# Dream Finders Homes, Inc. (DFH) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Dream Finders Homes, Inc.'s 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1825088/000182508823000011/dfh-20221231.htm
Accession: 0001825088-23-000011
Filing date: 2023-03-02
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/DFH/
All MD&A years: /company/DFH/mda/
Previous year: /company/DFH/mda/fy2021/ (FY 2021)
Next year: /company/DFH/mda/fy2023/ (FY 2023)

ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and related notes thereto. Unless the context otherwise requires, the terms “Dream Finders,” “DFH,” “the Company,” “we,” “us” and “our” refer to Dream Finders Homes, Inc. and its subsidiaries.

Business Overview

We design, build and sell homes in high-growth markets, including Charlotte, Raleigh, Jacksonville, Orlando, Denver, the Washington D.C. metropolitan area, Austin, Dallas and Houston. We sell homes under the Dream Finders Homes, DF Luxury, Craft Homes and Coventry Homes brands. We employ an asset-light land acquisition strategy with a focus on the design, construction and sale of single-family entry-level, first-time move-up and second-time move-up homes. To fully serve our homebuyer customers and capture ancillary business opportunities, we also offer title insurance through DF Title and mortgage banking solutions primarily through our mortgage banking joint venture, Jet LLC.

During the third and fourth quarters of 2022, housing demand was negatively impacted as rising mortgage rates created strains on affordability. In response to the negative effect on housing demand, we have introduced sales incentives primarily focused on mortgage buy down programs and continue to monitor net sales and traffic at the community level and are strategically renegotiating lot option contracts to match the adjusted sales pace. Our asset-light business model and conservative balance sheet management have allowed us to effectively navigate market volatility.

For the year ended December 31, 2022, we received 6,045 net new orders (new orders for homes less cancellations), a decrease of 763 or 11%, as compared to the 6,808 net new orders received for the year ended December 31, 2021. For the year ended December 31, 2022, we closed 6,878 homes, an increase of 2,004, or 41%, as compared to the 4,874 homes closed for the year ended December 31, 2021. As of December 31, 2022, our backlog of sold homes was 5,548. In addition, as of December 31, 2022, we owned or controlled an aggregate of 43,558 lots.

Key Results

Key financial results for the year ended December 31, 2022, as compared to the year ended December 31, 2021, were as follows:

•Revenues increased 74% to $3.3 billion from $1.9 billion.

•Net new orders decreased 11% to 6,045 from 6,808.

•Homes closed increased 41% to 6,878 from 4,874.

•Average sales price of homes closed increased 22% to $474,292 from $389,094.

•Gross margin as a percentage of homebuilding revenues increased to 18.4% from 16.0%.

•Adjusted gross margin (non-GAAP) as a percentage of homebuilding revenues increased to 24.6% from 21.7%.

•Net and comprehensive income increased 104% to $274 million from $135 million.

•Net and comprehensive income attributable to Dream Finders Homes, Inc. increased 117% to $262 million from $121 million.

•EBITDA (non-GAAP) as a percentage of total revenues increased to 12.6% from 10.1%.

•Backlog of sold homes decreased 13% to 5,548 from 6,381.

•Active communities at December 31, 2022 increased to 206 from 205 at December 31, 2021.

•Return on participating equity was 49.1% compared to 44.3%.

•Basic earnings per share was $2.67 and diluted earnings per share was $2.45, compared to $1.27 and $1.27, respectively.

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For reconciliations of the non-GAAP financial measures, including adjusted gross margin and EBITDA, to the most directly comparable GAAP financial measures, see “—Non-GAAP Financial Measures.”

Recent Developments

On October 10, 2022, the Company transferred the listing of its Class A common stock from the Nasdaq Global Select Market to the New York Stock Exchange. The Company's Class A common stock continues to trade under the stock symbol "DFH."

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Results of Operations

Year Ended December 31, 2022 Compared to Year Ended December 31, 2021

The following table sets forth our results of operations for the periods indicated:

[[GREPCENT_TABLE]]
[["","","For the Year Ended December 31,"],["","","2022","","2021","","Amount Change","","% Change"],["Revenues:"],["Homebuilding","","$","3,334,559","","","$","1,917,301","","","$","1,417,258","","","74","%"],["Other","","7,776","","","6,609","","","1,167","","","18","%"],["Total revenues","","3,342,335","","","1,923,910","","","1,418,425","","","74","%"],["Homebuilding cost of sales","","2,722,139","","","1,610,332","","","1,111,807","","","69","%"],["Selling, general and administrative expense","","271,040","","","154,405","","","116,635","","","76","%"],["Income from unconsolidated entities","","(16,122)","","","(9,428)","","","(6,694)","","","71","%"],["Contingent consideration revaluation","","11,053","","","7,533","","","3,520","","","47","%"],["Other (income) expense, net","","(1,963)","","","(1,653)","","","(310)","","","19","%"],["Interest expense","","32","","","672","","","(640)","","","(95)","%"],["Income before income taxes","","356,156","","","162,049","","","194,107","","","120","%"],["Income tax expense","","(81,859)","","","(27,455)","","","(54,404)","","","198","%"],["Net and comprehensive income","","274,297","","","134,594","","","139,703","","","104","%"],["Net and comprehensive income attributable to noncontrolling interests","","(11,984)","","","(13,461)","","","1,477","","","(11)","%"],["Net and comprehensive income attributable to Dream Finders Homes, Inc.","","$","262,313","","","$","121,133","","","$","141,180","","","117","%"],["Earnings per share(1)"],["Basic","","$","2.67","","","$","1.27","","","$","1.40","","","110","%"],["Diluted","","$","2.45","","","$","1.27","","","$","1.18","","","93","%"],["Weighted-average number of shares"],["Basic","","92,745,781","","","92,521,482","","","224,299","","","\u2014","%"],["Diluted","","106,691,248","","","95,313,593","","","11,377,655","","","12","%"],["Consolidated Balance Sheet Data (at period end):"],["Cash and cash equivalents","","$","364,531","","","$","227,227","","","$","137,304","","","60","%"],["Total assets","","$","2,371,137","","","$","1,894,248","","","$","476,889","","","25","%"],["Construction lines of credit","","$","966,248","","","$","763,292","","","$","202,956","","","27","%"],["Preferred mezzanine equity","","$","156,045","","","$","155,220","","","$","825","","","1","%"],["Common stock - Class A","","$","325","","","$","323","","","$","2","","","1","%"],["Common stock - Class B","","$","602","","","$","602","","","$","\u2014","","","\u2014","%"],["Additional paid-in capital","","$","264,757","","","$","257,963","","","$","6,794","","","3","%"],["Retained earnings","","$","365,994","","","$","118,194","","","$","247,800","","","210","%"],["Non-controlling interests","","$","12,970","","","$","24,081","","","$","(11,111)","","","(46)","%"],["Other Financial and Operating Data (unaudited)"],["Active communities at end of period(2)","","206","","","205","","","1","","","\u2014","%"],["Home closings","","6,878","","","4,874","","","2,004","","","41","%"],["Average sales price of homes closed(3)","","$","474,292","","","$","389,094","","","$","85,198","","","22","%"],["Net new orders","","6,045","","","6,808","","","(763)","","","(11)","%"],["Cancellation rate","","21.5","%","","12.2","%","","9.3","%","","76","%"],["Backlog (at period end) - homes","","5,548","","","6,381","","","(833)","","","(13)","%"],["Backlog (at period end, in thousands) - value","","$","2,502,564","","","$","2,913,170","","","$","(410,606)","","","(14)","%"],["Gross margin (in thousands)(4)","","$","612,420","","","$","306,969","","","$","305,451","","","100","%"],["Gross margin %(5)","","18.4","%","","16.0","%","","2.4","%","","15","%"],["Net profit margin %","","7.9","%","","6.3","%","","1.5","%","","25","%"],["Adjusted gross margin (in thousands)(6)","","$","820,158","","","$","416,382","","","$","403,776","","","97","%"],["Adjusted gross margin %(5)","","24.6","%","","21.7","%","","2.9","%","","13","%"],["EBITDA (in thousands)(6)","","$","422,582","","","$","194,967","","","$","227,615","","","117","%"],["EBITDA margin %(7)","","12.6","%","","10.1","%","","$","\u2014","","","25","%"],["Adjusted EBITDA (in thousands)(6)","","$","429,378","","","$","200,200","","","$","229,178","","","114","%"],["Adjusted EBITDA margin %(7)","","12.8","%","","10.7","%","","2.1","%","","20","%"]]
[[/GREPCENT_TABLE]]

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(1)Refer to Note 14, Earnings per Share to the consolidated financial statements for disclosure related to the calculation of earnings per share (“EPS”) as of December 31, 2021. Diluted shares were calculated by using the treasury stock method for stock grants and the if-converted method for the convertible preferred stock and the associated preferred dividends.Since the conversion price of the Company’s Convertible Preferred Stock is based on the average trailing 90 days’ closing price of Class A common stock, changes in the price of the Class A common stock may significantly affect, as it did in 2022, the number of additional assumed common shares outstanding under the if-converted method for diluted earnings per share, even when the number of Convertible Preferred Stock shares outstanding is unchanged.

(2)A community becomes active once a model is open to customers or the community has had five net new orders. A community becomes inactive when it has fewer than five units remaining to sell.

(3)Average sales price of homes closed is calculated based on homebuilding revenues, excluding the impact of deposit forfeitures, percentage of completion revenues and finished lot sales, over homes closed.

(4)Gross margin is homebuilding revenues less homebuilding cost of sales.

(5)Calculated as a percentage of homebuilding revenues.

(6)Adjusted gross margin, EBITDA and adjusted EBITDA are non-GAAP financial measures. For definitions of these non-GAAP financial measures and a reconciliation to our most directly comparable financial measures calculated and presented in accordance with GAAP, see “—Non-GAAP Financial Measures.”

(7)Calculated as a percentage of total revenues.

Revenues. Revenues for the year ended December 31, 2022 were $3.3 billion, an increase of $1.4 billion, or 74%, from $1.9 billion for the year ended December 31, 2021. The increase in revenues was primarily attributable to an increase in home closings of 2,004 homes, or 41%, during the year ended December 31, 2022 as compared to the year ended December 31, 2021. Our October 2021 acquisition of MHI contributed 2,229 closings and $1.3 billion in homebuilding revenues for the year ended December 31, 2022 and 689 closings and $361.1 million in homebuilding revenues for the year ended December 31, 2021. The average sales price of homes closed was $474,292 for 2022 compared to $389,094 in 2021, an increase of $85,198 or 22%. The increase was due to a higher average sales price of homes closed within the Texas segment, as well as overall price appreciation, which increased at a higher pace than cost inflation.

Homebuilding Cost of Sales and Gross Margin. Homebuilding cost of sales for the year ended December 31, 2022 was $2.7 billion, an increase of $1.1 billion, or 69%, from $1.6 billion for the year ended December 31, 2021. The increase in homebuilding cost of sales is primarily due to the increase in home closings in 2022 as compared to 2021. Homebuilding gross margin for the year ended December 31, 2022 was $612 million, an increase of $305 million, or 100%, from $307 million for the year ended December 31, 2021. Homebuilding gross margin as a percentage of homebuilding revenues was 18.4% for the year ended December 31, 2022, an increase of 240 basis points (“bps”), or 15%, from 16.0% for the year ended December 31, 2021. The increase in gross margin was primarily due to overall price appreciation, which increased at a higher pace than cost inflation.

Adjusted Gross Margin. Adjusted gross margin for the year ended December 31, 2022 was $820 million, an increase of $404 million, or 97%, from $416 million for the year ended December 31, 2021. Adjusted gross margin as a percentage of homebuilding revenues for the year ended December 31, 2022 was 24.6%, an increase of 290 bps, or 13%, as compared to 21.7%, for the year ended December 31, 2021. The increase in adjusted gross margin is attributable to overall price appreciation, which increased at a higher pace than cost inflation. Adjusted gross margin is a non-GAAP financial measure. For the definition of adjusted gross margin and a reconciliation to our most directly comparable financial measure calculated and presented in accordance with GAAP, see “—Non-GAAP Financial Measures.”

Selling, General and Administrative Expense. Selling, general and administrative expense for the year ended December 31, 2022 was $271 million, an increase of $117 million, or 76%, from $154 million for the year ended December 31, 2021. The increase in selling, general and administrative expense was primarily due to higher closing volume and the inclusion of $111 million in expenses from the Texas segment for the year ended December 31, 2022. Selling, general and administrative expenses as a percentage of homebuilding revenues for the year ended December 31, 2022 was 8%, remaining consistent when compared to 8% for the year ended December 31, 2021.

Income from Equity in Earnings of Unconsolidated Entities. Income from equity in earnings of unconsolidated entities for the year ended December 31, 2022 was $16 million, an increase of $7 million, or 71%, as compared to $9 million for the year ended December 31, 2021. The change in income from equity in earnings of unconsolidated entities was equally attributable to income from mortgage banking and title insurance joint ventures from MHI and distributions of profits from DF Capital funds for the year ended December 31, 2022.

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Contingent Consideration Revaluation. Contingent consideration expense for the year ended December 31, 2022 was $11 million, an increase of $3 million or 47%, as compared to $8 million for the year ended December 31, 2021. The increase in contingent consideration expense is primarily due to fair value adjustments of future expected earn-out payments from the acquisitions of MHI and H&H.

Contingent consideration liabilities are impacted by various inputs and estimates in addition to the fair value accretion, including: (i) updates to the discount rate used quarterly, (ii) changes to current year assumptions based on year to date actual results, (iii) changes to future year’s forecast assumptions, which are affected by macro-economic conditions and local market conditions, as well as management actions including capital allocation, growth plans, and restructuring, and (iv) contractual modifications that may merit additional adjustments to final pre-tax income prior to the calculation of the annual earn out payments. The change in estimates used to calculate the contingent consideration adjustment could be material at times and could potentially fluctuate from expense or income. Our policy is to separately disclose the impact of contingent consideration liability adjustments within the Consolidated Statements of Comprehensive Income.

Other (Income) Expense, Net. Other income for the year ended December 31, 2022 was $(2) million, when compared to $(2) million in other income for the year ended December 31, 2021. The other income, net remained consistent year over year as the income from the forgiveness of the Company's $7 million Paycheck Protection Program loan included in 2021 was offset by the expense for the settlement of the Silver Meadows Townhome Owners Association, Inc. lawsuit in 2021, both of which did not repeat in 2022.

Net and Comprehensive Income. Net and comprehensive income for the year ended December 31, 2022 was $274 million, an increase of $139 million, or 104%, from $135 million for the year ended December 31, 2021. The increase in net and comprehensive income was primarily attributable to an increase in gross margin on homes closed of $305 million, or 100%, during the year ended December 31, 2022 as compared to the year ended December 31, 2021. The net and comprehensive income for the year ended December 31, 2022 includes income tax expense of $82 million, an increase of $54 million, or 198%, from $27 million of income tax expense for the year ended December 31, 2021. This increase is due to the increase in pre-tax income as well as the effective income tax rate increase of 4.5%. The change in effective tax rate is primarily attributable to the Florida corporate tax rate increase to 5.5% in 2022 from 3.5% in 2021 and increases in non-deductible executive compensation. In addition, during 2021, the Company's Paycheck Protection Program loan was forgiven and the related income of $7 million was not taxable.

Net and Comprehensive Income Attributable to Dream Finders Homes, Inc. Net and comprehensive income attributable to Dream Finders Homes, Inc. for the year ended December 31, 2022 was $262 million, an increase of $141 million, or 117%, from $121 million for the year ended December 31, 2021. The increase was primarily attributable to higher home closings and gross margin of 6,878 and 18.4%, respectively.

Backlog. Backlog at December 31, 2022 was 5,548 homes valued at approximately $2,503 million based on average sales price, a decrease of 833 homes and $411 million in value, or 13% and 14%, respectively, as compared to 6,381 homes valued at approximately $2,913 million at December 31, 2021. The overall decrease in backlog was primarily attributable to a decrease in net new orders of 763 or 11%, which is reflective of the weakening housing market due to the rapid rise in interest rates, mostly in the latter half of the year. In addition, approximately 1,070 of the homes in our backlog are expected to be delivered in 2024 and beyond.

Refer to the Form 10-K for the year ended December 31, 2021 filed on March 16, 2022 for the results of operations and related discussion for December 31, 2021 compared to the year ended December 31, 2020.

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Non-GAAP Financial Measures

Adjusted Gross Margin

Adjusted gross margin is a non-GAAP financial measure used by management as a supplemental measure in evaluating operating performance. We define adjusted gross margin as gross margin excluding the effects of capitalized interest, amortization included in homebuilding cost of sales (primarily adjustments resulting from the application of purchase accounting in connection with acquisitions) and commission expense. Our management believes this information is meaningful because it isolates the impact that capitalized interest, amortization (primarily purchase accounting adjustments) and commission expense have on gross margin. We include commission expense in homebuilding cost of sales, not selling, general and administrative expense, and therefore commission expense is taken into account in gross margin. As a result, in order to provide a meaningful comparison to the public company homebuilders that include commission expense below the gross margin line in selling, general and administrative expense, we have excluded commission expense from adjusted gross margin. However, because adjusted gross margin information excludes capitalized interest, amortization (primarily purchase accounting adjustments) and commission expense, which have real economic effects and could impact our results of operations, the utility of adjusted gross margin information as a measure of our operating performance may be limited. In addition, other companies may not calculate adjusted gross margin information in the same manner that we do. Accordingly, adjusted gross margin information should be considered only as a supplement to gross margin information as a measure of our performance.

The following table presents a reconciliation of adjusted gross margin to the GAAP financial measure of gross margin for each of the periods indicated (unaudited and in thousands, except percentages):

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

(1)Gross margin is homebuilding revenues less homebuilding cost of sales.

(2)Calculated as a percentage of homebuilding revenues.

(3)Primarily represents purchase accounting adjustments.

EBITDA and Adjusted EBITDA

EBITDA and adjusted EBITDA are not measures of net income as determined by GAAP. EBITDA and adjusted EBITDA are supplemental non-GAAP financial measures used by management and external users of our consolidated financial statements, such as industry analysts, investors, lenders and rating agencies. We define EBITDA as net income before (i) interest income, (ii) capitalized interest expensed in homebuilding cost of sales, (iii) interest expense, (iv) income tax expense and (v) depreciation and amortization. We define adjusted EBITDA as EBITDA before stock-based compensation expense.

Management believes EBITDA and adjusted EBITDA are useful because they allow management to more effectively evaluate our operating performance and compare our results of operations from period to period without regard to our financing methods or capital structure or other items that impact the comparability of financial results from period to period. EBITDA and adjusted EBITDA should not be considered as alternatives to, or more meaningful than, net income or any other measure as determined in accordance with GAAP. Our computations of EBITDA and adjusted EBITDA may not be comparable to EBITDA or adjusted EBITDA of other companies. We present EBITDA and adjusted EBITDA because we believe they provide useful information regarding the factors and trends affecting our business.

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The following table presents a reconciliation of EBITDA and adjusted EBITDA to the GAAP financial measure of net income for each of the periods indicated (unaudited and in thousands, except percentages):

[[GREPCENT_TABLE]]
[["","Year Ended December 31,"],["","2022","","2021","","2020"],["Net and comprehensive income attributable to Dream Finders Homes, Inc.","$","262,313","","$","121,133","","$","79,093"],["Interest income","(169)","","(6)","","(45)"],["Interest expensed in cost of sales","60,595","","32,508","","32,044"],["Interest expense","32","","672","","871"],["Income tax expense","81,859","","27,455","","\u2014"],["Depreciation and amortization(2)","17,952","","13,205","","8,922"],["EBITDA","$","422,582","","$","194,967","","$","120,885"],["Stock-based compensation expense","6,796","","5,233","","947"],["Adjusted EBITDA","$","429,378","","$","200,200","","$","121,832"],["EBITDA margin %(1)","12.6%","","10.1%","","10.7%"],["Adjusted EBITDA margin %(1)","12.8%","","10.4%","","10.7%"]]
[[/GREPCENT_TABLE]]

(1)Calculated as a percentage of total revenues.

(2)Includes the impact of fair value of inventory adjustments from prior acquisitions of $7 million for the year ended December 31, 2022, which is included in homebuilding cost of sales reported on the Consolidated Statements of Comprehensive Income.

Components of Our Operating Results

Below are general definitions of the income statement line items and unaudited other financial and operating data set forth in our period over period changes in results of operations.

Revenues — Homebuilding and Other

Revenues include the proceeds from the closing of homes sold to our customers, as well as fees from our wholly-owned title insurance businesses. Revenues from home sales are recorded at the time each home sale is closed, title and possession are transferred to the buyer and there is no significant continuing involvement with the home. For home sales on a homesite that the customer owns, we recognize revenue based on the percentage of completion of the home. Proceeds from home sales are generally received within a few days after closing. Home sales are reported net of sales discounts and incentives granted to homebuyers, which includes seller-paid closing costs. The pace of closings, average home sales price, the level of incentives provided to the customer and the amount of upgrades or options selected all impact our recorded revenues in a given period.

Homebuilding Cost of Sales

Homebuilding cost of sales includes the lot purchase and carrying costs associated with each lot, construction costs of each home, capitalized interest expensed, lot option fees, building permits, internal and external realtor commissions and warranty costs (both incurred and estimated to be incurred). Land, development and other allocated costs, including interest, lot option fees and property taxes, incurred during development and home construction are capitalized and expensed to homebuilding cost of sales when the home is closed and revenue is recognized. We adjust the cost of lots remaining in a community on a pro rata basis, when changes to estimated total development costs occur, including lot option fees and community costs. Indirect costs such as maintenance of communities, signage and supervision are expensed as incurred.

Selling, General and Administrative Expense

Selling, general and administrative expense consists of corporate and marketing overhead expenses such as payroll, stock compensation expense, insurance, IT, office expenses, advertising, outside professional services and travel expenses.

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Selling, general and administrative expense also includes maintaining model homes and sales centers, including the rent associated with any model homes or sales centers that we have sold and lease from a third party. We recognize these costs in the period they are incurred.

Income from Equity in Earnings of Unconsolidated Entities

Income from equity in earnings of unconsolidated entities consists primarily of income earned from minority interests in our unconsolidated mortgage banking joint venture, Jet LLC, which underwrites and originates home mortgages across our geographic footprint. Our 49.9% minority interest in Jet LLC is accounted for under the equity investment method and is not consolidated in our consolidated financial statements, as we do not control, and are not deemed the primary beneficiary of, Jet LLC.

Other Income and Expense

Other income includes income from the sale of non-core assets, interest income and management fees we earn from shared services with the former owner of MHI and from managing certain joint ventures. In general, we earn four to six percent of the sales price of homes built by us on behalf of the joint ventures. Other expense consists primarily of expenses related to the sale of non-core assets. For 2021, other income also includes the one-time forgiveness of the Payroll Protection Program loan.

Contingent Consideration Revaluation

Contingent consideration revaluation is related to the valuation changes in existing earn out agreements with former owners of acquired entities.

Net and Comprehensive Income Attributable to Noncontrolling Interests

Net and comprehensive income attributable to noncontrolling interests consists of income attributable to partners in our consolidated joint ventures. In certain of our joint ventures, we agree to split the profits from home closings with our joint venture partners. Net and comprehensive income attributable to noncontrolling interests shows our joint venture partners’ share of homebuilding profits, less any community costs shared with our joint venture partners.

In addition, certain of our joint ventures own lots and from time to time we may record impairment charges relating to such lots. In such cases, we would typically record an impairment charge relating to our proportionate ownership of the joint venture, and the remaining impairment would be reflected through a decrease in income attributable to noncontrolling interests.

Net and Comprehensive Income Attributable to Dream Finders Homes, Inc.

Net and comprehensive income attributable to Dream Finders Homes, Inc. is total revenues less homebuilding cost of sales, selling, general and administrative expense, income from equity in earnings of unconsolidated entities, other income, other expense, interest expense and net and comprehensive income attributable to noncontrolling interests.

Return on Participating Equity

Return on participating equity is pre-tax net and comprehensive income attributable to Dream Finders Homes, Inc. tax effected for our federal and state blended tax rate less accrued preferred unit distributions divided by average total participating equity. Participating equity is all equity that participates in the earnings of the Company, including Series A preferred equity and all common equity. Following consummation of our initial public offering, we became subject to taxation as a corporation and consequently calculated return on equity as net income attributable to Dream Finders Homes, Inc. less preferred distributions divided by the average beginning and ending participating equity for the fiscal year.

Net New Orders

Net new orders is a key performance metric for the homebuilding industry and is an indicator of future revenues and cost of sales. Depending on whether net new orders are associated with a variable interest entity, they can also be an indicator of future net and comprehensive income attributable to noncontrolling interests.

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Net new orders for a period are gross sales less any customer cancellations received during the same period. Sales are recognized when a customer signs a contract and we approve such contract and collect any deposit from the customer required by such contract.

Cancellation Rate

We record a cancellation when a customer notifies us that he or she does not wish to purchase a home. Increasing cancellations are a negative indicator of future performance and can be an indicator of decreased revenues, homebuilding cost of sales and net income. When a cancellation occurs, we generally retain the customer deposit and resell the home to a new customer. Cancellations can occur due to customer credit issues or changes to the customer’s desires. The cancellation rate is the total number of new sales purchase contracts cancelled during the period divided by the total new gross sales for homes during the period.

Backlog (at period end)

Backlog (at period end) is the number of homes in backlog from the previous period plus the number of net new orders generated during the current period minus the number of homes closed during the current period. Backlog at period end includes homes currently under construction and homes that are sold where construction has not commenced.

Gross Margin

Gross margin is homebuilding revenues less homebuilding cost of sales for the reported period.

Adjusted Gross Margin

Adjusted gross margin is gross margin less capitalized interest expensed in homebuilding cost of sales, commission expense, and amortization in homebuilding cost of sales (primarily purchase accounting adjustments).

Liquidity and Capital Resources

Overview

We generate cash from the sale of our inventory and we intend to re-deploy a portion of the net cash generated from the sale of inventory to acquire and control land and further grow our operations year over year. As of December 31, 2022, we had $365 million in cash and cash equivalents (excluding $31 million of restricted cash), an increase of $137 million, or 60%, from $227 million as of December 31, 2021. We also maintain our Amended and Restated Credit Agreement (the “Amended and Restated Credit Agreement”) with a syndicate of lenders providing for a senior unsecured revolving credit facility, which has an aggregate commitment of up to $1.1 billion and matures on June 2, 2025. Borrowings under this Amended and Restated Credit Agreement are limited to the amount of inventory held on the Consolidated Balance Sheet, subject to unit-specific advance rates and other limitations. As of December 31, 2022, available liquidity under the Credit Agreement was $122 million, resulting in $487 million in total liquidity for the Company. We believe that our sources of liquidity are sufficient to satisfy our current commitments.

We continue to evaluate our capital structure and explore options to strengthen our Consolidated Balance Sheet. We will remain opportunistic while assessing available capital in the debt and equity markets.

Our principal uses of capital are lot deposits and purchases, vertical home construction, operating expenses and the payment of routine liabilities.

Cash flows generated by our projects can differ materially from our results of operations, as these depend upon the stage in the life cycle of each project. The majority of our projects begin at the land acquisition stage when we enter into finished lot option contracts by placing a deposit with a land seller or developer. Our lot deposits are an asset on our balance sheets and these cash outflows are not recognized in our results of operations. Early stages in our communities require material cash outflows relating to finished lot option purchases, entitlements and permitting, construction and furnishing of model homes, roads, utilities, general landscaping and other amenities, as well as ongoing association fees and property taxes. These costs are capitalized within our real estate inventory and are not recognized in our operating income until a home sale closes. As such, we incur significant cash outflows prior to the recognition of earnings.

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In later stages of the life cycle of a community, cash inflows could significantly exceed our results of operations, as the cash outflows associated with land purchase and home construction and other expenses were previously incurred.

We typically provide lot deposits in the range of 5% to 10% of the land purchase price. When entering into these contracts, we also agree to purchase finished lots at predetermined time frames and quantities that match our expected selling pace in the community.

We also enter into land development arrangements with land sellers, land developers and land bankers. We provide deposits to develop lots that we will have the option to acquire in the future, along with lot option fees based on the outstanding capital balance held by the land banker. The initial investment and lot option fees require our ability to allocate liquidity resources to projects that will not materialize into cash inflows or operating income in the near term. The above cash strategies allow us to maintain adequate lot supply in our existing markets and support ongoing growth and profitability. Although currently there is economic uncertainty that is impacting the homebuilding industry, we continue to operate in geographic regions with consistent increases in the demand for new homes and constrained lot supply compared to population and job growth trends. We intend to continue to reinvest our earnings into our business and focus on expanding our operations. In addition, as the opportunity to purchase finished lots in desired locations becomes increasingly more limited and competitive, we are committed to allocating additional liquidity to land bank deposits on land development projects, as this strategy mitigates the risks associated with holding undeveloped land on our balance sheet, while allowing us to control adequate lot supply in our key markets to support forecasted growth.

Credit Facilities, Letters of Credit, Surety Bonds and Financial Guarantees

On June 2, 2022, we entered into an Amended and Restated Credit Agreement to amend and restate our prior credit agreement originally dated as of January 25, 2021. The Amended and Restated Credit Agreement provides for a senior unsecured revolving credit facility and is with a syndicate of lenders. The Amended and Restated Credit Agreement provides for aggregate commitments of $1.125 billion and has an accordion feature that allows the aggregate commitments to increase up to $1.625 billion. The Amended and Restated Credit Agreement matures on June 2, 2025. Outstanding borrowings under the Amended and Restated Credit Agreement are subject to, among other things, a borrowing base. The borrowing base includes, among other things, (a) 90% of the net book value of presold housing units, (b) 85% of the net book value of model housing units, (c) 85% of the net book value of speculative housing units and (d) 70% of the net book value of finished lots, in each case subject to certain exceptions and limitations set forth in the Amended and Restated Credit Agreement.

Under the Amended and Restated Credit Agreement, borrowings under the revolving line of credit bear interest, at our option, at (1) a “Base Rate”, which means for any day a fluctuating rate per annum equal to credit spreads of 1.50% to 2.60%, which are determined based on our debt to capitalization ratio, plus the highest of (a) the Federal Funds Rate plus 0.5%, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America as its “prime rate,” (c) the Term Secured Overnight Financing Rate (“SOFR”) plus 1.00% and (d) 1.00%, or (2) a “Term SOFR Rate”, which means for any day a fluctuating rate per annum equal to credit spreads of 2.50% to 3.60%, which are determined based on our debt to capitalization ratio, plus the adjusted Term SOFR rate (based on one, three or six-month interest periods). Interest on each base rate advance borrowed under the Amended and Restated Credit Agreement is payable in arrears on a monthly basis. Interest on each Term SOFR rate advance borrowed under the Amended and Restated Credit Agreement is payable in arrears at the end of the interest period applicable to such advance, or, if less than such interest period, three months after the beginning of such interest period. We pay the lenders a commitment fee on the amount of the unused commitments on a quarterly basis at a rate per annum that will vary from 0.20% to 0.30% depending on our debt to capitalization ratio. We are also obligated to pay other customary closing fees, arrangement fees, administration fees and letter of credit fees for a credit facility of this size and type. All obligations under the Amended and Restated Credit Agreement are unsecured and unconditionally guaranteed by us and certain of our subsidiaries, excluding financial services subsidiaries, immaterial subsidiaries and variable interest entities.

As of December 31, 2022 and 2021, the outstanding balance under the Amended and Restated Credit Agreement was $965 million and $760 million, respectively. The Company had capitalized debt issuance costs related to the line of credit and notes payable, net of amortization, of $7 million and $6 million as of December 31, 2022 and 2021, respectively, which are included in other assets on the Consolidated Balance Sheets. The Company amortized $4 million and $2 million of debt issuance costs for the years ended December 31, 2022 and 2021, respectively.

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    The Amended and Restated Credit Agreement contains covenants that, among other things, require that we (i) maintain a maximum debt to capitalization ratio, as of the last day of each fiscal quarter, of 62.5% through December 2022 and 60.0% thereafter; (ii) maintain an interest coverage ratio, as of the last day of each fiscal quarter, of not less than 2.0 to 1.0; (iii) maintain a liquidity ratio, as of the last day of each fiscal quarter, of not less than 1.0 to 1.0; (iv) maintain tangible net worth of not less than the sum of (A) $385 million, (B) 50.0% of net income earned in each fiscal quarter after December 31, 2021 and (C) 50.0% of the aggregate increases in shareholders’ equity of the consolidated group after December 31, 2021 by reason of the issuance and sale of equity interests of the members of the consolidated group; (v) maintain a risk assets ratio (defined as (A) the sum of the GAAP net book value for all finished lots, lots under development and land held for future development or disposition to (B) tangible net worth), as of the last day of each fiscal quarter, of no less than 1.0 to 1.0; (vi) not allow aggregate investments in unconsolidated affiliates to exceed 15.0% of tangible net worth, as of the last day of any fiscal quarter; and (vii) not incur indebtedness other than, among other things, (A) the obligations under the Amended and Restated Credit Agreement, (B) non-recourse indebtedness in an amount not to exceed 15.0% of tangible net worth, as of the last day of each fiscal quarter, (C) operating lease liabilities, finance lease liabilities and purchase money obligations for fixed or capital assets not to exceed $5.0 million in the aggregate, (D) indebtedness of financial services subsidiaries and variable interest entities and (E) indebtedness under hedge contracts entered into for purposes other than for speculative purposes. The Company was in compliance with all debt covenants as of December 31, 2022 and December 31, 2021. The Company expects to remain in compliance with all debt covenants over the next twelve months.

We enter into surety bonds and letter of credit arrangements with local municipalities, government agencies, and land developers. These arrangements relate to certain performance-related obligations and serve as security for certain land option agreements. As of December 31, 2022, we had outstanding surety bonds and letters of credit totaling $85 million and $1 million, respectively.

Leases

The Company has operating leases primarily associated with office space that is used by divisions outside of the Jacksonville area, model home sale-leasebacks and a corporate office building sale-leaseback. The Company also has finance leases for corporate office furniture. As of December 31, 2022, the future minimum lease payments required under these leases totaled $30 million, with $8 million payable within 12 months. Further information regarding our leases is provided in Note 6, Commitments and Contingencies to our consolidated financial statements.

Contingent Consideration

Based on the terms of the purchase agreement, at the time of an acquisition, the Company may record a contingent consideration liability based on the expected fair value of any future earn out payments due to the acquiree for a typical period of up to five years post-acquisition. This liability is remeasured to fair value quarterly and the adjustment is recorded in contingent consideration revaluation. As of December 31, 2022, the contingent consideration liability totaled $115 million, with approximately $43 million payable within 12 months. Further information regarding our contingent consideration liability is provided in Note 1, Nature of Business and Significant Accounting Policies and Note 2, Business Combinations to our consolidated financial statements.

Series B Preferred Units

Following a corporate reorganization and upon completion of the Company’s initial public offering as described in Note 1, Nature of Business and Significant Accounting Policies to our consolidated financial statements, MOF II DF Home LLC and MCC Investment Holdings LLC (both controlled by Medley Capital Corporation) continue to hold the Series B preferred units of DFH LLC. As such, they have certain rights and preferences with regard to DFH LLC that holders of our Class A common stock do not have. The series B preferred units are not convertible into the Company’s common stock.

The Series B preferred units shall automatically be deemed to be cancelled when a holder of a Series B preferred unit receives aggregate distributions from DFH LLC on a Series B preferred unit equal to the sum of (i) $1,000 per unit and (ii) the unreturned capital contributions per unit plus an 8% per annum cumulative preferred return (the “Series B Distribution Amount”).

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In the event of a liquidation or dissolution of DFH LLC, the holders of Series B preferred units shall have preference over our membership interest in DFH LLC. Further, in the event of (i) a sale of substantially all of DFH LLC’s assets or (ii) a merger or reorganization resulting in the members of DFH LLC immediately prior to such transaction no longer beneficially owning at least 50% of the voting power of DFH LLC, the holders of the Series B preferred units may demand redemption of their Series B preferred units at a price equal to the Series B Distribution Amount (less prior distributions on such shares).

Series C Preferred Units

Following a corporate reorganization and upon completion of the Company’s initial public offering as described in Note 1. Nature of Business and Significant Accounting Policies to our consolidated financial statements, on January 27, 2021 we redeemed all 26,000 outstanding Series C preferred units of DFH LLC at a redemption price of $26 million, including accrued unpaid preferred distributions.

Convertible Preferred Stock

On September 29, 2021, we sold 150,000 shares of newly-created Convertible Preferred Stock with an initial liquidation preference of $1,000 per share and a par value $0.01 per share, for an aggregate purchase price of $150 million. We used the proceeds from the sale of the Convertible Preferred Stock to partially fund the MHI acquisition and for general corporate purposes. Pursuant to the Certificate of Designations, the Convertible Preferred Stock ranks senior to the Class A and B common stock with respect to dividends and distributions on liquidation, winding-up and dissolution. Accordingly, upon a liquidation, dissolution or winding up of the Company, each share of Convertible Preferred Stock is entitled to receive the initial liquidation preference of $1,000 per share, subject to adjustment, plus all accrued and unpaid dividends thereon. In addition, the Convertible Preferred Stock has the following terms:

•Cumulative Dividends: The Convertible Preferred Stock accumulates cumulative dividends at a rate per annum equal to 9% payable quarterly in arrears.

•Duration: The Convertible Preferred Stock is perpetual with call and conversion rights. The Convertible Preferred Stock is not convertible by the Purchasers in the first five years following issuance, with the exception of the acceleration of the Conversion Right (as defined below) upon breach of the protective covenants (described below). We can call the outstanding Convertible Preferred Stock at any time for one-hundred and two percent (102%) of its liquidation preference during the fourth year following its issuance and for one-hundred and one percent (101%) of its liquidation preference during the fifth year following its issuance, plus accrued but unpaid dividends, if any. Subsequent to the fifth anniversary of its issuance, a purchaser can convert the Convertible Preferred Stock into Class A common stock (the “Conversion Right”). The conversion price will be based on the average of the trailing 90 days’ closing price of Class A common stock, less 20% of the average and subject to a floor conversion price of $4.00 (the “Conversion Discount”).

•Protective Covenants: The protective covenants of the Convertible Preferred Stock require us to maintain compliance with all covenants related to (i) the Credit Agreement, as may be further amended from time to time; provided that any amendment, restatement, modification or waiver of the Credit Agreement that would adversely and materially affect the rights of the Purchasers will require the written consent of holders of a majority of the then-outstanding shares of Convertible Preferred Stock; and (ii) any agreement between the Company and any Purchaser (the covenants referred to in clauses (i) and (ii), collectively, the “Protective Covenants”). Non-compliance beyond any applicable cure period with the Protective Covenants (in the case of the Protective Covenants related to the Credit Agreement) will accelerate the Conversion Right, and in the event of such acceleration that occurs before the fifth anniversary following the issuance of the Convertible Preferred Stock, the “Conversion Discount” shall be increased from 20% to 25%.

•Voting Rights: Except as may be expressly required by Delaware law, the shares of Convertible Preferred Stock have no voting rights.

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•Redemption in a Change of Control: The Convertible Preferred Stock will be redeemed, contingent upon and concurrently with the consummation of a change of control of the Company. Shares of Convertible Preferred Stock will be redeemed in a change of control of the Company at a price, in cash, equal to the liquidation preference, subject to adjustment, plus all accumulated and unpaid dividends, plus, if the change of control occurs before the fourth anniversary of the date of issuance of the Convertible Preferred Stock, a premium equal to the dividends that would have accumulated on such share of Convertible Preferred Stock from and after the change of control redemption date and through the fourth anniversary of the issuance of the Convertible Preferred Stock.

Pursuant to the terms of the Certificate of Designations, unless and until approval of the Company’s stockholders is obtained, no shares of Class A common stock will be issued or delivered upon conversion of any Convertible Preferred Stock to the extent that such issuance would (i) result in the holder beneficially owning in excess of 19.99% of the outstanding Class A common stock as of the date of the Certificate of Designations or (ii) exceed 19.99% of the outstanding shares of Class A and Class B common stock combined as of the date of the Certificate of Designations.

Cash Flows

The following table summarizes our cash flows for the periods indicated (in thousands):

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[[/GREPCENT_TABLE]]

Year Ended December 31, 2022 Compared to Year Ended December 31, 2021

Net cash used in operating activities was $28 million for the year ended December 31, 2022, as compared to $65 million of net cash provided by operating activities for the year ended December 31, 2021. The change in net cash used in operating activities was primarily driven by an increase in inventories, partially offset by the increase in net income generated on home closings and less cash used for lot deposits for the year ended December 31, 2022.

Net cash used in investing activities was $6 million for the year ended December 31, 2022, as compared to $523 million of cash used in investing activities for the year ended December 31, 2021. The change in net cash used in investing activities was primarily attributable to the Company’s acquisitions of Century Homes and MHI during the first quarter and fourth quarter of 2021, respectively, compared to no acquisitions for the year ended December 31, 2022.

Net cash provided by financing activities was $147 million for the year ended December 31, 2022, as compared to $646 million of cash provided by financing activities for the year ended December 31, 2021. The change in net cash provided by financing activities was primarily attributable to the Corporate Reorganization, which included IPO net proceeds of $130 million, $148 million net proceeds related to the issuance of convertible preferred stock, and $447 million in net proceeds from construction lines of credit. No such transaction occurred for the year ended December 31, 2022, except for $203 million of net proceeds from construction lines of credit.

Refer to the Form 10-K for the year ended December 31, 2021 filed on March 16, 2022 for the cash flows and related discussion for December 31, 2021 compared to year ended December 31, 2020.

Factors Affecting Our Results of Operations

We believe that our future performance will depend on many factors, including those described below and in the sections titled “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” included elsewhere in this Annual Report on Form 10-K.

Changes in Price and Availability of Land

Acquiring home sites or finished lots in desirable geographic areas with prices and acquisition terms that drive profitable home delivery is an important component of our business. Our infrastructure is designed to build a certain number of homes each year and an adequate lot supply is crucial to meeting our business objectives.

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Our sourcing of finished lots is affected by changes in the general availability of finished lots in the markets in which we operate, the willingness of land sellers to sell finished lots at competitive prices, competition for available finished lots and other market conditions. Lot value appreciation or depreciation varies across the markets in which we operate. Our acquisition costs associated with finished lots have increased in certain of our markets where job and population growth are outpacing lot supply.

If the supply of finished lots is limited because of these or other factors, we may build and sell fewer homes as a result. To the extent that we are unable to acquire finished lots at competitive prices, or at all, our revenues, margins and other results of operations could be negatively impacted.

Availability of Mortgages; Applicable Interest Rates

The majority of our homebuyers in 2022 obtained a mortgage to purchase their home. As a result, the availability of mortgages on terms that make purchases of our homes affordable to a broad base of consumers has a significant impact on our business. The availability and accessibility of mortgages can depend in part on current interest rates and down payment requirements, which are not within our control. The majority of our customers that obtain mortgages obtain loans that conform to the terms established by Freddie Mac and Fannie Mae. During 2022, mortgage interest rates have sharply increased, and continue to rise. Additionally, interest rates available to homebuyers obtaining conforming loans are driven by Freddie Mac’s and Fannie Mae’s ability to package and sell loans in the secondary market. Disruptions in this supply chain could impact our business significantly if our homebuyers are unable to obtain mortgages on terms that are acceptable, or at all.

Costs of Building Materials and Labor

Our cost of sales includes the acquisition and finance costs of home sites or lots, municipality fees, the costs associated with obtaining building permits, materials and labor to construct the home, interest costs for construction loans, internal and external realtor commissions and other miscellaneous closing costs. Home site costs range from 20-30% of the average cost of a home. Building materials range from 40-50% of the average cost to build the home, labor ranges from 25-30% of the average cost to build the home, and interest, commissions and closing costs range from 5-10% of the average cost to build the home.

In general, the cost of building materials fluctuates with overall trends in the underlying prices of raw materials. The cost of certain of our building materials, such as lumber and oil-based products, fluctuates with market-based pricing curves. We often obtain volume discounts and/or rebates with certain suppliers of our building materials, which in turn reduces our cost of sales.

However, increases in the cost of building materials may reduce gross margin to the extent that market conditions prevent the recovery of increased costs through higher home sales prices. The price changes that most significantly influence our operations are price increases in commodities. Significant price increases of these materials may negatively impact our cost of sales and, in turn, our net income.

Housing Supply and Demand

When the supply of new homes exceeds new home demand, new home prices may generally be expected to decline. The COVID-19 pandemic caused a sharp decline in our homebuilding business in March and April 2020 and was followed by a sharp increase in our sales that began in May 2020. Elevated sales were observed through early 2022. As a result of the COVID-19 pandemic, we observed an increase in demand from entry-level homebuyers, our primary customer focus, seeking to move out of apartments and into more spacious homes in anticipation of spending more time at home with remote-working arrangements increasing in prevalence. During the third and fourth quarters of 2022, housing demand was negatively impacted as rising mortgage rates created strains on affordability, and as a result, has contributed to lower net sales. We expect housing market conditions in the majority of the markets that we construct homes to remain relatively healthy in 2023 based on the limited supply of resale homes and population growth continuing to outpace new home construction, even in the face of the rising interest rates.

Seasonality

In all of our markets, we have historically experienced similar variability in our results of operations and capital requirements from quarter to quarter due to the seasonal nature of the homebuilding industry.

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We generally sell more homes in the first and second quarters and close more homes in our third and fourth quarters. As a result, our revenue may fluctuate on a quarterly basis and we may have higher capital requirements in our second, third and fourth quarters in order to maintain our inventory levels. As a result of seasonal activity, our quarterly results of operations and financial position at the end of a particular quarter, especially our first quarter, are not necessarily representative of the results we expect at year end. We expect this seasonal pattern to continue in the long term.

Factors Affecting the Comparability of Our Financial Condition and Results of Operations

Our historical financial condition and results of operations for the periods presented may not be comparable, either from period to period or going forward, as a result of our recent acquisitions as well as the following reasons:

Corporate Reorganization

The Company was formed for the purpose of completing an initial public offering (“IPO”) of its common stock and related transactions in order to carry on the business of Dream Finders Holdings LLC, a Florida limited liability company (“DFH LLC”), as a publicly-traded entity. Pursuant to a corporate reorganization and completion of its IPO on January 25, 2021, the Company became a holding company for DFH LLC and its subsidiaries. For information regarding the Company’s corporate reorganization, see Note 1, Nature of Business and Significant Accounting Policies to the consolidated financial statements.

Income Taxes

Prior to the Company’s initial public offering (“IPO”), we were composed of various pass-through entities that are all treated as partnerships for federal income tax purposes, but are subject to certain minimal taxes and fees; however, income taxes on taxable income or losses realized by our predecessor, DFH LLC, are generally the obligation of the individual members or partners. Following the consummation of the IPO, we became a corporation subject to corporate-level taxes, our income taxes became dependent upon our taxable income, and our net income since the IPO reflects such taxes. We recognize the financial statement impacts of GAAP and tax timing differences on a quarterly basis.

Selling, General and Administrative Expense

Our selling, general and administrative expenses have increased as a result of our acquisitions and the initial and ongoing compliance costs associated with being a public company, including certain provisions of the Sarbanes-Oxley Act and related SEC regulations, and the requirements associated with our Class A common stock listed on the NYSE. In 2021, we also recognized the acceleration of certain of our predecessor’s, DFH LLC, costs, such as capitalized debt issuance costs and unvested stock compensation, which vested at the date of the Company’s initial public offering.

Equity Incentive Plan

To incentivize individuals providing services to us or our affiliates, the Board of Directors adopted the 2021 Equity Incentive Plan in connection with the IPO. Our 2021 Equity Incentive Plan provides for the grant, from time to time, at the discretion of our Board of Directors or a committee thereof, of stock options, stock appreciation rights, restricted stock, restricted stock units, stock awards, dividend equivalents, other stock-based awards, cash awards, substitute awards and performance awards, which generally results in stock compensation expense. Any individual who is our officer or employee or an officer or employee of any of our affiliates, and any other person who provides services to us or our affiliates, including our directors, is eligible to receive awards under our 2021 Equity Incentive Plan at the discretion of our Board of Directors or the Compensation Committee of our Board of Directors.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in accordance with GAAP. Our critical accounting policies are those that we believe have the most significant impact to the presentation of our financial position and results of operations and that require the most difficult, subjective or complex judgments. In many cases, the accounting treatment of a transaction is specifically dictated by GAAP without the need for the application of judgment.

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In certain circumstances, however, the preparation of consolidated financial statements in conformity with GAAP requires us to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period.

While our significant accounting policies are more fully described in Note 1. Nature of Business and Significant Accounting Policies to our consolidated financial statements, we believe the following topics reflect our critical accounting policies and our more significant judgment and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue in two ways in accordance with Accounting Standards Codification (“ASC”) 606. This includes revenues from home sales with respect to homes that we construct on homesites to which we own title that are recorded at the time each home sale is closed and title and possession are transferred to the buyer, as well as revenues from home sales in which the buyer retains title to the homesite while we build the home that are recognized based on the percentage of completion of the home construction, which is measured on a quarterly basis. We determine the percentage of completion based on the number of days of construction completed to the total estimated number of days to construct the home.

Real Estate Inventory and Homebuilding Cost of Sales

Inventories include the cost of direct land acquisition, land development, construction, capitalized interest, real estate taxes and direct overhead costs incurred related to land acquisition and development and home construction. Indirect overhead costs are charged to selling, general and administrative expense as incurred.

Land and development costs are typically allocated to individual residential lots on a pro-rata basis based on the number of lots in the development, and the costs of residential lots are transferred to construction work in progress when home construction begins. Sold units are expensed on a specific identification basis as homebuilding cost of sales. Homebuilding cost of sales for homes closed includes the specific construction costs of each home and all applicable land acquisition, land development and related costs allocated to each residential lot.

Inventories are carried at the lower of accumulated cost or net realizable value. We periodically review the performance and outlook of our inventories for indicators of potential impairment.

Business Combinations and Valuation of Contingent Consideration

The Company accounts for business combinations using the acquisition method. Under ASC 805 a business combination occurs when an entity obtains control of a “business.” The Company determines whether or not the gross assets acquired meet the definition of a business. If they meet this criteria, the Company accounts for the transaction as a stock purchase. If they do not meet this criteria the transaction is accounted for as an asset purchase. The consideration transferred in the acquisition is generally measured at fair value, as are the identifiable net assets acquired. Any goodwill that arises is tested annually for impairment. Any gain on a bargain purchase is recognized in profit or loss immediately. Transaction costs are expensed as incurred, except if related to the issuance of debt or equity securities. Any contingent consideration is measured at fair value at the date of acquisition and is based on expected cash flow of the acquisition target discounted over time using an observable market discount rate. The Company generally utilizes outside valuation experts to determine the amount of contingent consideration. Contingent consideration is remeasured at fair value at each reporting date and subsequent changes in the fair value of the contingent consideration are recognized in other income or other expense in the Consolidated Statements of Comprehensive Income.

Recent Accounting Pronouncements

See Note 1, Nature of Business and Significant Accounting Policies, to our consolidated financial statements.

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Inflation

Inflation in the United States materially increased during the year ended December 31, 2022. To combat these inflationary pressures, the Federal Reserve raised interest rates during 2022 and signaled future interest rate increases.

Our operations may be negatively impacted by inflation due to increasing construction costs, labor, materials as well as land acquisition and financing costs. Inflation can also result in rising mortgage interest rates, which can, in turn, substantially limit the ability of a typical homebuyer, relying on mortgage financing, to purchase a new home. During 2022, although there were increases in the cost of labor and materials, these additional costs were outpaced by price increases in homes closed, and as such, did not have a material impact on our gross margins.

Off-Balance Sheet Arrangements

Asset-Light Lot Acquisition Strategy

We operate an asset-light and capital-efficient lot acquisition strategy primarily through finished lot option contracts and land bank option contracts. These contracts generally allow us to forfeit our right to purchase the lots controlled by these option contracts for any reason, and our sole legal obligation and economic loss as a result of such forfeitures is limited to the amount of the deposits paid pursuant to such option contracts and, in the case of land bank option contracts, any related lot option fees paid to the land bank partner, any potential performance obligations, management of the development to completion and any cost overruns relative to the project. We do not have any financial guarantees or completion obligations, and we do not guarantee lot purchases on a specific performance basis under these agreements. See “Business—Land Acquisition and Development Process” for further information on these option contracts.

As of December 31, 2022, we controlled 37,615 lots through finished lot option contracts and land bank option contracts. Our entire risk of loss pertaining to the aggregate purchase price of contractual commitments resulting from our non-performance under our finished lot option contracts and land bank option contracts is limited to approximately $277 million in lot deposits as of December 31, 2022. In addition, we have capitalized costs of $184 million relating to our off-balance sheet arrangements and land development due diligence.

Surety Bonds and Letters of Credit

We enter into surety bonds and letters of credit arrangements with local municipalities, government agencies and land developers. These arrangements relate to certain performance-related obligations and serve as security for certain land option agreements. As of December 31, 2022, we had outstanding surety bonds and letters of credit totaling $85 million and $1 million, respectively. We believe we will fulfill our obligations under the related arrangements and do not anticipate any material losses under these surety bonds and letters of credit.