5 Lien Notes (defined below) (the “Additional 1.5 Lien Notes”) in exchange for $59.1 million aggregate principal amount of second lien notes held by certain participating bondholders (the “Exchange Holders”) pursuant to an Exchange Agreement, dated March 25, 2020 (the “Exchange Agreement”), among K. Hovnanian, the Notes Guarantors, the Exchanging Holders and certain holders of the Initial 1.5 Lien Notes (defined below) (the “Consenting Holders”). In connection therewith, the Consenting Holders provided their consents (the “Consents”) under the Indenture under which the 1.5 Lien Notes were issued to permit the issuance of the Additional 1.5 Lien Notes.
The Additional 1.5 Lien Notes were issued as additional notes of the same series as the $103.1 million aggregate principal amount of K. Hovnanian’s 11.25% Senior Secured 1.5 Lien Notes due 2026 issued on October 31, 2019 (the “Initial 1.5 Lien Notes” and, together with the Additional 1.5 Lien Notes, the “1.5 Lien Notes”). In connection with the issuance of the Additional 1.5 Lien Notes in the Exchange, K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as trustee (the “Trustee”) and collateral agent (the “Collateral Agent”), entered into the Fourth Supplemental Indenture, dated as of March 25, 2020 (the “Supplemental Indenture”), to the Indenture, dated as of October 31, 2019 (as amended and supplemented prior to the Supplemental Indenture, the “Indenture”), among the K. Hovnanian, the Notes Guarantors, the Trustee and the Collateral Agent. The Supplemental Indenture also amended the Indenture in accordance with the Consents to permit K. Hovnanian and the Notes Guarantors to secure up to $162.3 million of 1.5 Lien Obligations (as defined in the Indenture). For a discussion of the 1.5 Lien Notes see “Secured Obligations” below.
During the year ended October 31, 2020, the Company repurchased in open market transactions $25.5 million aggregate principal amount of the 10.0% 2022 Notes. The aggregate purchase price for these repurchases was $21.4 million, which included accrued and unpaid interest. These repurchases resulted in a gain on extinguishment of debt of $4.1 million for the year ended October 31, 2020, net of the write-off of unamortized financing costs and fees. The gains from the repurchases are included in the Consolidated Statement of Operations as "(Loss) gain on extinguishment of debt, net".
Secured Obligations
On October 31, 2019, K. Hovnanian, HEI, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and affiliates of certain investment managers (the “Investors”), as lenders, entered into a credit agreement (the “Secured Credit Agreement” and, together with the Unsecured Term Loan Facility (defined below) and the Secured Term Loan Facility, the “Credit Facilities”) providing for up to $125.0 million in aggregate amount of Secured Revolving Loans to be used for general corporate purposes, upon the terms and subject to the conditions set forth therein. Secured Revolving Loans are to be borrowed by K. Hovnanian and guaranteed by the Notes Guarantors. In the fourth quarter of fiscal 2022, we amended our Secured Credit Facility, which amendments became effective in the first quarter of fiscal 2023. As amended, the revolving loans thereunder have a maturity of June 30, 2024 and borrowings bear interest, at K. Hovnanian’s option, at either (i) a term secured overnight financing rate (subject to a floor of 1.00%) plus an applicable margin of 4.50% or (ii) an alternate base rate plus an applicable margin of 3.50%. In addition, K. Hovnanian will pay an unused commitment fee on the undrawn revolving commitments at a rate of 1.00% per annum.
The 1.125 Lien Notes have a maturity of February 15, 2026 and bear interest at a rate of 7.75% per annum payable semi-annually on February 15 and August 15 of each year, to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. K. Hovnanian may redeem some or all of the 1.125 Lien Notes at 103.875% of principal commencing February 15, 2022, at 101.937% of principal commencing February 15, 2023 and at 100.0% of principal commencing February 15, 2024.
The 10.5% Senior Secured 1.25 Lien Notes due 2026 (the "1.25 Lien Notes") have a maturity of February 15, 2026 and bear interest at a rate of 10.5% per annum payable semi-annually on February 15 and August 15 of each year to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. K. Hovnanian may redeem some or all of the 1.25 Lien Notes at 105.25% of principal commencing February 15, 2022, at 102.625% of principal commencing February 15, 2023 and at 100.0% of principal commencing February 15, 2024.
The 11.25% Senior Secured 1.5 Lien Notes due 2026 (the "1.5 Lien Notes") have a maturity of February 15, 2026 and bear interest at a rate of 11.25% per annum payable semi-annually on February 15 and August 15 of each year to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. The 1.5 Lien Notes are redeemable in whole or in part at our option at any time prior to February 15, 2026 at 100.0% of their principal amount.
See “Fiscal 2020” for a discussion of the 1.75 Lien Notes and the Secured Term Loan.
Each series of secured notes and the guarantees thereof, the Secured Term Loans and the guarantees thereof and the Secured Credit Agreement and the guarantees thereof are secured by the same assets. Among the secured debt, the liens securing the Secured Credit Agreement are senior to the liens securing all of K. Hovnanian’s other secured notes and the Secured Term Loan. The liens securing the 1.125 Lien Notes are senior to the liens securing the 1.25 Lien Notes, 1.5 Lien Notes, the 1.75 Lien Notes, the Secured Term Loans and any other future secured obligations that are junior in priority with respect to the assets securing the 1.125 Lien Notes, the liens securing the 1.25 Lien Notes are senior to the liens securing the 1.5 Lien Notes, the 1.75 Lien Notes, the Secured Term Loans and any other future secured obligations that are junior in priority with respect to the assets securing the 1.25 Lien Notes, the liens securing the 1.5 Lien Notes are senior to the liens securing the 1.75 Lien Notes, the Secured Term Loans and any other future secured obligations that are junior in priority with respect to the assets securing the 1.5 Lien Notes, the liens securing the 1.75 Lien Notes and the Secured Term Loans (which are secured on a pari passu basis with each other) are senior to any other future secured obligations that are junior in priority with respect to the assets securing the 1.75 Lien Notes and the Secured Term Loans, in each case, with respect to the assets securing such debt.
As of October 31, 2022, the collateral securing the Secured Credit Agreement, the Secured Term Loan Facility and the secured notes included (1) $333.2 million of cash and cash equivalents, which included $6.1 million of restricted cash collateralizing certain letters of credit (subsequent to such date, fluctuations as a result of cash uses include general business operations and real estate and other investments along with cash inflow primarily from deliveries); (2) $409.1 million aggregate book value of real property, which does not include the impact of inventory investments, home deliveries or impairments thereafter and which may differ from the value if it were appraised; and (3) equity interests in joint venture holding companies with an aggregate book value of $87.3 million.
Unsecured Obligations
The 13.5% Senior Notes due 2026 (the “13.5% 2026 Notes”) bear interest at 13.5% per annum and mature on February 1, 2026. Interest on the 13.5% 2026 Notes is payable semi-annually on February 1 and August 1 of each year to holders of record at the close of business on January 15 or July 15, as the case may be, immediately preceding each such interest payment date. The 13.5% 2026 Notes are redeemable in whole or in part at K. Hovnanian’s option at any time prior to February 1, 2025 at a redemption price equal to 100% of their principal amount plus an applicable “Make Whole Amount”. At any time and from time to time on or after February 1, 2025, K. Hovnanian may also redeem some or all of the 13.5% 2026 Notes at a redemption price equal to 100.0% of their principal amount.
The 5.0% Senior Notes due 2040 (the “5.0% 2040 Notes”) bear interest at 5.0% per annum and mature on February 1, 2040. Interest on the 5.0% 2040 Notes is payable semi-annually on February 1 and August 1 of each year to holders of record at the close of business on January 15 or July 15, as the case may be, immediately preceding each such interest payment date. At any time and from time to time, K. Hovnanian may redeem some or all of the 5.0% 2040 Notes at a redemption price equal to 100.0% of their principal amount.
The Unsecured Term Loans bear interest at a rate equal to 5.0% per annum and interest is payable in arrears, on the last business day of each fiscal quarter. The Unsecured Term Loans will mature on February 1, 2027.
Other
We have certain stand-alone cash collateralized letter of credit agreements and facilities under which there was a total of $6.0 million and $9.3 million letters of credit outstanding at October 31, 2022 and October 31, 2021, 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. At October 31, 2022 and October 31, 2021, the amount of cash collateral in these segregated accounts was $6.1 million and $9.9 million, respectively, which is included in “Restricted cash and cash equivalents” on the Consolidated Balance Sheets.
10. Operating and Reporting Segments
HEI’s operating segments are components of the Company’s business for which discrete financial information is available and reviewed regularly by the chief operating decision maker, our Chief Executive Officer, to evaluate performance and make resource allocations.
We currently have homebuilding operations in 14 states that are aggregated into reportable segments based primarily upon geographic proximity.
Historically, the Company had seven reportable segments consisting of six homebuilding segments (Northeast, Mid-Atlantic, Midwest, Southeast, Southwest and West) and its financial services segment. During the fourth quarter of fiscal 2022, we reevaluated our reportable segments as a result of changes in the business and our management thereof. In particular, we considered the fact that, since our segments were last established, the Company had exited the Minnesota, North Carolina and Tampa markets and is currently in the process of exiting the Chicago market. Applying the principles set forth under ASC 280, including that our business trends are reflective of economic conditions in markets with general geographic proximity, we realigned our homebuilding operating segments.
HEI’s reportable segments now consist of the following three homebuilding segments and a financial services segment.
Homebuilding:
| | (1) | Northeast (Delaware, Illinois, Maryland, New Jersey, Ohio, Pennsylvania, Virginia and West Virginia) |
| | (2) | Southeast (Florida, Georgia and South Carolina) |
| | (3) | West (Arizona, California and Texas) |
All prior period amounts related to the segment change have been retrospectively reclassified throughout to conform to the new presentation.
Operations of the homebuilding segments primarily include the sale and construction of single-family attached and detached homes, attached townhomes and condominiums, urban infill and active lifestyle homes in planned residential developments. In addition, from time to time, operations of the homebuilding segments include sales of land. Operations of the financial services segment include mortgage banking and title services provided to the homebuilding operations’ customers. Our financial services subsidiaries do not typically retain or service mortgages that we originate but sell the mortgages and related servicing rights to investors.
Corporate and unallocated primarily represents operations at our headquarters in New Jersey. This includes our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services, administration of insurance, quality and safety. It also includes interest income and interest expense resulting from interest incurred that cannot be capitalized in inventory in the homebuilding segments, as well as the gains or losses on extinguishment of debt from any debt repurchases or exchanges.
Evaluation of segment performance is based primarily on income (loss) before income taxes. Income (loss) before income taxes for the homebuilding segments consist of revenues generated from the sales of homes and land, income (loss) from unconsolidated entities, management fees and other income, less the cost of homes and land sold, selling, general and administrative expenses and interest expense. Income (loss) before income taxes for the financial services segment consist of revenues generated from mortgage financing, title insurance and closing services, less the cost of such services and corporate general and administrative expenses.
Operational results of each segment are not necessarily indicative of the results that would have occurred had the segment been an independent stand-alone entity during the periods presented.
Financial information relating to our reportable segments are as follows:
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Revenues: | | | | | | | | | | | | |
| Northeast | | $ | 1,085,081 | | | $ | 871,091 | | | $ | 821,456 | |
| Southeast | | | 323,961 | | | | 285,658 | | | | 232,730 | |
| West | | | 1,450,632 | | | | 1,544,397 | | | | 1,217,086 | |
| Total homebuilding | | | 2,859,674 | | | | 2,701,146 | | | | 2,271,272 | |
| Financial services | | | 61,540 | | | | 81,692 | | | | 72,162 | |
| Corporate and unallocated | | | 1,017 | | | | 19 | | | | 467 | |
| Total revenues | | $ | 2,922,231 | | | $ | 2,782,857 | | | $ | 2,343,901 | |
| Income before income taxes: | | | | | | | | | | | | |
| Northeast | | $ | 177,406 | | | $ | 102,896 | | | $ | 63,136 | |
| Southeast | | | 60,178 | | | | 17,764 | | | | 1,355 | |
| West | | | 207,519 | | | | 198,343 | | | | 84,599 | |
| Total homebuilding | | | 445,103 | | | | 319,003 | | | | 149,090 | |
| Financial services | | | 19,121 | | | | 37,563 | | | | 32,102 | |
| Corporate and unallocated (1) | | | (144,471 | ) | | | (166,705 | ) | | | (125,789 | ) |
| Income before income taxes | | $ | 319,753 | | | $ | 189,861 | | | $ | 55,403 | |
(1) Corporate and unallocated for the year ended October 31, 2022 included corporate general and administrative expenses of $102.6 million, interest expense of $28.6 million (a component of Other interest in our Consolidated Statements of Operations), loss on extinguishment of debt of $6.8 million and $6.5 million of other expenses. Corporate and unallocated for the year ended October 31, 2021 included corporate general and administrative expenses of $106.7 million, interest expense of $57.1 million, loss on extinguishment of debt of $3.7 million and $0.8 million of other income. Corporate and unallocated for the year ended October 31, 2020 included corporate general and administrative expenses of $80.5 million, interest expense of $61.9 million, gain on extinguishment of debt of $13.3 million and $3.3 million of other income.
| | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| Assets: | | | | | | | | |
| Northeast | | $ | 530,884 | | | $ | 491,507 | |
| Southeast | | | 330,894 | | | | 257,044 | |
| West | | | 802,704 | | | | 643,342 | |
| Total homebuilding | | | 1,664,482 | | | | 1,391,893 | |
| Financial services | | | 155,993 | | | | 202,758 | |
| Corporate and unallocated | | | 741,555 | | | | 725,857 | |
| Total assets | | $ | 2,562,030 | | | $ | 2,320,508 | |
| | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| Investments in and advances to unconsolidated joint ventures: | | | | | | | | |
| Northeast | | $ | 20,241 | | | $ | 18,920 | |
| Southeast | | | 52,651 | | | | 40,563 | |
| West | | | 174 | | | | 268 | |
| Total homebuilding | | | 73,066 | | | | 59,751 | |
| Corporate and unallocated | | | 1,874 | | | | 1,146 | |
| Total investments in and advances to unconsolidated joint ventures | | $ | 74,940 | | | $ | 60,897 | |
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Homebuilding interest expense: | | | | | | | | | | | | |
| Northeast | | $ | 31,552 | | | $ | 30,212 | | | $ | 39,089 | |
| Southeast | | | 17,403 | | | | 19,490 | | | | 17,005 | |
| West | | | 55,056 | | | | 55,029 | | | | 60,120 | |
| Total homebuilding | | | 104,011 | | | | 104,731 | | | | 116,214 | |
| Corporate and unallocated | | | 28,572 | | | | 57,085 | | | | 61,917 | |
| Financial services interest expense (income) (1) | | | (213 | ) | | | (35 | ) | | | (35 | ) |
| Total interest expense, net | | $ | 132,370 | | | $ | 161,781 | | | $ | 178,096 | |
| | (1) | Financial services interest expense (income) is included in Financial services revenue or expense in the Consolidated Statements of Operations. |
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Depreciation: | | | | | | | | | | | | |
| Northeast | | $ | 1,542 | | | $ | 1,459 | | | $ | 1,605 | |
| Southeast | | | 291 | | | | 214 | | | | 327 | |
| West | | | 1,298 | | | | 1,811 | | | | 1,500 | |
| Total homebuilding | | | 3,131 | | | | 3,484 | | | | 3,432 | |
| Financial services | | | 5 | | | | 13 | | | | 13 | |
| Corporate and unallocated | | | 2,321 | | | | 1,783 | | | | 1,859 | |
| Total depreciation | | $ | 5,457 | | | $ | 5,280 | | | $ | 5,304 | |
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Net additions to property and equipment: | | | | | | | | | | | | |
| Northeast | | $ | 1,848 | | | $ | 1,271 | | | $ | 1,069 | |
| Southeast | | | 229 | | | | 256 | | | | 102 | |
| West | | | 1,841 | | | | 1,174 | | | | 1,622 | |
| Total homebuilding | | | 3,918 | | | | 2,701 | | | | 2,793 | |
| Financial services | | | 28 | | | | - | | | | - | |
| Corporate and unallocated | | | 8,646 | | | | 3,241 | | | | 587 | |
| Total net additions to property and equipment | | $ | 12,592 | | | $ | 5,942 | | | $ | 3,380 | |
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Equity in earnings from unconsolidated joint ventures: | | | | | | | | | | | | |
| Northeast | | $ | 12,674 | | | $ | 2,958 | | | $ | 10,644 | |
| Southeast | | | 16,359 | | | | 2,061 | | | | 820 | |
| West | | | - | | | | 3,830 | | | | 5,101 | |
| Total equity in earnings from unconsolidated joint ventures | | $ | 29,033 | | | $ | 8,849 | | | $ | 16,565 | |
11. Income Taxes
Income taxes (receivable) payable, including deferred benefits, consists of the following:
| | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| State income taxes: | | | | | | | | |
| Current | | $ | 3,167 | | | $ | 3,851 | |
| Deferred | | | (69,248 | ) | | | (90,070 | ) |
| Federal income taxes: | | | | | | | | |
| Current | | | - | | | | - | |
| Deferred | | | (275,545 | ) | | | (335,608 | ) |
| Total | | $ | (341,626 | ) | | $ | (421,827 | ) |
The (benefit) provision for income taxes is composed of the following charges:
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | | | 2020 | |
| Current income tax expense: | | | | | | | | | | | | |
| Federal (1) | | $ | - | | | $ | - | | | $ | - | |
| State (2) | | | 13,377 | | | | 7,722 | | | | 4,475 | |
| Total current income tax expense: | | | 13,377 | | | | 7,722 | | | | 4,475 | |
| Federal | | | 60,064 | | | | (335,608 | ) | | | - | |
| State | | | 20,822 | | | | (90,070 | ) | | | - | |
| Total deferred income tax expense (benefit): | | | 80,886 | | | | (425,678 | ) | | | - | |
| Total | | $ | 94,263 | | | $ | (417,956 | ) | | $ | 4,475 | |
| (1) | The current federal income tax expense is net of the use of federal net operating losses totaling $306.0 million (tax effected $64.3 million), $173.8 million (tax effected $36.5 million) and $183.0 million (tax effected $38.4 million) for the years ended October 31, 2022, 2021 and 2020, respectively. |
| (2) | The current state income tax expense is net of the use of state net operating losses totaling $80.1 million, $55.7 million and $72.5 million for the years ended October 31, 2022, 2021 and 2020, respectively. |
The total income tax expense for the year ended October 31, 2022 was $94.3 million. The expense was primarily due to federal and state tax expense recorded as a result of our income before income taxes. The federal tax expense is not paid in cash as it is offset by the use of our existing net operating loss (“NOL”) carryforwards. The total income tax benefit for the year ended October 31, 2021 was $418.0 million. The benefit was primarily due to the reversal of a substantial portion of our valuation allowance previously recorded against our deferred tax assets (“DTAs”). The total income tax expense of $4.5 million for the year ended October 31, 2020 was primarily related to state tax expense from income generated in states where we do not have NOL carryforwards to offset the current year income. In addition, the expense for the year ended October 31, 2020 was primarily related to state tax expense from the impact of a cancellation of debt income recorded for tax purposes but not for U.S. GAAP purposes, creating a permanent difference.
Our federal net operating losses of $909.6 million expire between 2029 and 2038, and $15.7 million have an indefinite carryforward period. Of our $2.3 billion of state NOLs, $411.4 million expire between 2023 through 2027; $1.4 billion expire between 2028 through 2032; $369.7 million expire between 2033 through 2037; $73.7 million expire between 2038 through 2042; and $51.5 million have an indefinite carryforward period.
The Company recognizes deferred income taxes for deferred tax benefits arising from NOL carryforwards and temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. A valuation allowance is provided to offset DTAs if, based upon the available evidence, it is more likely than not that some or all of the DTAs will not be realized. Future realization of DTAs depends on the existence of sufficient taxable income of the appropriate character. Sources of taxable income include future reversals of existing taxable temporary differences, expected future taxable income, taxable income in prior carryback years if permitted under the tax law and tax planning strategies. Management has determined that it is more likely than not that sufficient taxable income will be generated in the future to realize its DTAs except for a portion related to state DTAs.
As of October 31, 2020, we had a valuation allowance of $396.5 million of federal DTAs related to NOLs, as well as other matters, all of which was reversed during the year ended October 31, 2021. We also had a valuation allowance of $181.0 million of DTAs related to state NOLs as of October 31, 2020, of which $78.1 million was reversed during the year ended October 31, 2021.
As of October 31, 2022, we considered all available positive and negative evidence to determine whether, based on the weight of that evidence, our valuation allowance for our DTAs was appropriate in accordance with ASC 740. Overall, the positive evidence, both objective and subjective, outweighed the negative evidence. The significant positive improvement in our operations in the last three years, coupled with our contract backlog of $1.3 billion as of October 31, 2022 provided positive evidence to support the conclusion that a full valuation allowance is not necessary for all of our DTAs. As such, we used our go forward projections to estimate our usage of our existing federal and state DTAs. Based on this analysis, we determined that the current valuation allowance for our DTAs of $95.7 million as of October 31, 2022 is appropriate.
| | 1. | As of October 31, 2022, on a tax basis, the Company had adjusted pre-tax income, which is income before income taxes excluding land-related charges and loss (gain) on extinguishment of debt, on a three-year cumulative basis. On a U.S. GAAP basis, the Company had generated $565.0 million of cumulative income before income taxes in the three years ended October 31, 2022. We believe these positive results will continue given the strength of our contract backlog and recent homebuilding market conditions. (Positive Objective Evidence) |
| | 2. | Over the last several years, we have completed a number of debt refinancing/restructuring transactions to extend our debt maturities, which will allow us to allocate cash to opportunistically grow our community count and potentially generate additional income. (Positive Objective Evidence) |
| | 3. | In July 2021 we paid off in full $111.2 million of 10.0% 2022 Notes and in August 2021, we paid off in full $69.7 million of 10.5% 2024 Notes. Additionally, in April 2022 we redeemed $100.0 million in principal of our 7.75% Senior Secured 1.125 Lien Notes due 2026. These actions reduced our annual interest incurred by approximately $23 million, which will enhance our profitability going forward. (Positive Objective Evidence) |
| | 4. | We incurred pre-tax losses during the housing market decline that began in 2007 and the slower than expected housing market recovery. Given our improved but still highly leveraged Consolidated Balance Sheet, another sustained downturn in the housing market, would be significantly more damaging to the Company than to other better capitalized homebuilders and make it very difficult for us to avoid future losses, given our high interest expenses. (Negative Objective Evidence) |
| | 5. | We exited several geographic markets over the last few years that have historically had pre-tax losses. By exiting these underperforming markets, the Company has been able to redeploy capital to better performing markets, which over time should improve our profitability. (Positive Subjective Evidence) |
| | 6. | The historical cyclicality of the U.S. housing market, a more restrictive mortgage lending environment compared to before the housing downturn of 2007-2009, the uncertainty of the overall U.S. economy, government policies and consumer confidence, all could adversely impact the housing market. (Negative Subjective Evidence) |
Deferred tax assets and liabilities have been recognized on the Consolidated Balance Sheets as follows:
| | | October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| Deferred tax assets: | | | | | | | | |
| Inventory impairments | | $ | 30,772 | | | $ | 34,973 | |
| Uniform capitalization of overhead | | | 4,285 | | | | 4,483 | |
| Warranty and legal reserves | | | 5,668 | | | | 5,671 | |
| Compensation | | | 13,746 | | | | 12,464 | |
| Deferred income | | | 2,425 | | | | 1,420 | |
| Interest expense | | | 3,646 | | | | 2,582 | |
| Restricted stock units | | | 1,628 | | | | 1,159 | |
| Stock options | | | 818 | | | | 1,009 | |
| Provision for losses | | | 17,700 | | | | 17,064 | |
| Joint venture loss | | | - | | | | 743 | |
| Federal net operating losses | | | 206,560 | | | | 263,366 | |
| State net operating losses | | | 150,832 | | | | 177,163 | |
| Other | | | 5,005 | | | | 5,136 | |
| Total deferred tax assets | | | 443,085 | | | | 527,233 | |
| Deferred tax liabilities: | | | | | | | | |
| Joint venture income | | | (2,565 | ) | | | - | |
| Total deferred tax liabilities | | | (2,565 | ) | | | - | |
| Valuation allowance | | | (95,727 | ) | | | (101,555 | ) |
| Deferred tax assets, net | | $ | 344,793 | | | $ | 425,678 | |
Our effective tax rate varied from the statutory federal income tax rate. The effective tax rate is affected by a number of factors, the most significant of which has been the valuation allowance related to our DTAs. Due to the effects of these factors, our effective tax rates for 2022, 2021 and 2020 are not correlated to the amount of our income before income taxes. The sources of these factors were as follows:
| | | Year Ended October 31, | |
| | | 2022 | | | 2021 | | | 2020 | |
| Federal statutory income tax rate | | | 21.0 | % | | | 21.0 | % | | | 21.0 | % |
| State income taxes, net of federal income tax benefit | | | 9.8 | | | | 4.0 | | | | 10.6 | |
| Permanent differences, net | | | 0.8 | | | | 3.6 | | | | 53.2 | |
| Deferred tax asset valuation allowance impact | | | 0.0 | | | | (248.5 | ) | | | (83.3 | ) |
| Tax contingencies | | | (0.1 | ) | | | (0.2 | ) | | | (0.5 | ) |
| Adjustments to prior years’ tax accruals | | | (2.0 | ) | | | 0.0 | | | | 7.0 | |
| Effective tax rate | | | 29.5 | % | | | (220.1 | )% | | | 8.0 | % |
ASC 740 provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits.
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 of tax liabilities. These differences will be reflected as increases or decreases to income tax (benefit) provision in the period in which they are determined.
We recognize interest and penalties related to unrecognized tax benefits within income taxes in the Consolidated Statement of Operations. Accrued interest and penalties are included within "Income taxes payable" line on the Consolidated Balance Sheets.
The following is a tabular reconciliation of the total amount of unrecognized tax benefits excluding interest and penalties:
| | | | |
| (In millions) | | | 2022 | | | | 2021 | |
| Unrecognized tax benefit—November 1, | | $ | 0.5 | | | $ | 0.7 | |
| Gross increases—tax positions in current period | | | - | | | | - | |
| Lapse of statute of limitations | | | (0.3 | ) | | | (0.2 | ) |
| Unrecognized tax benefit—October 31, | | $ | 0.2 | | | $ | 0.5 | |
Related to the unrecognized tax benefits noted above, as of October 31, 2022 and 2021, we recognized a liability for interest and penalties of $0.1 million and $0.3 million, respectively. For the years ended October 31, 2022, 2021 and 2020, we recognized $128 thousand, $84 thousand and $60 thousand, respectively, of interest and penalties in income taxes (benefits).
It is likely that, within the next 12 months, the amount of the Company's unrecognized tax benefits will decrease by $0.2 million, excluding interest and penalties. This reduction is expected primarily due to the expiration of certain statutes of limitation. The portion of unrecognized tax benefits that, if recognized, would affect the Company’s effective tax rate (excluding any related impact to the valuation allowance) is $0.2 million and $0.5 million for the years ended October 31, 2022 and 2021. The recognition of unrecognized tax benefits could have an impact on the Company’s DTAs.
The consolidated federal tax returns have been audited through October 31, 2021 and these years are closed. We are also subject to various income tax examinations in the states in which we do business. The outcome for a particular audit cannot be determined with certainty prior to the conclusion of the audit, appeal, and in some cases, litigation process. As each audit is concluded, adjustments, if any, are recorded in the period determined. To provide for potential exposures, tax reserves are recorded, if applicable, based on reasonable estimates of potential audit results. However, if the reserves are insufficient upon completion of an audit, there could be an adverse impact on our financial position and results of operations. The statute of limitations for our major tax jurisdictions remains open for examination for tax years 2018 - 2021.
12. Reduction of Inventory to Fair Value
We had 374 communities under development and held for future development or sale at both October 31, 2022 and 2021, and 354 communities under development and held for future development or sale at October 31, 2020, which we evaluated for impairment indicators. We had an indicator of impairment on one community during the year ended October 31, 2022, with a carrying value of $10.6 million. We performed an impairment analysis on the community which included increased land development costs from previous projections. The increased land development costs, along with the recent downturn in the market, resulted in an impairment of $8.4 million for the year ended October 31, 2022. We performed undiscounted future cash flow analyses for three communities (i.e., those with a projected operating loss or other impairment indicators) during the year ended October 31, 2021, with an aggregate carrying value of $11.5 million. As a result of our undiscounted future cash flow analyses, we performed discounted cash flow analyses for all three of those communities, resulting in impairments of $2.0 million. We performed undiscounted future cash flow analyses for three communities during the year ended October 31, 2020, with an aggregate carrying value of $5.4 million. As a result of our undiscounted future cash flow analyses, we performed discounted cash flow analyses for two of those communities, resulting in impairments of $2.0 million. The one community that did not require a discounted cash flow analysis to be performed during the year ended October 31, 2020 had an aggregate carrying value of $0.6 million and did not have undiscounted future cash flows that exceeded the carrying amount by less than 20%. Our discount rates used for all impairments recorded during fiscal 2021 and fiscal 2020 ranged from 17.3% to 19.3%. Our aggregate impairment charges are included within "Inventory impairments and land option write-offs" in the Consolidated Statement of Operations and deducted from inventory.
The following table represents impairments by segment for fiscal 2022, 2021 and 2020:
| (Dollars in millions) | | Year Ended October 31, 2022 | |
| | | | | | | Dollar | | | Pre- | |
| | | Number of | | | Amount of | | | Impairment | |
| | | Communities | | | Impairment | | | Value (1) | |
| Northeast | | | - | | | $ | - | | | $ | - | |
| Southeast | | | - | | | | - | | | | - | |
| West | | | 1 | | | | 8.4 | | | | 10.6 | |
| Total | | | 1 | | | $ | 8.4 | | | $ | 10.6 | |
| (Dollars in millions) | | Year Ended October 31, 2021 | |
| | | | | | | Dollar | | | Pre- | |
| | | Number of | | | Amount of | | | Impairment | |
| | | Communities | | | Impairment | | | Value (1) | |
| Northeast | | | - | | | $ | - | | | $ | - | |
| Southeast | | | 2 | | | | 1.2 | | | | 9.2 | |
| West | | | 1 | | | | 0.8 | | | | 2.3 | |
| Total | | | 3 | | | $ | 2.0 | | | $ | 11.5 | |
| (Dollars in millions) | | Year Ended October 31, 2020 | |
| | | | | | | Dollar | | | Pre- | |
| | | Number of | | | Amount of | | | Impairment | |
| | | Communities | | | Impairment | | | Value (1) | |
| Northeast | | | 2 | | | $ | 2.0 | | | $ | 4.8 | |
| Southeast | | | - | | | | - | | | | - | |
| West | | | - | | | | - | | | | - | |
| Total | | | 2 | | | $ | 2.0 | | | $ | 4.8 | |
| (1) | Represents carrying value, net of prior period impairments, if any, at the time of recording the applicable period’s impairments. |
Write-offs of options, engineering and capitalized interest costs are also recorded in "Inventory impairments and land option write-offs" when we redesign communities, abandon certain engineering costs or do not exercise options in various locations because the pro forma profitability is not projected to produce adequate returns on investment commensurate with the risk. The total aggregate write-offs related to these items were $5.7 million, $1.6 million and $6.8 million for the years ended October 31, 2022, 2021 and 2020, respectively. Occasionally, these write-offs are offset by recovered deposits, sometimes through legal action, which had been written off in a prior period as walk-away costs. Historically, these recoveries have not been significant in comparison to the total costs written off.
The following table represents write-offs of such costs by segment for fiscal 2022, 2021 and 2020:
| | | Year Ended October 31, | |
| (In millions) | | 2022 | | | 2021 | | | 2020 | |
| Northeast | | $ | 0.4 | | | $ | 0.3 | | | $ | 5.0 | |
| Southeast | | | 0.9 | | | | 0.2 | | | | 0.8 | |
| West | | | 4.4 | | | | 1.1 | | | | 1.0 | |
| Total | | $ | 5.7 | | | $ | 1.6 | | | $ | 6.8 | |
13. Per Share Calculations
Basic and diluted earnings per share for the periods presented below were calculated as follows:
| | | Year Ended October 31, | |
| (In thousands, except per share data) | | 2022 | | | 2021 | | | 2020 | |
| | | | | | | | | | | | | |
| Numerator: | | | | | | | | | | | | |
| Net income | | $ | 225,490 | | | $ | 607,817 | | | $ | 50,928 | |
| Less: preferred stock dividends | | | (10,675 | ) | | | - | | | | - | |
| Less: undistributed earnings allocated to participating securities | | | (19,702 | ) | | | (57,676 | ) | | | (4,652 | ) |
| Numerator for basic earnings per share | | $ | 195,113 | | | $ | 550,141 | | | $ | 46,276 | |
| Plus: undistributed earnings allocated to participating securities | | | 19,702 | | | | 57,676 | | | | 4,652 | |
| Less: undistributed earnings reallocated to participating securities | | | (19,717 | ) | | | (58,687 | ) | | | (4,652 | ) |
| Numerator for diluted earnings per share | | $ | 195,098 | | | $ | 549,130 | | | $ | 46,276 | |
| Denominator: | | | | | | | | | | | | |
| Denominator for basic earnings per share – weighted average shares outstanding | | | 6,437 | | | | 6,287 | | | | 6,189 | |
| Effect of dilutive securities: | | | | | | | | | | | | |
| Stock-based payments | | | 291 | | | | 108 | | | | 395 | |
| Denominator for diluted earnings per share – weighted-average shares outstanding | | | 6,728 | | | | 6,395 | | | | 6,584 | |
| Basic earnings per share | | $ | 30.31 | | | $ | 87.50 | | | $ | 7.48 | |
| Diluted earnings per share | | $ | 29.00 | | | $ | 85.86 | | | $ | 7.03 | |
In addition, 26 thousand, 25 thousand and 0.2 million shares related to out-of-the money stock options, which could potentially dilute basic earnings per share in the future, were not included in the computation of diluted earnings per share for the years ended October 31, 2022, 2021 and 2020, respectively, because to do so would have been anti-dilutive for each period.
14. Capital Stock
Common Stock
Each share of Class A common stock entitles its holder to one vote per share, and each share of Class B common stock generally entitles its holder to ten votes per share. The amount of any regular cash dividend payable on a share of Class A common stock will be an amount equal to 110% of the corresponding regular cash dividend payable on a share of Class B common stock. If a shareholder desires to sell shares of Class B common stock, such stock must be converted into shares of Class A common stock at a one-to-one conversion rate.
On August 4, 2008, the Board of Directors (the "Board") adopted a shareholder rights plan (the “Rights Plan”), which was amended on January 11, 2018 and January 18, 2021, designed to preserve shareholder value and the value of certain tax assets primarily associated with NOLs and built-in losses under Section 382 of the Internal Revenue Code. Our ability to use NOLs and built-in losses would be limited if there was an “ownership change” under Section 382. This would occur if shareholders owning (or deemed under Section 382 to own) 5% or more of our stock increase their collective ownership of the aggregate amount of our outstanding shares by more than 50 percentage points over a defined period of time. The Rights Plan was adopted to reduce the likelihood of an “ownership change” occurring as defined by Section 382. Under the Rights Plan, one right was distributed for each share of Class A common stock and Class B common stock outstanding as of the close of business on August 15, 2008. Effective August 15, 2008, if any person or group acquires 4.9% or more of the outstanding shares of Class A common stock without the approval of the Board, there would be a triggering event causing significant dilution in the voting power of such person or group. However, existing stockholders who owned, at the time of the Rights Plan’s initial adoption on August 4, 2008, 4.9% or more of the outstanding shares of Class A common stock will trigger a dilutive event only if they acquire additional shares. The approval of the Board's decision to adopt the Rights Plan may be terminated by the Board at any time, prior to the Rights being triggered. The Rights Plan will continue in effect until August 14, 2024, unless it expires earlier in accordance with its terms. The approval of the Board's decision to initially adopt the Rights Plan and the amendments thereto were approved by shareholders. Our shareholders also approved an amendment to our Certificate of Incorporation to restrict certain transfers of Class A common stock in order to preserve the tax treatment of our NOLs and built-in losses under Section 382 of the Internal Revenue Code. Subject to certain exceptions pertaining to pre-existing 5% stockholders and Class B stockholders, the transfer restrictions in our Restated Certificate of Incorporation generally restrict any direct or indirect transfer (such as transfers of our stock that result from the transfer of interests in other entities that own our stock) if the effect would be to (i) increase the direct or indirect ownership of our stock by any person (or public group) from less than 5% to 5% or more of our common stock; (ii) increase the percentage of our common stock owned directly or indirectly by a person (or public group) owning or deemed to own 5% or more of our common stock; or (iii) create a new “public group” (as defined in the applicable U.S. Treasury regulations). Transfers included under the transfer restrictions include sales to persons (or public groups) whose resulting percentage ownership (direct or indirect) of common stock would exceed the 5% thresholds discussed above, or to persons whose direct or indirect ownership of common stock would by attribution cause another person (or public group) to exceed such threshold.
On July 3, 2001, the Board authorized a stock repurchase program to purchase up to 0.2 million shares of Class A common stock. On September 1, 2022, the Board terminated our prior repurchase program and authorized a new program for the repurchase of up to $50.0 million of our Class A common stock. Under the new repurchase program, repurchases may be made from time to time in open market transactions, in privately negotiated transactions or otherwise. The timing and the actual dollar amount repurchased will depend on a variety of factors, including legal requirements, price, future tax implications and economic and market conditions. The repurchase program may be changed, suspended or discontinued at any time and does not have a specified expiration date. As of October 31, 2022, $37.8 million of our Class A common stock is available to repurchase under the stock repurchase program.
On October 31, 2020, in connection with the issuance of the 7.75% Senior Secured 1.25 Lien Notes due 2026, we issued and sold an aggregate of 178,427 shares of Class A common stock, par value $0.01 per share (and associated Preferred Stock Purchase Rights), to the purchasers of such Notes for an aggregate purchase price of $1,784.27. The issuance was exempt from registration under Section 4(a)(2) of the Securities Act of 1933.
Preferred Stock
On July 12, 2005, we issued 5,600 shares of 7.625% Series A preferred stock, with a liquidation preference of $25,000 per share. 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. 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.” In fiscal 2022 we paid dividends of $10.7 million on the Series A preferred stock. In fiscal 2021 and 2020, we did not pay any dividends on the Series A preferred stock due to covenant restrictions in our debt instruments.
Retirement Plan
We have established a tax-qualified, defined contribution savings and investment retirement plan (a 401(k) plan). All associates are eligible to participate in the retirement plan, and employer contributions are based on a percentage of associate contributions and our operating results. 401(k) plan expenses were $8.3 million, $7.0 million and $7.4 million for the years ended October 31, 2022, 2021 and 2020, respectively.
Treasury Stock
During the year ended October 31, 2022, we repurchased 312,471 shares under the new stock repurchase program, with a market value of $12.2 million, or $39.12 per share, which were added to "Treasury stock" on our Consolidated Balance Sheets as of October 31, 2022. There were no shares repurchased during the years ended October 31, 2021 or 2020.
15. Stock-Based Compensation Plans
We have stock incentive plans for certain officers, key employees and directors that are approved by a committee appointed by the Board or its delegate. As of October 31, 2022, we had 0.6 million shares authorized and remaining for future issuance under our stock incentive plans. Based on the terms of our stock incentive plans, awards that are forfeited become available to us for future grants.
Stock Options
Prior to fiscal 2020, stock options were granted. There have been no stock option grants during fiscal years 2022, 2021 or 2020. The exercise price of all stock options is at least equal to the fair market value of an underlying share of our Class A common stock on the date of the grant. The fair value of each stock option is estimated using the Black-Scholes option-pricing model. Stock options granted to officers and associates generally vest in four equal installments on the second, third, fourth and fifth anniversaries of the date of the grant. Non-employee directors’ stock options vest in three equal installments on the first, second and third anniversaries of the date of the grant. All stock options expire on the tenth anniversary from the date of grant.
The following table summarizes stock option activity at October 31, 2022:
| | | October 31, | | | Weighted-Average | |
| | | 2022 | | | Exercise Price | |
| Stock options outstanding at beginning of period | | | 206,234 | | | $ | 51.67 | |
| Granted | | | - | | | $ | - | |
| Exercised | | | (9,575 | ) | | $ | 51.50 | |
| Forfeited | | | - | | | $ | - | |
| Expired | | | (30,100 | ) | | $ | 71.97 | |
| Stock options outstanding at end of period | | | 166,559 | | | $ | 48.02 | |
| Stock options exercisable at end of period | | | 127,780 | | | | | |
The total intrinsic value of stock options exercised during fiscal 2022 and 2021 was $0.2 million and $4.8 million, respectively. The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price. There were no stock options exercised in fiscal 2020.
Based on the fair value at the time of grant, the per share weighted-average fair value of stock options vested in fiscal 2022, 2021 and 2020 was $16.46, $8.82 and $25.34, respectively.
The following table summarizes the exercise price range and related number of outstanding stock options at October 31, 2022:
| | | | | | | | | | | Weighted- | |
| | | | | | | | | | | Average | |
| | | | | | | Weighted- | | | Remaining | |
| | | Number | | | Average | | | Contractual | |
| Range of Exercise Prices | | Outstanding | | | Exercise Price | | | Life | |
| $7.85 – $38.75 | | | 73,174 | | | $ | 9.54 | | | | 6.62 | |
| $42.50 – $63.75 | | | 67,439 | | | $ | 54.16 | | | | 4.56 | |
| $66.75 – $100.25 | | | 1,700 | | | $ | 66.75 | | | | 2.61 | |
| $110.25 – $157.00 | | | 24,246 | | | $ | 145.73 | | | | 0.86 | |
| | | | 166,559 | | | $ | 48.02 | | | | 4.90 | |
The following table summarizes the exercise price range and related number of exercisable stock options at October 31, 2022:
| | | | | | | | | | | Weighted- | |
| | | | | | | | | | | Average | |
| | | | | | | Weighted- | | | Remaining | |
| | | Number | | | Average | | | Contractual | |
| Range of Exercise Prices | | Exercisable | | | Exercise Price | | | Life | |
| $7.85 – $38.75 | | | 36,578 | | | $ | 9.58 | | | | 6.62 | |
| $42.50 – $63.75 | | | 65,256 | | | $ | 54.34 | | | | 4.52 | |
| $66.75 – $100.25 | | | 1,700 | | | $ | 66.75 | | | | 2.61 | |
| $110.25 – $157.00 | | | 24,246 | | | $ | 145.73 | | | | 0.86 | |
| | | | 127,780 | | | $ | 59.03 | | | | 4.40 | |
RSUs and Performance Units
RSUs are measured based upon the fair value of a share of our Class A common stock on the date of grant. Shares underlying RSUs granted to officers and associates generally vest in four equal installments on the first, second, third, and fourth anniversaries of the grant date. During fiscal year 2022, each of our six existing non-employee directors were granted RSUs subject to a two-year post-vesting holding period. Generally, participants aged 60 years or older, or aged 58 with 15 years of service, are eligible to vest in their awards on an accelerated basis upon their retirement (which in the case of RSUs granted prior to 2019 only applies to a retirement that is at least one year after the date of grant).
Grants of market share units ("MSUs"), performance share units ("PSUs") and the stock portion of the long-term incentive plans ("LTIPs") (each discussed below), are also awarded as compensation.
The following table summarizes nonvested time-based RSU and MSU share activity as of October 31, 2022:
| | | October 31, | | | Weighted-Average Grant Date | |
| | | 2022 | | | Fair Value | |
| Nonvested time-based at beginning of period | | | 229,924 | | | $ | 26.51 | |
| Granted | | | 63,159 | | | $ | 50.14 | |
| Vested (1) | | | (113,684 | ) | | $ | 23.51 | |
| Forfeited | | | (3,762 | ) | | $ | 39.49 | |
| Nonvested time-based at end of period | | | 175,637 | | | $ | 33.43 | |
The following table summarizes nonvested performance-based LTIP, PSU and MSU share activity as of October 31, 2022:
| | | October 31, | | | Weighted-Average Grant Date | |
| | | 2022 | | | Fair Value | |
| Nonvested performance-based at beginning of period | | | 350,983 | | | $ | 35.60 | |
| Granted | | | 335,794 | | | $ | 42.91 | |
| Vested (1) | | | (179,265 | ) | | $ | 29.36 | |
| Forfeited | | | (355 | ) | | $ | 73.50 | |
| Nonvested performance-based at end of period | | | 507,157 | | | $ | 41.14 | |
(1) Includes 49,484 time-based vested share awards and 116,785 performance-based vested share awards which were deferred and not yet issued at October 31, 2022.
LTIP awards include share adjustments for the difference between target performance metrics at the time of grant and the final performance outcome. Share adjustments are reflected in the “Granted” line above at the time the performance is finalized. For LTIP awards granted prior to fiscal 2022, shares vest on the third, fourth and fifth anniversary of the grant date, subject to performance achievement. The 2022 LTIP is subject to cliff vesting at the end of the performance period.
PSUs granted in fiscal 2020 vest in four equal installments commencing on the second, third, fourth and fifth anniversary of the grant date, except that no portion of the award will vest unless the Board determines that the Company achieved specified earnings goals. Fiscal 2022 and 2021 PSUs are subject to cliff vesting on the third year after the grant date. The fair value of PSUs is determined using the Finnerty model, which uses an arithmetic average strike, put option. The strike price is based on the predetermined period average value of the underlying asset. The following assumptions were used for the 2022 PSU grants: historical volatility factor of 78.82% based on the expected market price of our Class A common stock for the two-year period ending on the valuation date, concluded stock price assumption of 3.04% equal to the continuously compounded two-year yield and a dividend yield of zero.
There were no MSUs granted in fiscal 2022, 2021 and 2020. The fair value of MSUs is determined using the Monte-Carlo simulation model. The first 50% of an MSU grant vests in four equal annual installments, commencing on the second anniversary from the date of grant, subject to stock price performance conditions, pursuant to which the actual number of shares issuable with respect to vested MSUs may range from 0% to 200% of the target number of shares under each MSU award, generally depending on the growth in the 60-day average trading price of the Company’s shares during the period between the grant date and the relevant vesting dates. The remaining 50% of an MSU grant is subject to financial performance conditions in addition to the stock price performance conditions. These remaining MSUs vest in four equal installments with the first installment vesting on the third January 1st after the grant date, and the remaining annual installments commencing on the third anniversary from the date of grant, except that no portion of the award will vest unless the Board determines the Company achieved certain specified performance goals.
During the year-ended October 31, 2022 we issued 60,751 RSUs, 60,130 MSUs and 17,023 LTIP shares. As of October 31, 2022, there was $15.4 million of unrecognized stock-based compensation, which is primarily comprised of unrecognized expenses for RSUs, MSUs, PSUs, and the stock portion of LTIPs. The cost is expected to be recognized over a weighted-average period of 1.6 years.
Stock-Based Compensation Expense
For the years ended October 31, 2022, 2021 and 2020, stock-based compensation expense was $10.3 million ($7.3 million post tax), $7.7 million ($5.2 million post tax) and $2.8 million ($2.6 million post tax), respectively. Stock-based compensation for RSUs, MSUs, PSUs, and the stock portion of LTIPs was $10.2 million, $7.4 million and $2.4 million for fiscal 2022, 2021 and 2020, respectively. In addition, stock option compensation expense was $0.1 million, $0.2 million and $0.4 million for the years ended October 31, 2022, 2021 and 2020, respectively. Stock-based compensation expense for the year ended October 31, 2020 included income of $2.4 million from previously recognized expense for certain time and performance-based awards where the performance metrics were not satisfied.
16. Warranty Costs
General liability insurance for homebuilding companies and their suppliers and subcontractors is very difficult to obtain. The availability of general liability insurance is limited due to a decreased number of insurance companies willing to underwrite for the industry. In addition, those few insurers willing to underwrite liability insurance have significantly increased the premium costs. To date, we have been able to obtain general liability insurance but at higher premium costs with higher deductibles. Our subcontractors and suppliers have advised us that they have also had difficulty obtaining insurance that also provides us coverage. As a result, we have an owner-controlled insurance program for certain of our subcontractors whereby the subcontractors pay us an insurance premium (through a reduction of amounts we would otherwise owe such subcontractors for their work on our homes) based on the risk type of the trade. We absorb the liability associated with their work on our homes as part of our overall general liability insurance at no additional cost to us because our existing general liability and construction defect insurance policy and related reserves for amounts under our deductible covers construction defects regardless of whether we or our subcontractors are responsible for the defect. For the years ended October 31, 2022 and 2021, we received $6.0 million and $5.5 million, respectively, from subcontractors related to the owner controlled-insurance program, which we accounted for as reductions to inventory.
Additions and charges in the warranty reserve and general liability reserve for the years ended October 31, 2022 and 2021 were as follows:
| | | Year Ended October 31, | |
| (In thousands) | | 2022 | | | 2021 | |
| | | | | | | | | |
| Balance, beginning of period | | $ | 94,916 | | | $ | 86,417 | |
| Additions: Selling, general and administrative | | | 8,495 | | | | 10,419 | |
| Additions: Cost of sales | | | 9,054 | | | | 13,410 | |
| Charges incurred during the period | | | (18,271 | ) | | | (14,342 | ) |
| Changes to pre-existing reserves | | | 3,525 | | | | (988 | ) |
| Balance, end of period | | $ | 97,719 | | | $ | 94,916 | |
Warranty accruals are based upon historical experience. In fiscal 2022, we recorded an increase of $4.3 million to our construction defect reserves related to specific claims. These changes are reflected in the changes to pre-existing reserves in the table above.
Insurance claims paid by our insurance carriers, excluding insurance deductibles paid, were $0.2 million and $0.1 million for the years ended October 31, 2022 and 2021, respectively, for prior year deliveries.
17. Transactions with Related Parties
During the years ended October 31, 2022, 2021 and 2020, an engineering firm owned by Tavit Najarian, a relative of Ara K. Hovnanian, our Chairman of the Board and our Chief Executive Officer, provided services to the Company totaling $1.1 million, $0.6 million and $0.7 million, respectively. Neither the Company nor Mr. Hovnanian has a financial interest in the relative’s company from whom the services were provided.
Alexander Hovnanian, the son of Ara K. Hovnanian, is employed by the Company. Alexander Hovnanian holds the position of Executive Vice President - National Homebuilding Operations. For fiscal 2022, he received cash compensation of approximately $1,684,000 and equity awards with an aggregate grant date fair value of approximately $531,000. For fiscal 2021, he received cash compensation of approximately $989,000 and equity awards with an aggregate grant date fair value of approximately $523,000. For fiscal 2020, his total compensation was approximately $1,152,000.
Carson Sorsby, the son of J. Larry Sorsby one of our Board directors and our Chief Financial Officer, is employed by the Company. Carson Sorsby holds the position of Account Manager in the Company’s mortgage subsidiary. His compensation is commensurate with that of similarly situated employees in his position.
18. Commitments and Contingent Liabilities
We are involved in litigation arising in the ordinary course of business, none of which is expected to have a material adverse effect on our financial position, results of operations or cash flows, and we are subject to extensive and complex laws and regulations that affect the development of land and home building, sales and customer financing processes, including zoning, density, building standards and mortgage financing. These laws and regulations often provide broad discretion to the administering governmental authorities. This can delay or increase the cost of development or homebuilding. The significant majority of our litigation matters are related to construction defect claims. Our estimated losses from construction defect litigation matters, if any, are included in our construction defect reserves.
We also are subject to a variety of local, state, federal and foreign laws and regulations concerning protection of health and the environment, including those regulating the emission or discharge of materials into the environment, the management of storm water runoff at construction sites, the handling, use, storage and disposal of hazardous substances, impacts to wetlands and other sensitive environments, and the remediation of contamination at properties that we have owned or developed or currently own or are developing (“environmental laws”). The particular environmental laws that apply to a site may vary greatly according to the community site, for example, due to the community, the environmental conditions at or near the site, and the present and former uses of the site. These environmental laws may result in delays, may cause us to incur substantial compliance, remediation and/or other costs, and can prohibit or severely restrict development and homebuilding activity. In addition, noncompliance with these laws and regulations could result in fines and penalties, obligations to remediate or take corrective action, permit revocations or other sanctions; and contamination or other environmental conditions at or in the vicinity of our developments may result in claims against us for personal injury, property damage or other losses.
We anticipate that increasingly stringent requirements will continue to be imposed on developers and homebuilders in the future. In addition, some of these laws and regulations that significantly affect how certain properties may be developed are contentious, attract intense political attention, and may be subject to significant changes over time. For example, regulations governing wetlands permitting under the federal Clean Water Act have been the subject of extensive rulemakings for many years, resulting in several major joint rulemakings by the EPA and the U.S. Army Corps of Engineers that have expanded and contracted the scope of wetlands subject to regulation; and such rulemakings have been the subject of many legal challenges, some of which remain pending. It is unclear how these and related developments, including at the state or local level, ultimately may affect the scope of regulated wetlands where we operate. Although we cannot reliably predict the extent of any effect these developments regarding wetlands, or any other requirements that may take effect, may have on us, they could result in time-consuming and expensive compliance programs and in substantial expenditures, which could cause delays and increase our cost of operations. In addition, our ability to obtain or renew permits or approvals and the continued effectiveness of permits already granted or approvals already obtained is dependent upon many factors, some of which are beyond our control, such as changes in policies, rules and regulations and their interpretations and application.
In March 2013, we received a letter from the EPA requesting information about our involvement in a housing redevelopment project in Newark, New Jersey that a Company entity undertook during the 1990s. We understand that the development is in the vicinity of a former lead smelter and that tests on soil samples from properties within the development conducted by the EPA showed elevated levels of lead. We also understand that the smelter ceased operations many years before the Company entity involved acquired the properties in the area and carried out the re-development project. We responded to the EPA’s request. In August 2013, we were notified that the EPA considers us a PRP with respect to the site, that the EPA will clean up the site, and that the EPA is proposing that we fund and/or contribute towards the cleanup of the contamination at the site. We began preliminary discussions with the EPA concerning a possible resolution. The EPA requested additional information in April 2014 and again in March 2017 and the Company responded to the information requests. On May 2, 2018 the EPA sent a letter to the Company entity demanding reimbursement for 100% of the EPA’s costs to clean-up the site in the amount of $2.7 million. The Company responded to the EPA’s demand letter on June 15, 2018 setting forth the Company’s defenses and expressing its willingness to enter into settlement negotiations. Two other PRPs identified by the EPA began negotiations with the EPA and preliminary negotiations with the Company regarding the site. The EPA then requested that the three PRPs present a joint settlement offer to the EPA. In June 2022, the Company and one of the other PRPs reached an agreement with the EPA for a total settlement of $1.5 million (plus accrued interest), with the Company contributing approximately $0.8 million to the settlement, slightly below the amount we had previously accrued. The consent decree entered into by the settling parties was submitted to the United States District Court for the District of New Jersey (where the EPA has filed a complaint seeking reimbursement of response costs) on June 14, 2022 and was signed and filed by such Court on August 9, 2022.
In 2015, the condominium association of the Four Seasons at Great Notch condominium community (the “Great Notch Plaintiff”) filed a lawsuit in the Superior Court of New Jersey, Law Division, Passaic County (the “Court”) alleging various construction defects, design defects, and geotechnical issues relating to the community. The operative complaint (“Complaint”) asserts claims against Hovnanian Enterprises, Inc. and several of its affiliates, including K. Hovnanian at Great Notch, LLC, K. Hovnanian Construction Management, Inc., and K. Hovnanian Companies, LLC. The Complaint also asserts claims against various other design professionals and contractors. The Special Masters appointed by the Court to decide non-dispositive motions issued an opinion that (a) granted the Great Notch Plaintiff’s motion to permit it to assert a claim to pierce the corporate veil of K. Hovnanian at Great Notch, LLC to hold its alleged parent entities liable for any damages awarded against it, and (b) further stated that the Great Notch Plaintiff is not permitted to pursue that claim until after any trial on the underlying liability claims. To date, the Hovnanian-affiliated defendants have reached a partial settlement with the Great Notch Plaintiff as to a portion of the Great Notch Plaintiff’s claims against them for an amount immaterial to the Company. On its remaining claims against the Hovnanian-affiliated defendants, the Great Notch Plaintiff has asserted damages of approximately $119.5 million, which amount is potentially subject to treble damages pursuant to the Great Notch Plaintiff’s claim under the New Jersey Consumer Fraud Act. The trial is currently scheduled for April 17, 2023. The Hovnanian-affiliated defendants intend to defend these claims vigorously.
In December 2020, the New Jersey Department of Environmental Protection ("NJDEP") and the Administrator of the New Jersey Spill Compensation Fund (the “Spill Fund”) filed a lawsuit in the Superior Court of New Jersey, Law Division, Union County against Hovnanian Enterprises, Inc. in addition to other unrelated parties, in connection with contamination at Hickory Manor, a residential condominium development. Alleged predecessors of certain defendants had used the Hickory Manor property for decades for manufacturing purposes. In 1998, NJDEP confirmed that groundwater at this site was impacted from an off-site source. The site was later remediated, resulting in the NJDEP issuing an unconditional site-wide No Further Action determination letter and Covenant Not to Sue in 1999. Subsequently, one of our affiliates was involved in redeveloping the property as a residential community. The complaint asserts claims under the New Jersey Spill Act and other state law claims and alleges that the NJDEP and the Spill Fund have incurred over $5.3 million since 2009 to investigate vapor intrusion at the development and to install vapor mitigation systems. Among other things, the complaint seeks recovery of the costs incurred, an order that defendants perform additional required remediation and disgorgement of profits on our affiliate’s sales of the units in the development. Discovery has commenced. Hovnanian Enterprises, Inc. intends to defend these claims vigorously.
19. Variable Interest Entities
We enter into land and lot option purchase contracts to procure land or lots for the construction of homes. Under these contracts, the Company will fund a stated deposit in consideration for the right, but not the obligation, to purchase land or lots at a future point in time with predetermined terms. Under the terms of the option purchase contracts, many of the option deposits are not refundable at the Company's discretion. Under the requirements of ASC 810, certain option purchase contracts may result in the creation of a VIE that owns the land parcel under option.
In compliance with ASC 810, the Company analyzes its option purchase contracts to determine whether the corresponding land sellers are VIEs and, if so, whether the Company is the primary beneficiary. Although the Company does not have legal title to the underlying land, ASC 810 requires the Company to consolidate a VIE if the Company is determined to be the primary beneficiary. In determining whether it is the primary beneficiary, the Company considers, among other things, whether it has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Such activities would include, among other things, determining or limiting the scope or purpose of the VIE, selling or transferring property owned or controlled by the VIE, or arranging financing for the VIE. The Company also considers whether it has the obligation to absorb losses of the VIE or the right to receive benefits from the VIE. As a result of our analyses, we have concluded, the Company is not the primary beneficiary of any VIEs from which it is purchasing land under option purchase contracts.
We will continue to secure land and lots using options, some of which are with VIEs. Including deposits on our unconsolidated VIEs, at October 31, 2022, we had total cash deposits amounting to $180.8 million to purchase land and lots with a total purchase price of $1.9 billion. The maximum exposure to loss with respect to our land and lot options is limited to the deposits plus any pre-development costs invested in the property, although some deposits are refundable at our request or refundable if certain conditions are not met.
20. Investments in Unconsolidated Homebuilding and Land Development Joint Ventures
We enter into homebuilding and land development joint ventures from time to time as a means of accessing lot positions, expanding our market opportunities, establishing strategic alliances, managing our risk profile, leveraging our capital base and enhancing returns on capital. Our homebuilding joint ventures are generally entered into with third-party investors to develop land and construct homes that are sold directly to third-party home buyers. Our land development joint ventures include those entered into with developers and other homebuilders as well as financial investors to develop finished lots for sale to the joint venture’s members or other third-parties.
During the third quarter of fiscal 2021, we purchased the remaining equity interest in one of our unconsolidated joint ventures for $6.3 million of net cash. As a result of this transaction, we took control of four communities, including three active communities. The unconsolidated joint venture was subsequently dissolved.
During the second quarter of fiscal 2021, we contributed six communities we owned, including three active communities, to two new joint ventures for $21.2 million of net cash.
During the first quarter of fiscal 2020, we contributed eight communities we owned, including four active communities, to a new joint venture for $29.8 million of net cash.
The tables set forth below summarize the combined financial information related to our unconsolidated homebuilding and land development joint ventures that are accounted for under the equity method:
| | | October 31, 2022 | |
| | | | | | | Land | | | | | |
| (In thousands) | | Homebuilding | | | Development | | | Total | |
| Assets: | | | | | | | | | | | | |
| Cash and cash equivalents | | $ | 153,176 | | | $ | 868 | | | $ | 154,044 | |
| Inventories | | | 441,140 | | | | - | | | | 441,140 | |
| Other assets | | | 20,037 | | | | - | | | | 20,037 | |
| Total assets | | $ | 614,353 | | | $ | 868 | | | $ | 615,221 | |
| Liabilities and equity: | | | | | | | | | | | | |
| Accounts payable and accrued liabilities | | $ | 471,813 | | | $ | 651 | | | $ | 472,464 | |
| Notes payable | | | 34,880 | | | | - | | | | 34,880 | |
| Total liabilities | | | 506,693 | | | | 651 | | | | 507,344 | |
| Equity of: | | | | | | | | | | | | |
| Hovnanian Enterprises, Inc. | | | 73,142 | | | | 209 | | | | 73,351 | |
| Others | | | 34,518 | | | | 8 | | | | 34,526 | |
| Total equity | | | 107,660 | | | | 217 | | | | 107,877 | |
| Total liabilities and equity | | $ | 614,353 | | | $ | 868 | | | $ | 615,221 | |
| Debt to capitalization ratio | | | 24 | % | | | 0 | % | | | 24 | % |
| | | October 31, 2021 | |
| | | | | | | Land | | | | | |
| (In thousands) | | Homebuilding | | | Development | | | Total | |
| Assets: | | | | | | | | | | | | |
| Cash and cash equivalents | | $ | 132,963 | | | $ | 1,972 | | | $ | 134,935 | |
| Inventories | | | 442,347 | | | | - | | | | 442,347 | |
| Other assets | | | 34,551 | | | | - | | | | 34,551 | |
| Total assets | | $ | 609,861 | | | $ | 1,972 | | | $ | 611,833 | |
| Liabilities and equity: | | | | | | | | | | | | |
| Accounts payable and accrued liabilities | | $ | 386,117 | | | $ | 1,681 | | | $ | 387,798 | |
| Notes payable | | | 73,994 | | | | - | | | | 73,994 | |
| Total liabilities | | | 460,111 | | | | 1,681 | | | | 461,792 | |
| Equity of: | | | | | | | | | | | | |
| Hovnanian Enterprises, Inc. | | | 58,460 | | | | 254 | | | | 58,714 | |
| Others | | | 91,290 | | | | 37 | | | | 91,327 | |
| Total equity | | | 149,750 | | | | 291 | | | | 150,041 | |
| Total liabilities and equity | | $ | 609,861 | | | $ | 1,972 | | | $ | 611,833 | |
| Debt to capitalization ratio | | | 33 | % | | | 0 | % | | | 33 | % |
As of October 31, 2022 and 2021, we had advances outstanding of $1.6 million and $2.2 million, respectively, to these unconsolidated joint ventures. These amounts were included in “Accounts payable and accrued liabilities” in the tables above. On our Consolidated Balance Sheets, our “Investments in and advances to unconsolidated joint ventures” amounted to $74.9 million and $60.9 million at October 31, 2022 and 2021, respectively. In some cases, our net investment in these unconsolidated joint ventures is less than our proportionate share of the equity reflected in the table above because of the differences between asset impairments recorded against our unconsolidated joint venture investments and any impairments recorded in the applicable unconsolidated joint venture. Impairments of unconsolidated joint venture investments are recorded at fair value while impairments recorded in the unconsolidated joint venture are recorded when undiscounted cash flows trigger the impairment. During the years ended October 31, 2022 and 2021, we did not write-down any of our unconsolidated joint venture investments.
| | | For The Year Ended October 31, 2022 | |
| | | | | | | Land | | | | | |
| (In thousands) | | Homebuilding | | | Development | | | Total | |
| Revenues | | $ | 351,767 | | | $ | 113 | | | $ | 351,880 | |
| Cost of sales and expenses | | | (318,788 | ) | | | (37 | ) | | | (318,825 | ) |
| Joint venture net income | | $ | 32,979 | | | $ | 76 | | | $ | 33,055 | |
| Our share of net income | | $ | 29,002 | | | $ | 31 | | | $ | 29,033 | |
| | | For The Year Ended October 31, 2021 | |
| | | | | | | Land | | | | | |
| (In thousands) | | Homebuilding | | | Development | | | Total | |
| Revenues | | $ | 347,898 | | | $ | 691 | | | $ | 348,589 | |
| Cost of sales and expenses | | | (335,077 | ) | | | (209 | ) | | | (335,286 | ) |
| Joint venture net income | | $ | 12,821 | | | $ | 482 | | | $ | 13,303 | |
| Our share of net income | | $ | 8,754 | | | $ | 195 | | | $ | 8,949 | |
| | | For The Year Ended October 31, 2020 | |
| | | | | | | Land | | | | | |
| (In thousands) | | Homebuilding | | | Development | | | Total | |
| Revenues | | $ | 435,077 | | | $ | 13,024 | | | $ | 448,101 | |
| Cost of sales and expenses | | | (420,977 | ) | | | (11,225 | ) | | | (432,202 | ) |
| Joint venture net income | | $ | 14,100 | | | $ | 1,799 | | | $ | 15,899 | |
| Our share of net income | | $ | 16,904 | | | $ | 17 | | | $ | 16,921 | |
“Income (loss) from unconsolidated joint ventures” in the Consolidated Statements of Operations reflects our proportionate share of income or loss from these unconsolidated homebuilding and land development joint ventures. The difference between our share of the income or loss from these unconsolidated joint ventures in the tables above compared to the Consolidated Statements of Operations is due primarily to the reclassification of the intercompany portion of management fee income from certain unconsolidated joint ventures and the deferral of income for lots purchased by us from certain unconsolidated joint ventures.
The reason “Our share of net income” is higher or lower than the “Joint venture net income” shown in the tables above for the years ended October 31, 2022 and 2021, respectively, is because we have varying ownership percentages, ranging from 20% to over 50%, in our seven and ten unconsolidated joint ventures for both periods, respectively. Therefore, depending on mix, if the unconsolidated joint ventures in which we have higher sharing percentages are more profitable than our other unconsolidated joint ventures, that results in us having a higher overall percentage of income in the aggregate than would occur if all joint ventures had the same sharing percentage; conversely, if the unconsolidated joint ventures in which we have lower sharing percentages are more profitable than our other unconsolidated joint ventures, that results in us having a lower overall percentage of income in the aggregate than would occur if all joint ventures had the same sharing percentage. For the year ended October 31, 2022, "Our share of net income" was lower than the "Joint venture net income" due to increased income on two of our newer unconsolidated joint ventures during the year for which we currently recognize a lower profit-sharing percentage based on the joint venture agreements, a third unconsolidated joint venture which we recognize a lower profit-sharing percentage having higher profit in the current period, and a fourth unconsolidated joint venture that generated profit that we did not recognize due to the fact that we had previously written off our investment balance in the unconsolidated joint venture. For the year ended October 31, 2021, "Our share of net income" was lower than the "Joint venture net income" due to increased income on one of our newer unconsolidated joint ventures during the year for which we currently recognize no share percentage of the profit based on the joint venture agreement, and a second unconsolidated joint venture which we recognize a lower profit-sharing percentage having higher profit in the current period. In addition, for the year ended October 31, 2022, we had written off our investment in one of our unconsolidated joint ventures that was generating losses and therefore we currently do not recognize those losses. For the year ended October 31, 2021, we had written off our investment in two of our unconsolidated joint ventures that were generating losses and therefore we did not recognize those losses. Had we not fully written off our investment, our share of the net loss in this unconsolidated joint venture would have been approximately 50%, which would have reduced our overall share of net income across all of our unconsolidated joint ventures. As a result, these unconsolidated joint venture losses significantly reduce the profit when looking at all seven and ten of our unconsolidated joint ventures, respectively, in the aggregate, without having any impact on our share of net income or loss recorded in the applicable period.
To compensate us for the administrative services we provide as the manager of certain unconsolidated joint ventures, we receive a management fee based on a percentage of the applicable unconsolidated joint venture’s revenues. These management fees, which totaled $12.5 million, $11.6 million and $16.0 million for the years ended October 31, 2022, 2021 and 2020, are recorded in “Selling, general and administrative” homebuilding expenses in the Consolidated Statements of Operations.
Typically, our unconsolidated joint ventures obtain separate project specific mortgage financing. For some of our unconsolidated joint ventures, obtaining financing was challenging, therefore, some of our unconsolidated joint ventures are capitalized only with equity. Any unconsolidated joint venture financing is on a nonrecourse basis, with guarantees from us limited only to performance and completion of development, environmental warranties and indemnification, standard indemnification for fraud, misrepresentation and other similar actions, including a voluntary bankruptcy filing. In some instances, the unconsolidated joint venture entity is considered a VIE under ASC 810 due to the returns being capped to the equity holders; however, in these instances, we have determined that we are not the primary beneficiary, and therefore we do not consolidate these entities.
21. Fair Value of Financial Instruments
ASC 820, "Fair Value Measurements and Disclosures", provides a framework for measuring fair value and establishes a fair-value hierarchy which prioritizes the use of observable inputs when measuring fair value. The fair value hierarchy can be summarized as follows:
Level 1: Fair value determined based on quoted prices in active markets for identical assets.
Level 2: Fair value determined using significant other observable inputs.
Level 3: Fair value determined using significant unobservable inputs.
Our financial instruments measured at fair value on a recurring basis are summarized below:
| | | | Fair Value at | | | Fair Value at | |
| | Fair Value | | October 31, | | | October 31, | |
| (In thousands) | Hierarchy | | 2022 | | | 2021 | |
| | | | | | | | | | |
| Mortgage loans held for sale (1) | Level 2 | | $ | 110,548 | | | $ | 151,059 | |
| Forward contracts | Level 2 | | | 752 | | | | (107 | ) |
| Total | | $ | 111,300 | | | $ | 150,952 | |
| Interest rate lock commitments | Level 3 | | | - | | | | 152 | |
| Total | | $ | 111,300 | | | $ | 151,104 | |
(1) The aggregate unpaid principal balance was $110.2 million and $146.5 million at October 31, 2022 and 2021, respectively.
Fair value of mortgage loans held for sale is based on independent quoted market prices, where available, or the prices for other mortgage loans with similar characteristics.
The financial services segment had a pipeline of loan applications in process of $583.6 million at October 31, 2022. Loans in process for which interest rates were committed to the borrowers totaled $96.8 million as of October 31, 2022. Substantially all of these commitments were for periods of 60 days or less. Since a portion of these commitments is expected to expire without being exercised by the borrowers, the total commitments do not necessarily represent future cash requirements.
In addition, the financial services segment uses investor commitments and forward sales of mandatory MBS to hedge its mortgage-related interest rate exposure. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk is managed by entering into MBS forward commitments, option contracts with investment banks, federally regulated bank affiliates and loan sales transactions with permanent investors meeting the segment’s 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 and option contracts. At October 31, 2022, we had open commitments amounting to $4.0 million to sell MBS with varying settlement dates through December 13, 2022.
The assets accounted for using the fair value option are initially measured at fair value. Subsequent changes in fair value are recognized in the Consolidated Statements of Operations in “Financial services” revenue. Changes in fair value that are included in income are shown, by financial instrument and financial statement line item, below:
| | | Year Ended October 31, 2022 | |
| | | Mortgage | | | Interest Rate | | | | | |
| | | Loans Held | | | Lock | | | Forward | |
| (In thousands) | | for Sale | | | Commitments | | | Contracts | |
| | | | | | | | | | | | | |
| Change in fair value included in financial services revenue | | $ | 385 | | | $ | - | | | $ | 752 | |
| | | Year Ended October 31, 2021 | |
| | | Mortgage | | | Interest Rate | | | | | |
| | | Loans Held | | | Lock | | | Forward | |
| (In thousands) | | for Sale | | | Commitments | | | Contracts | |
| | | | | | | | | | | | | |
| Change in fair value included in financial services revenue | | $ | 4,580 | | | $ | 152 | | | $ | (107 | ) |
| | | Year Ended October 31, 2020 | |
| | | Mortgage | | | Interest Rate | | | | | |
| | | Loans Held | | | Lock | | | Forward | |
| (In thousands) | | for Sale | | | Commitments | | | Contracts | |
| | | | | | | | | | | | | |
| Change in fair value included in financial services revenue | | $ | 3,928 | | | $ | 11 | | | $ | (28 | ) |
Assets measured at fair value on a nonrecurring basis are those assets for which we have recorded valuation adjustments and write-offs during the years ended October 31, 2022 and 2021. The assets measured at fair value on a nonrecurring basis are all within our homebuilding operations and are summarized below:
| | Year Ended | |
| | October 31, 2022 | |
| (In thousands) | Fair | | Pre- | | | | | | | | | |
| | Value | | Impairment | | | | | | | | | |
| | Hierarchy | | Amount | | | Total Losses | | | Fair Value | |
| | | | | | | | | | | | | | |
| Land and land options held for future development or sale | Level 3 | | $ | 10,558 | | | $ | (8,374 | ) | | $ | 2,184 | |
| | Year Ended | |
| | October 31, 2021 | |
| (In thousands) | Fair | | Pre- | | | | | | | | | |
| | Value | | Impairment | | | | | | | | | |
| | Hierarchy | | Amount | | | Total Losses | | | Fair Value | |
| | | | | | | | | | | | | | |
| Sold and unsold homes and lots under development | Level 3 | | $ | 11,522 | | | $ | (2,009 | ) | | $ | 9,513 | |
We recorded inventory impairments, which are included in the Consolidated Statements of Operations as “Inventory impairments and land option write-offs” and deducted from inventory of $8.4 million, $2.0 million and $2.0 million for the years ended October 31, 2022, 2021 and 2020, respectively (see Note 12).
The fair value of our cash equivalents, restricted cash and cash equivalents and customers' deposits approximates their carrying amount, based on Level 1 inputs.
The fair value of each series of our notes and credit facilities are listed below. Level 3 measurements are estimated based on third-party broker quotes or management’s estimate of the fair value based on available trades for similar debt instruments.
Fair Value as of October 31, 2022
| (In thousands) | | Level 1 | | | Level 2 | | | Level 3 | | | Total | |
| Senior Secured Notes: | | | | | | | | | | | | | | | | |
| 10.0% Senior Secured 1.75 Lien Notes due November 15, 2025 | | | - | | | | - | | | | 165,844 | | | | 165,844 | |
| 7.75% Senior Secured 1.125 Lien Notes due February 15, 2026 | | | - | | | | - | | | | 240,393 | | | | 240,393 | |
| 10.5% Senior Secured 1.25 Lien Notes due February 15, 2026 | | | - | | | | - | | | | 272,966 | | | | 272,966 | |
| 11.25% Senior Secured 1.5 Lien Notes due February 15, 2026 | | | - | | | | - | | | | 162,566 | | | | 162,566 | |
| Senior Notes: | | | | | | | | | | | | | | | | |
| 13.5% Senior Notes due February 1, 2026 | | | - | | | | - | | | | 94,282 | | | | 94,282 | |
| 5.0% Senior Notes due February 1, 2040 | | | - | | | | - | | | | 55,654 | | | | 55,654 | |
| Senior Credit Facilities: | | | | | | | | | | | | | | | | |
| Senior Unsecured Term Loan Credit Facility due February 1, 2027 | | | - | | | | - | | | | 31,301 | | | | 31,301 | |
| Senior Secured 1.75 Lien Term Loan Credit Facility due January 31, 2028 | | | - | | | | - | | | | 85,247 | | | | 85,247 | |
| Total fair value | | $ | - | | | $ | - | | | $ | 1,108,253 | | | $ | 1,108,253 | |
Fair Value as of October 31, 2021
| (In thousands) | | Level 1 | | | Level 2 | | | Level 3 | | | Total | |
| Senior Secured Notes: | | | | | | | | | | | | | | | | |
| 10.0% Senior Secured 1.75 Lien Notes due November 15, 2025 | | | - | | | | - | | | | 167,348 | | | | 167,348 | |
| 7.75% Senior Secured 1.125 Lien Notes due February 15, 2026 | | | - | | | | - | | | | 366,426 | | | | 366,426 | |
| 10.5% Senior Secured 1.25 Lien Notes due February 15, 2026 | | | - | | | | - | | | | 300,913 | | | | 300,913 | |
| 11.25% Senior Secured 1.5 Lien Notes due February 15, 2026 | | | - | | | | - | | | | 162,548 | | | | 162,548 | |
| Senior Notes: | | | | | | | | | | | | | | | | |
| 13.5% Senior Notes due February 1, 2026 | | | - | | | | - | | | | 92,331 | | | | 92,331 | |
| 5.0% Senior Notes due February 1, 2040 | | | - | | | | - | | | | 63,084 | | | | 63,084 | |
| Senior Credit Facilities: | | | | | | | | | | | | | | | | |
| Senior Unsecured Term Loan Credit Facility due February 1, 2027 | | | - | | | | - | | | | 28,196 | | | | 28,196 | |
| Senior Secured 1.75 Lien Term Loan Credit Facility due January 31, 2028 | | | - | | | | - | | | | 86,046 | | | | 86,046 | |
| Total fair value | | $ | - | | | $ | - | | | $ | 1,266,892 | | | $ | 1,266,892 | |
The Senior Secured Revolving Credit Facility is not included in the above tables because there were no borrowings outstanding thereunder as of October 31, 2022 and 2021.