News Column

NVR INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 1, 2014

(dollars in thousands)

Forward-Looking Statements

Some of the statements in this Quarterly Report on Form 10-Q, as well as statements made by us in periodic press releases or other public communications, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Certain, but not necessarily all, of such forward-looking statements can be identified by the use of forward-looking terminology, such as "believes," "expects," "may," "will," "should," or "anticipates" or the negative thereof or other comparable terminology. All statements other than of historical facts are forward-looking statements. Forward-looking statements contained in this document may include those regarding market trends, NVR's financial position, business strategy, the outcome of pending litigation, investigations or similar contingencies, projected plans and objectives of management for future operations. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results or performance of NVR to be materially different from future results, performance or achievements expressed or implied by the forward-looking statements. Such risk factors include, but are not limited to the following: general economic and business conditions (on both a national and regional level); interest rate changes; access to suitable financing by NVR and NVR's customers; increased regulation in the mortgage banking industry; the ability of our mortgage banking subsidiary to sell loans it originates into the secondary market; competition; the availability and cost of land and other raw materials used by NVR in its homebuilding operations; shortages of labor; weather related slow-downs; building moratoriums; governmental regulation; fluctuation and volatility of stock and other financial markets; mortgage financing availability; and other factors over which NVR has little or no control. NVR undertakes no obligation to update such forward-looking statements except as required by law. For additional information regarding risk factors, see Part II, Item 1A of this Quarterly Report on Form 10-Q and Part I, Item 1A of NVR's Annual Report on Form 10-K for the fiscal year ended December 31, 2013.



Unless the context otherwise requires, references to "NVR," "we," "us," or "our" include NVR and its consolidated subsidiaries.

Results of Operations for the Three and Six Months Ended June 30, 2014 and 2013

Overview Business Our primary business is the construction and sale of single-family detached homes, townhomes and condominium buildings, all of which are primarily constructed on a pre-sold basis. To fully serve customers of our homebuilding operations, we also operate a mortgage banking and title services business. We primarily conduct our operations in mature markets. Additionally, we generally grow our business through market share gains in our existing markets and by expanding into markets contiguous to our current active markets. Our four homebuilding reportable segments consist of the following regions:



Mid Atlantic: Maryland, Virginia, West Virginia, Delaware and Washington, D.C.

North East: New Jersey and eastern Pennsylvania Mid East: New York, Ohio, western Pennsylvania, Indiana and Illinois South East: North Carolina, South Carolina, Florida and Tennessee



Our lot acquisition strategy is predicated upon avoiding the financial requirements and risks associated with direct land ownership and development. Historically, we generally have not engaged in land development

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to obtain finished lots for use in our homebuilding operations. Instead, we typically have acquired finished lots at market prices from various third party land developers pursuant to fixed price purchase agreements. These purchase agreements require deposits, typically ranging up to 10% of the aggregate purchase price of the finished lots, in the form of cash or letters of credit that may be forfeited if we fail to perform under the purchase agreement. This strategy has allowed us to maximize inventory turnover, which we believe enables us to minimize market risk and to operate with less capital, thereby enhancing rates of return on equity and total capital. Our continued success is contingent upon our ability to control an adequate supply of finished lots on which to build, and on our developers' ability to timely deliver finished lots to meet the sales demands of our customers. However, during the past several years, the impact of economic conditions on the homebuilding industry negatively impacted our developers' ability to obtain acquisition and development financing or to raise equity investments to finance land development activity. As a result, in certain specific strategic circumstances we deviated from our historical lot acquisition strategy and engaged in joint venture arrangements with land developers or directly acquired raw ground already zoned for its intended use for development. Once we acquire control of any raw ground, we determine whether to sell the raw parcel to a developer and enter into a fixed price purchase agreement with the developer to purchase the finished lots, or whether we will hire a developer to develop the land on our behalf. While joint venture arrangements and direct land development activity are not our preferred method of acquiring finished building lots, we may enter into additional transactions in the future on a limited basis where there exists a compelling strategic or prudent financial reason to do so. We expect, however, to continue to acquire substantially all our finished lot inventory using fixed price purchase agreements with forfeitable deposits. As of June 30, 2014, we controlled approximately 60,900 lots under purchase agreements with deposits in cash and letters of credit totaling approximately $306,200 and $2,400, respectively. Included in the number of controlled lots are approximately 8,000 lots for which we have recorded a contract land deposit impairment reserve of approximately $55,900 as of June 30, 2014. We also controlled approximately 5,600 lots through four joint venture limited liability corporations ("JVs") with an aggregate investment of approximately $85,500. Further, as of June 30, 2014, we directly owned six separate raw parcels of land, zoned for their intended use, with a current cost basis, including development costs, of approximately $63,800 that once fully developed will result in approximately 1,150 lots. Of the total finished lots expected to be developed, 125 lots are under contract to be sold to an unrelated party under lot purchase agreements (see Notes 2, 3 and 4 to the condensed consolidated financial statements included herein for additional information regarding fixed price purchase agreements, JVs and land under development, respectively). In addition, NVR has certain properties under contract with land owners that are expected to yield approximately 4,900 lots, which are not included in our number of total lots controlled. Some of these properties may require rezoning or other approvals to achieve the expected yield. These properties are controlled with deposits and letters of credit totaling approximately $3,500 and $4,000, respectively as of June 30, 2014, of which approximately $7,300 is refundable if NVR does not perform under the contract. NVR generally expects to assign the raw land contracts to a land developer and simultaneously enter into a lot purchase agreement with the assignee if the project is determined to be feasible. In addition to constructing homes primarily on a pre-sold basis and utilizing what we believe is a conservative lot acquisition strategy, we focus on obtaining and maintaining a leading market position in each market we serve. This strategy allows us to gain valuable efficiencies and competitive advantages in our markets, which we believe contributes to minimizing the adverse effects of regional economic cycles and provides growth opportunities within these markets.



Current Business Environment and Key Financial Results

Through the first six months of 2014, the housing markets we serve have generally seen a flattening in the number of home sales and prices. Slow economic growth coupled with reduced affordability have been the primary drivers of the slowdown in the housing recovery. We have experienced a decline in traffic per community in the first six months of 2014 compared to the same period in 2013. In addition, new home

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competitors have been increasing the number of communities open for sale, which has resulted in a decline in sales per community. The housing market also continues to face challenges from tight mortgage underwriting standards.

Our consolidated revenues for the second quarter of 2014 totaled $1,102,100, a 9% increase from the second quarter of 2013. Our net income and diluted earnings per share in the current quarter were $68,178 and $15.17, respectively, increases of 34% and 50%, respectively, compared to the second quarter of 2013. Diluted earnings per share was favorably impacted by our ongoing share repurchase program, under which we repurchased 317,739 shares of our stock at an aggregate purchase price of $347,448 during the first six months of 2014. Our gross profit margin within our homebuilding business increased to 18.6% in the second quarter of 2014 compared to 15.9% in the second quarter of 2013. Gross profit margin in the second quarter of 2013 was negatively impacted by a previously disclosed service related accrual of approximately $15,600 which reduced gross profit margin by 157 basis points of revenue. Our new orders, net of cancellations ("New Orders") and the average sales price for New Orders increased 4% and 2%, respectively, compared to the second quarter of 2013. While our gross profit margin improved from year ago levels, we continue to face gross margin pressure due to increasing land and construction costs. In addition, increased competition in the mortgage banking industry has resulted in reduced loan profitability. We believe that continued improvement in the housing market is dependent upon a sustained overall economic recovery, driven by continued improvement in job growth and consumer confidence levels as well as improvement in wage growth and household formation. Due to the strength of our balance sheet, we believe that we are well positioned to take advantage of opportunities that may arise from future economic and homebuilding market volatility.



Homebuilding Operations

The following table summarizes the results of operations and other data for the consolidated homebuilding operations:

Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Revenues $ 1,084,080$ 992,210$ 1,883,267$ 1,743,078 Cost of sales $ 882,778$ 834,288$ 1,537,930$ 1,458,373 Gross profit margin percentage 18.6 % 15.9 % 18.3 % 16.3 % Selling, general and administrative expenses $ 93,583$ 82,120$ 184,215$ 160,533 Settlements (units) 2,943 2,878 5,154 5,150 Average settlement price $ 368.2$ 344.7$ 365.3$ 338.4 New orders (units) 3,415 3,278 6,740 6,788 Average new order price $ 368.0$ 361.1$ 368.0$ 351.8 Backlog (units) 6,531 6,617 Average backlog price $ 374.1$ 358.6 New order cancellation rate 13.2 % 13.8 % 12.4 % 13.5 %



Consolidated Homebuilding - Three Months Ended June 30, 2014 and 2013

Homebuilding revenue increased 9% in the second quarter of 2014 compared to the same period in 2013 primarily as a result of a 7% increase in the average settlement price and a 2% increase in the number of units settled quarter over quarter. The increase in the average settlement price was primarily attributable to the average price of homes in backlog being approximately 7% higher entering the second quarter of 2014 23



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compared to the same period in 2013. The higher average price of homes in backlog entering the second quarter of 2014 was attributable to the improved market conditions experienced in 2013 which led to increasing prices in 2013 and into the first quarter of 2014. In addition, beginning backlog was also favorably impacted by a shift in backlog units to our Mid Atlantic segment which is our highest priced segment. Gross profit margin in the second quarter of 2014 increased 265 basis points to 18.6% compared to 15.9% the second quarter of 2013. Gross profit margin in the second quarter of 2013 was negatively impacted by the aforementioned service related accrual which reduced gross profit margin by 157 basis points. Additionally, second quarter 2014 gross profit margin was favorably impacted by our average settlement price increasing at a higher rate than material and lot costs quarter over quarter. Selling, general and administrative ("SG&A") expense in the second quarter of 2014 increased approximately $11,500, or 14%, compared to the second quarter of 2013, and increased as a percentage of revenue to 8.6% from 8.3% quarter over quarter. SG&A expense increased primarily due to an increase in sales and marketing expenses and equity-based compensation expense. Sales and marketing costs increased approximately $5,300 quarter over quarter due to the 9% increase in the average number of active communities. Equity-based compensation expense increased approximately $4,900 due primarily to the granting of non-qualified stock options under the 2014 Equity Incentive Plan (the "2014 Plan"), which was approved by our shareholders at the May 2014 Annual Meeting (see Note 6 in the accompanying condensed consolidated financial statements for additional discussion of equity-based compensation and the 2014 Plan). The number of New Orders and the average sales price of New Orders increased 4% and 2%, respectively, in second quarter of 2014 when compared to the second quarter of 2013. The increase in New Orders was driven by a 9% increase in the average number of active communities, offset partially by lower absorption rates quarter over quarter. Although the average sales price of New Orders increased slightly quarter over quarter, we have seen a leveling off of sales prices from the first quarter of 2014 through the second quarter.



Consolidated Homebuilding - Six Months Ended June 30, 2014 and 2013

Homebuilding revenue increased 8% for the six months ended June 30, 2014 compared to the same period in 2013 as a result of an 8% increase in the average settlement price. The increase in the average settlement price was primarily attributable to an 8% higher average price of homes in backlog entering 2014 compared to 2013. The higher average price of homes in backlog entering 2014 was attributable to the improved market conditions experienced in 2013. Gross profit margin in the first six months of 2014 increased to 18.3% compared to 16.3% in the first six months of 2013. As noted previously, gross profit margin in the second quarter of 2013 was negatively impacted by a service related accrual which reduced the 2013 gross profit margin by 89 basis points. Additionally, 2014 gross profit margin was favorably impacted by our average settlement prices increasing at a higher rate than material and lot costs year over year. SG&A expense in the first six months of 2014 increased approximately $23,700 compared to the first six months of 2013 and increased as a percentage of revenue to 9.8% from 9.2% year over year. The increase in SG&A expense was attributable to an approximate $9,100 increase in sales and marketing costs due to the increase in the average number of active communities, an approximate $7,700 increase in personnel costs due to an increase in headcount year over year, and an approximate $7,200 increase in equity-based compensation expense in 2014. Equity-based compensation expense increased due to the aforementioned non-qualified stock option grants in the second quarter of 2014 under the 2014 Plan and restricted share unit grants in the second quarter of 2013. The number of New Orders was 1% lower for the first six months of 2014 compared to the first six months of 2013, while the average sales price of New Orders increased 5% year over year. New Orders were 24



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down despite a 10% increase in the average number of active communities year over year as sales absorption rates were lower in each of our market segments. Average sales prices were higher in each of our market segments year over year as a result of favorable market conditions in 2013, which led to increasing prices entering 2014. The average sales price of New Orders in the current year was also favorably impacted by a shift in New Orders to our Mid Atlantic and North East market segments, which have higher average sales prices. Backlog units and dollars were 6,531 units and $2,443,238, respectively, as of June 30, 2014 compared to 6,617 units and $2,372,757, respectively, as of June 30, 2013. Backlog units were lower primarily due to our backlog units being approximately 1% lower entering 2014 compared to the same period in 2013. Backlog dollars were favorably impacted by a 5% higher average price of New Orders for the six month period ended June 30, 2014 compared to the six month period ended June 30, 2013. Backlog, which represents homes sold but not yet settled with the customer, may be impacted by customer cancellations for various reasons that are beyond our control, such as failure to obtain mortgage financing, inability to sell an existing home, job loss, or a variety of other reasons. In any period, a portion of the cancellations that we experience are related to new sales that occurred during the same period, and a portion are related to sales that occurred in prior periods and therefore appeared in the beginning backlog for the current period. Expressed as the total of all cancellations during the period as a percentage of gross sales during the period, our cancellation rate was approximately 12.4% and 13.5% in the first six months of 2014 and 2013, respectively. During the most recent four quarters, approximately 6% of a reporting quarter's beginning backlog cancelled during the fiscal quarter. We can provide no assurance that our historical cancellation rates are indicative of the actual cancellation rates that may occur during the remainder of 2014 or future years. The backlog turnover rate is impacted by various factors, including, but not limited to, changes in New Order activity, internal production capacity, external subcontractor capacity and other external factors over which we do not exercise control. Reportable Segments Homebuilding profit before tax includes all revenues and income generated from the sale of homes, less the cost of homes sold, SG&A expenses, and a corporate capital allocation charge determined at the corporate headquarters. The corporate capital allocation charge eliminates in consolidation, is based on the segment's average net assets employed, and is charged using a consistent methodology in the periods presented. The corporate capital allocation charged to the operating segment allows the Chief Operating Decision Maker to determine whether the operating segment's results are providing the desired rate of return after covering our cost of capital. We record charges on contract land deposits when we determine that it is probable that recovery of the deposit is impaired. For segment reporting purposes, impairments on contract land deposits are generally charged to the operating segment upon the determination to terminate a finished lot purchase agreement with the developer or to restructure a lot purchase agreement resulting in the forfeiture of the deposit. We evaluate our entire net contract land deposit portfolio for impairment each quarter. For additional information regarding our contract land deposit impairment analysis, see the Critical Accounting Policies section within this Management Discussion and Analysis. For presentation purposes below, the contract land deposit reserve at June 30, 2014 and 2013 has been allocated to each reportable segment for the respective years to show contract land deposits on a net basis. The net contract land deposit balances below also include approximately $6,400 and $2,400 at June 30, 2014 and 2013, respectively, of letters of credit issued as deposits in lieu of cash. The following tables summarize certain homebuilding operating activity by reportable segment for the three months ended June 30, 2014 and 2013: 25



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Selected Segment Financial Data:

Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Revenues: Mid Atlantic $ 657,825$ 594,902$ 1,122,855$ 1,026,770 North East 92,438 82,260 171,230 144,871 Mid East 221,088 213,463 371,736 384,219 South East 112,729 101,585 217,446 187,218 Gross profit margin: Mid Atlantic $ 123,097$ 94,825$ 212,383$ 172,105 North East 17,677 14,176 31,985 24,556 Mid East 34,784 31,101 55,634 52,155 South East 20,389 15,666 39,336 28,679 Segment profit: Mid Atlantic $ 67,347$ 48,727$ 108,358$ 85,266 North East 8,398 6,397 14,705 10,083 Mid East 11,116 9,412 10,867 11,235 South East 7,895 5,101 15,941 8,748 Gross profit margin percentage: Mid Atlantic 18.7 % 15.9 % 18.9 % 16.8 % North East 19.1 % 17.2 % 18.7 % 17.0 % Mid East 15.7 % 14.6 % 15.0 % 13.6 % South East 18.1 % 15.4 % 18.1 % 15.3 % Operating Activity: Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 2014 2013 2014 2013 Units Average Price Units Average Price Settlements: Mid Atlantic 1,547 1,493 $ 425.1$ 398.4 2,671 2,631 $ 420.3$ 390.2 North East 271 259 $ 341.1$ 317.6 504 450 $ 339.7$ 321.9 Mid East 707 722 $ 312.5$ 295.6 1,185 1,315 $ 313.6$ 292.1 South East 418 404 $ 269.6$ 251.4 794 754 $ 273.7$ 248.3 Total 2,943 2,878 $ 368.2$ 344.7 5,154 5,150 $ 365.3$ 338.4 New orders, net of cancellations: Mid Atlantic 1,751 1,671 $ 427.4$ 421.0 3,426 3,387 $ 428.1$ 409.9 North East 288 274 $ 337.9$ 338.4 586 567 $ 342.1$ 330.0 Mid East 825 833 $ 314.3$ 304.2 1,716 1,782 $ 313.1$ 302.6 South East 551 500 $ 275.4$ 268.2 1,012 1,052 $ 272.8$ 259.4 Total 3,415 3,278 $ 368.0$ 361.1 6,740 6,788 $ 368.0$ 351.8 26



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Table of Contents As of June 30, 2014 2013 2014 2013 Units Average Price Backlog: Mid Atlantic 3,465 3,439 $ 430.0$ 412.8 North East 577 550 $ 347.0$ 336.8 Mid East 1,563 1,619 $ 319.1$ 310.2 South East 926 1,009 $ 274.7$ 263.4 Total 6,531 6,617 $ 374.1$ 358.6 Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 New order cancellation rate: Mid Atlantic 13.6 % 12.2 % 12.3 % 13.2 % North East 13.5 % 17.7 % 13.4 % 14.7 % Mid East 12.4 % 14.1 % 11.0 % 12.7 % South East 13.1 % 16.0 % 14.4 % 14.7 % Average active communities: Mid Atlantic 246 218 244 211 North East 45 38 44 38 Mid East 128 129 126 129 South East 75 67 73 66 Total 494 452 487 444 Homebuilding Inventory: As of June 30, 2014 2013 Sold inventory: Mid Atlantic $ 502,787$ 473,220 North East 62,568 59,155 Mid East 147,003 148,617 South East 72,059 74,492 Total (1) $ 784,417$ 755,484 Unsold lots and housing units inventory: Mid Atlantic $ 67,730$ 39,606 North East 3,665 4,056 Mid East 5,615 10,092 South East 11,587 9,169 Total (1) $ 88,597$ 62,923



(1) The reconciling items between segment inventory and consolidated inventory

include certain consolidation adjustments necessary to convert the reportable

segments' results, which are predominantly maintained on a cash basis, to a

full accrual basis for external financial statement presentation purposes and

are not allocated to our operating segment. 27



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Table of Contents Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013



Sold and Unsold inventory impairments:

Mid Atlantic $ 123$ 86$ 220$ 86 North East 4 30 5 47 Mid East - 445 78 445 South East - - - - Total $ 127$ 561$ 303$ 578



Lots Controlled and Land Deposits:

As of June 30, 2014 2013 Total lots controlled: Mid Atlantic 33,600 31,100 North East 5,700 4,900 Mid East 16,900 16,500 South East 11,300 8,700 Total 67,500 61,200 Lots included in impairment reserve: Mid Atlantic 3,700 4,400 North East 900 1,000 Mid East 2,200 2,500 South East 1,200 1,400 Total 8,000 9,300 Contract land deposits, net: Mid Atlantic $ 169,711$ 141,941 North East 20,456 13,416 Mid East 38,893 34,434 South East 31,175 18,692 Total $ 260,235$ 208,483 Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Contract land deposit impairment (recoveries): Mid Atlantic $ (60 )$ (209 )$ (60 )$ (264 ) North East - (25 ) 2 (25 ) Mid East 19 4 30 54 South East 154 - 190 - Total $ 113$ (230 )$ 162$ (235 ) 28



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Mid Atlantic

Three Months Ended June 30, 2014 and 2013

The Mid Atlantic segment had an approximate $18,600, or 38%, increase in segment profit in the second quarter of 2014 compared to the second quarter of 2013. Segment revenue increased approximately $62,900, or 11%, quarter over quarter due primarily to a 7% increase in the average settlement price and a 4% increase in the number of units settled. The increase in the average settlement price was favorably impacted by a 7% higher average price of homes in backlog entering the second quarter of 2014 compared to the same period in 2013. The higher average price of homes in backlog entering 2014 was attributable to the improved market conditions experienced in 2013, which led to increasing prices in 2013 and into the first quarter of 2014. The increase in units settled was attributable to a higher backlog turnover rate quarter over quarter. The Mid Atlantic segment's gross profit margin increased 277 basis points to 18.7% from 15.9% quarter over quarter. Gross profit margin in the second quarter of 2013 was negatively impacted by the previously discussed service related accrual, which reduced 2013 gross profit margin by 262 basis points of revenue. Segment New Orders and the average sales price of New Orders increased 5% and 2%, respectively, in the second quarter of 2014 compared to the second quarter of 2013. The increase in New Orders quarter over quarter was driven by a 13% increase in the average number of active communities, offset partially by lower absorption rates. In addition, New Orders in the current quarter were negatively impacted by an increase in the cancellation rate to 13.6% from 12.2% in the prior year quarter.



Six Months Ended June 30, 2014 and 2013

The Mid Atlantic segment had an approximate $23,100, or 27%, increase in segment profit in the first six months of 2014 compared to the same period in 2013. Segment revenue increased approximately $96,100, or 9%, year over year due primarily to an 8% increase in the average settlement price in 2014 compared to 2013. The increase in the average settlement price was favorably impacted by a 7% higher average price of homes in backlog entering 2014 compared to the same period in 2013. The Mid Atlantic segment's gross profit margin increased to 18.9% in 2014 from 16.8% in 2013. As noted above, gross profit margin in the second quarter of 2013 was negatively impacted by a service related accrual which reduced 2013 gross profit margin by 152 basis points of revenue. In addition, 2014 gross profit margin was favorably impacted as a result of our average settlement price increasing at a higher rate than material and lot costs year over year. Segment New Orders and the average sales price for New Orders in the first six months of 2014 increased 1% and 4%, respectively compared to the same period in 2013. New Orders were relatively flat despite a 15% increase in the average number of active communities in 2014 compared to 2013 due to lower absorption rates attributable to lower traffic levels year over year. The increase in the average sales price of New Orders is attributable to the favorable market conditions in 2013, which led to higher average sales prices entering 2014.



North East

Three Months Ended June 30, 2014 and 2013

The North East segment had an approximate $2,000, or 31%, increase in segment profit in the second quarter of 2014 compared to the second quarter of 2013. Segment revenue increased approximately $10,200, or 12%, quarter over quarter due to a 5% increase in the number of units settled, coupled with a 7% increase in the average settlement price. The increase in units settled was attributable to a 5% higher backlog unit balance entering the second quarter of 2014 compared to the backlog unit balance entering the second quarter of 2013. The increase in the average settlement price was favorably impacted by a 7% higher average price of homes in backlog entering the second quarter of 2014 compared to the same period in 2013. The North East segment's gross profit margin increased to 19.1% in 2014 from 17.2% in 2013. Segment profit and gross profit margin were favorably impacted by a shift in settlements to higher priced markets with higher gross margins. 29



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Segment New Orders increased approximately 5%, while the average sales price of New Orders was flat in the second quarter of 2014 compared to the same period in 2013. The increase in New Orders was driven by a 17% increase in the average number of active communities, offset partially by a decrease in community absorption rates attributable to reduced traffic levels quarter over quarter. New Orders were also favorably impacted by a decrease in the cancellation rate to 13.5% in the second quarter of 2014 from 17.7% in the same period in 2013.



Six Months Ended June 30, 2014 and 2013

The North East segment had an approximate $4,600, or 46%, increase in segment profit in the first six months of 2014 compared to the same period of 2013. The increase in segment profit was primarily driven by an increase of approximately $26,400, or 18%, in revenue year over year due to a 12% increase in the number of units settled, coupled with a 6% increase in the average settlement price. The increase in units settled was attributable to a 14% higher backlog unit balance entering 2014 compared to the backlog unit balance entering 2013. The increase in the average settlement price was favorably impacted by a 5% higher average price of homes in backlog entering 2014 compared to the same period in 2013. The North East segment's gross profit margin increased to 18.7% in 2014 from 17.0% in 2013. Gross profit margin was favorably impacted by the increase in the average settlement price and by increased settlement volume, allowing us to better leverage certain operating costs in 2014. Segment New Orders and the average sales price of New Orders increased approximately 3% and 4%, respectively, during the first six months of 2014 from the same period in 2013. The increase in New Orders was driven by a 17% increase in the average number of active communities, offset partially by a decrease in community absorption rates attributable to reduced traffic levels year over year. The increase in the average sales price of New Orders is attributable to the favorable market conditions in 2013, which led to higher average sales prices entering 2014.



Mid East

Three Months Ended June 30, 2014 and 2013

The Mid East segment had an approximate $1,700, or 18%, increase in segment profit in the second quarter of 2014 compared to the second quarter of 2013. Segment revenue was higher by approximately $7,600, or 4%, quarter over quarter. Revenue increased primarily due to a 6% increase in the average settlement price, offset partially by a 2% decrease in the number of units settled quarter over quarter. The average settlement price was favorably impacted by a 4% higher average price of homes in backlog entering the second quarter of 2014 compared to the same period in 2013. The decrease in units settled was attributable to a 4% lower backlog unit balance entering the second quarter of 2014 compared to the same period in 2013. The Mid East's gross profit margin increased to 15.7% in the second quarter of 2014 from 14.6% in the same period of 2013, due primarily to our average settlement price increasing at a higher rate than lot and certain material costs quarter over quarter. Segment New Orders decreased 1% in the second quarter of 2014 compared to the same period in 2013, while the average sales price increased 3% quarter over quarter. New Orders were negatively impacted by a 1% decrease in the average number of active communities quarter over quarter. The increase in the average sales price of New Orders was attributable to a shift in mix to higher priced communities in certain markets. 30



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Six Months Ended June 30, 2014 and 2013

The Mid East segment had an approximate $400, or 3%, decrease in segment profit in the first six months of 2014 compared to the same period of 2013. The decrease in segment profit was driven by a decrease in revenue of approximately $12,500 or 3%, year over year due primarily to a 10% decrease in the number of units settled, offset partially by a 7% increase in the average settlement price year over year. The decrease in settlements was primarily attributable to a 10% lower backlog unit balance entering 2014 compared to the same period in 2013. The average settlement price was favorably impacted by an 8% higher average price of homes in backlog entering 2014 compared to the same period in 2013. The segment's gross profit margin increased to 15.0% in 2014 from 13.6% in 2013, due primarily to our average settlement price increasing at a higher rate than lot and certain material costs year over year. Segment New Orders decreased 4%, while the average sales price of New Orders increased 3% in the first six months of 2014 compared to the same period in 2013. New Orders were negatively impacted by a 2% decrease in the average number of active communities year over year. The increase in the average price of New Orders was attributable to a shift in mix to higher priced communities in certain markets.



South East

Three Months Ended June 30, 2014 and 2013

The South East segment had an approximate $2,800, or 55%, increase in segment profit in the second quarter of 2014 compared to the second quarter of 2013. Segment revenue increased approximately $11,100, or 11%, quarter over quarter primarily due to a 3% increase in the number of units settled and a 7% increase in the average settlement price. The increase in settlements was driven primarily by a higher backlog turnover rate in the second quarter of 2014 compared to the same period in 2013. The increase in the average settlement price was attributable primarily to a 6% higher average sales price of homes in backlog entering the second quarter of 2014 compared to the same period in 2013. The South East segment's gross profit margin increased to 18.1% in the second quarter of 2014 from 15.4% in the second quarter of 2013 due primarily to our average settlement prices increasing at a higher rate than lot and certain material costs quarter over quarter. Segment New Orders and the average sales price of New Orders increased approximately 10% and 3%, respectively, during the second quarter of 2014 compared to the same period in 2013. New Orders were favorably impacted by a 13% increase in the average number of active communities, offset partially by lower absorption rates attributable to reduced traffic levels quarter over quarter. In addition, New Orders were favorably impacted by a decrease in the cancellation rate to 13.1% in the second quarter of 2014 from 16.0% in the same period of 2013. The increase in the average sales price for New Orders was primarily attributable to the initial sales of our NVHomes product line in the Raleigh market in 2014, which sells at a higher price point.



Six Months Ended June 30, 2014 and 2013

The South East segment had an approximate $7,200, or 82%, increase in segment profit in the first six months of 2014 compared to the same period of 2013. Segment revenue increased approximately $30,200, or 16%, year over year due to a 5% increase in the number of units settled and a 10% increase in the average settlement price. The increase in settlements was driven primarily by a higher backlog turnover rate in 2014 compared to 2013. The average settlement price in 2014 was favorably impacted by a 9% higher average price of homes in backlog entering 2014 compared to the same period in 2013. The South East segment's gross profit margin increased to 18.1% in 2014 from 15.3% in 2013, due primarily to our average settlement prices increasing at a higher rate than lot and certain material costs year over year. Segment New Orders decreased 4%, while the average sales price increased 5% in the first six months of 2014 compared to the same period in 2013. New Orders were lower despite an 11% increase in the average 31



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number of active communities in 2014 compared to 2013 due to lower absorption levels attributable to lower traffic levels year over year. The increase in the average sales price for New Orders in 2014 was attributable to the introduction of our NVHomes product line in the Raleigh market in 2014, which sells at a higher price point and to a shift in mix in New Orders to higher priced markets.



Homebuilding Segment Reconciliations to Consolidated Homebuilding Operations

In addition to the corporate capital allocation and contract land deposit impairments discussed above, the other reconciling items between homebuilding segment profit and homebuilding consolidated profit before tax include unallocated corporate overhead (which includes all management incentive compensation), equity-based compensation expense, consolidation adjustments and external corporate interest expense. Our overhead functions, such as accounting, treasury, human resources, etc., are centrally performed and the costs are not allocated to our operating segments. Consolidation adjustments consist of such items to convert the reportable segments' results, which are predominantly maintained on a cash basis, to a full accrual basis for external financial statement presentation purposes, and are not allocated to our operating segments. Likewise, equity-based compensation expense is not charged to the operating segments. External corporate interest expense is primarily comprised of interest charges on our 3.95% Senior Notes due 2022, and is not charged to the operating segments because the charges are included in the corporate capital allocation discussed above. Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Homebuilding Consolidated Gross Profit: Mid Atlantic $ 123,097$ 94,825$ 212,383$ 172,105 North East 17,677 14,176 31,985 24,556 Mid East 34,784 31,101 55,634 52,155 South East 20,389 15,666 39,336 28,679 Consolidation adjustments and other 5,355 2,154 5,999 7,210 Consolidated Homebuilding gross profit $ 201,302$ 157,922



$ 345,337$ 284,705

Homebuilding Consolidated Profit Before Tax: Mid Atlantic $ 67,347$ 48,727$ 108,358$ 85,266 North East 8,398 6,397 14,705 10,083 Mid East 11,116 9,412 10,867 11,235 South East 7,895 5,101 15,941 8,748 Reconciling items: Contract land deposit reserve adjustment (1) 1,672 2,845 3,655 3,852 Equity-based compensation expense (2) (14,757 ) (9,791 ) (24,611 ) (17,213 ) Corporate capital allocation (3) 34,511 29,673 63,477 55,291 Unallocated corporate overhead (15,513 ) (20,972 ) (41,473 ) (46,170 ) Consolidation adjustments and other 7,488 5,479 11,629 15,138 Corporate interest expense (5,579 ) (5,208



) (11,254 ) (10,623 )

Reconciling items sub-total 7,822 2,026 1,423 275



Homebuilding consolidated profit before taxes $ 102,578$ 71,663

$ 151,294$ 115,607



(1) This item represents changes to the contract land deposit impairment reserve

which are not allocated to the reportable segments.

(2) The increase in equity-based compensation expense in the three month period

ended June 30, 2014 was primarily attributable to the issuance of Options

under the 2014 Plan during the second quarter of 2014. The increase in

equity-based compensation expense in the six month period ended June 30, 2014

is primarily attributable to the second quarter 2014 Options granted and

restricted share unit grants in the second quarter of 2013. See Note 6 in the

accompanying condensed financial statements for additional discussion of

equity-based compensation. 32



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Table of Contents (3) This item represents the elimination of the corporate capital allocation

charge included in the respective homebuilding reportable segments. The

corporate capital allocation charge is based on the segment's monthly average

asset balance, and is as follows for the periods presented: Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Mid Atlantic $ 21,742$ 18,609$ 39,898$ 34,716 North East 2,733 2,353 5,182 4,347 Mid East 6,180 5,716 11,478 10,731 South East 3,856 2,995 6,919 5,497 Total $ 34,511$ 29,673$ 63,477$ 55,291 Mortgage Banking Segment



Three and Six Months Ended June 30, 2014 and 2013

We conduct our mortgage banking activity through NVR Mortgage Finance, Inc. ("NVRM"), a wholly owned subsidiary. NVRM focuses almost exclusively on serving homebuilding's customer base. Following is a table of financial and statistical data for the three and six months ended June 30, 2014 and 2013: Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Loan closing volume: Total principal $ 675,624$ 646,450$ 1,148,557$ 1,120,216 Loan volume mix: Adjustable rate mortgages 17 % 4 % 15 % 3 % Fixed rate mortgages 83 % 96 % 85 % 97 % Operating profit: Segment profit $ 7,427$ 9,316$ 9,267$ 21,118 Stock option expense (1,181 ) (798 ) (2,030 ) (1,439 )



Mortgage banking income before tax $ 6,246$ 8,518

$ 7,237$ 19,679 Capture rate: 82 % 85 % 80 % 84 % Mortgage Banking fees: Net gain on sale of loans $ 12,510$ 12,586$ 20,505$ 28,159 Title services 5,349 4,980 9,378 8,723 Servicing fees 115 116 214 188 $ 17,974$ 17,682$ 30,097$ 37,070 Loan closing volume for the three and six months ended June 30, 2014 increased 5% and 3%, respectively, over the same period for 2013. The 2014 increases were primarily attributable to a 6% increase in the average loan amount for both the three and six month periods, which is consistent with the average settlement price increases for the homebuilding operations. The increase in the average loan amount was partially offset by a decrease in the number of loans closed by NVRM for our homebuyers who obtain a 33



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mortgage to purchase the home (the "Capture Rate"), which for the three and six months ended June 30, 2014 decreased to 82% and 80%, respectively, compared to 85% and 84%, respectively, for the same periods in 2013. The decrease in Capture Rate is primarily due to a more competitive market for mortgage loans as other lenders' refinancing activity has slowed. Segment profit for the three and six months ended June 30, 2014 decreased by approximately $1,900 and $11,900, respectively, from the same periods for 2013. For the three month period, the decrease was primarily attributable to an approximate $2,000 increase in general and administrative expenses. The increase in general and administrative expenses was primarily attributable to increased staffing in response to increased mortgage regulations and expected higher loan volume. For the six month period, the decrease was primarily attributable to an approximately $4,900 increase in general and administrative expenses and a decrease of approximately $7,000 in mortgage banking fees. The increase in general and administrative expenses was a result of the aforementioned increase in staffing. The decrease in mortgage banking fees is primarily attributable to a more competitive mortgage market for mortgage loans as other lenders' refinancing activity has slowed, resulting in reduced loan profitability.



Mortgage Banking - Other

We sell all of the loans we originate into the secondary mortgage market. Insofar as we underwrite our originated loans to the standards and specifications of the ultimate investor, we have no further financial obligations from the issuance of loans, except in certain limited instances where early payment default occurs. Those underwriting standards are typically equal to or more stringent than the underwriting standards required by Fannie Mae ("FNMA"), the Department of Veterans Affairs ("VA") and the Federal Housing Administration ("FHA"). Because we sell all of our loans and do not service them, there is often a substantial delay between the time that a loan goes into default and the time that the investor requests us to reimburse them for losses incurred because of the default. We believe that all of the loans that we originate are underwritten to the standards and specifications of the ultimate investor to whom we sell our originated loans. We employ a quality control department to ensure that our underwriting controls are effective, and further assess the underwriting function as part of our assessment of internal controls over financial reporting. NVRM has always maintained an allowance for losses on mortgage loans originated that reflects our judgment of the present loss exposure from the loans that we have originated and sold. The allowance is calculated based on an analysis of historical experience and exposure. At June 30, 2014, we had an allowance for loan losses of approximately $8,950. Although we consider the allowance for loan losses reflected on the June 30, 2014 balance sheet to be adequate, there can be no assurance that this allowance will prove to be adequate to cover losses on loans previously originated. NVRM is dependent on our homebuilding operations' customers for business. If New Orders and sales prices of the homebuilding operations decline, NVRM's operations will also be adversely affected. In addition, the mortgage segment's operating results may be adversely affected in future periods due to the continued tightening and volatility of the credit markets, changes in investor funding times, increased regulation of mortgage lending practices and increased competition in the mortgage market.



Liquidity and Capital Resources

Lines of Credit and Notes Payable

Our homebuilding business segment funds its operations from cash flows provided by operating activities and the public debt and equity markets. On September 5, 2012, we filed a Shelf Registration Statement (the "Shelf") with the Securities and Exchange Commission to register for future offer and sale an unlimited amount of debt securities, common shares, preferred shares, depositary shares representing preferred shares and warrants. On September 10, 2012, we issued $600,000 aggregate principal amount of 3.95% Senior Notes due 2022 (the "Senior Notes") under the Shelf. The Senior Notes mature on September 15, 2022 and 34



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bear interest at 3.95%, payable semi-annually in arrears on March 15 and September 15. The Senior Notes are senior unsecured obligations and rank equally in right of payment with any of NVR's existing and future unsecured senior indebtedness, will rank senior in right of payment to any of NVR's future indebtedness that is by its terms expressly subordinated to the Senior Notes and will be effectively subordinated to any of NVR's existing and future secured indebtedness to the extent of the value of the collateral securing such indebtedness. The indenture governing the Senior Notes does not contain any financial covenants, however, it does contain, among other items, and subject to certain exceptions, covenants that restrict our ability to create, incur, assume or guarantee secured debt, enter into sale and leaseback transactions and conditions related to mergers and/or the sale of assets. Our mortgage banking subsidiary, NVRM, provides for its mortgage origination and other operating activities using cash generated from operations, borrowings from its parent company, NVR, as well as a revolving mortgage repurchase facility, which is non-recourse to NVR. Our revolving mortgage repurchase agreement with U.S. Bank National Association provides for loan purchases up to $25,000, subject to certain sub-limits (the "Repurchase Agreement"). The purpose of the Repurchase Agreement is to finance the origination of mortgage loans by NVRM. The Repurchase Agreement expires on July 29, 2015. Advances under the Repurchase Agreement carry a Pricing Rate based on the Libor Rate plus the Libor Margin, or the Default Pricing Rate, as determined under the Repurchase Agreement, provided that the Pricing Rate shall not be less than 3.00%. There are several restrictions on purchased loans, including that they cannot be sold to others, they cannot be pledged to anyone other than the agent, and they cannot support any other borrowing or repurchase agreement. The Repurchase Agreement contains various affirmative and negative covenants. The negative covenants include among others, certain limitations on transactions involving acquisitions, mergers, the incurrence of debt, sale of assets and creation of liens upon any of its mortgage notes. Additional covenants include (i) a tangible net worth requirement, (ii) a minimum liquidity requirement, (iii) a minimum net income requirement, and (iv) a maximum leverage ratio requirement. The Company was in compliance with all covenants under the Repurchase Agreement at June 30, 2014. At June 30, 2014 there was no debt outstanding under the Repurchase Agreement and there were no borrowing base limitations.



Cash Flows

For the six months ended June 30, 2014, cash and cash equivalents decreased by $312,548. Cash used in our operating activities was $17,080. Cash was used to fund the increase in homebuilding inventory of $212,502, as a result of an increase in units under construction at June 30, 2014 compared to December 31, 2013. Cash was provided by net proceeds of $62,648 from mortgage loan activity and a $27,298 increase in customer deposits. Cash from operating activities was also favorably impacted by a $49,946 increase in accounts payable due to the increase in inventory. Net cash used in investing activities was $12,160. Cash was used for additions to property, plant and equipment of $20,805. Cash was provided by the receipt of capital distributions from our unconsolidated JVs totaling $8,282. Net cash used in financing activities was $283,308. Cash was used to repurchase 317,739 shares of our common stock at an aggregate purchase price of $347,448 under our ongoing common stock repurchase program. Stock option exercise activity provided $60,593 in exercise proceeds, and we realized $6,050 in excess income tax benefits from equity-based compensation plan activity.



Equity Repurchases

In addition to funding growth in our homebuilding and mortgage banking operations, we historically have used a substantial portion of our excess liquidity to repurchase outstanding shares of our common stock in open market and privately negotiated transactions. This ongoing repurchase activity is conducted pursuant to publicly announced Board authorizations, and is typically executed in accordance with the safe-harbor provisions of Rule 10b-18 promulgated under the Exchange Act. In addition, the Board resolutions 35



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authorizing us to repurchase shares of our common stock specifically prohibit us from purchasing shares from our officers, directors, Profit Sharing/401(k) Plan Trust or Employee Stock Ownership Plan Trust. The repurchase program assists us in accomplishing our primary objective of increasing shareholder value. See Part II, Item 2 of this Quarterly Report on Form 10-Q for further discussion of repurchase activity during the second quarter of 2014.



Critical Accounting Policies

General

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. We continually evaluate the estimates we use to prepare the consolidated financial statements and update those estimates as necessary. In general, our estimates are based on historical experience, on information from third party professionals, and other various assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ materially from those estimates made by management.



Homebuilding Inventory

The carrying value of inventory is stated at the lower of cost or market value. The cost of lots and completed and uncompleted housing units represent the accumulated actual cost of the units. Field construction supervisors' salaries and related direct overhead expenses are included in inventory costs. Interest costs are not capitalized into inventory, with the exception of land under development. Upon settlement, the cost of the unit is expensed on a specific identification basis. The cost of building materials is determined on a first-in, first-out basis. Sold inventory is evaluated for impairment based on the contractual sales price compared to the total estimated cost to construct. Unsold inventory is evaluated for impairment by analyzing recent comparable sales prices within the applicable community compared to the costs incurred to date plus the expected costs to complete. Any calculated impairments are recorded immediately.



Land Under Development and Contract Land Deposits

Land Under Development

On a very limited basis, we directly acquire raw parcels of land already zoned for its intended use to develop into finished lots. Land under development includes the land acquisition costs, direct improvement costs, capitalized interest, where applicable, and real estate taxes.

Land under development, including the land under development held by our unconsolidated joint ventures and the related joint venture investments, is reviewed for potential write-downs when impairment indicators are present. In addition to considering market and economic conditions, we assess land under development impairments on a community-by-community basis, analyzing, as applicable, current sales absorption levels, recent sales' gross profit, and the dollar differential between the projected fully-developed cost of the lots and the current market price for lots. If indicators of impairment are present for a community, we perform an analysis to determine if the undiscounted cash flows estimated to be generated by those assets are less than their carrying amounts, and if they are, impairment charges are required to be recorded in an amount by which the carrying amount of the assets exceeds the fair value of the assets. Our determination of fair value is primarily based on discounting the estimated future cash flows at a rate commensurate with the inherent risks associated with the assets and related estimated cash flow streams. 36



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At June 30, 2014, we had approximately $63,800 in land under development in six separate communities. In addition, at June 30, 2014, we had an aggregate investment totaling approximately $85,500 in four separate JVs that controlled land under development. None of the communities classified as land under development nor any of the undeveloped land held by the JVs had any indicators of impairment at June 30, 2014. As such, we do not believe that any of the land under development is impaired at this time. However, there can be no assurance that we will not incur impairment charges in the future due to unanticipated adverse changes in the economy or other events adversely affecting specific markets or the homebuilding industry.



Contract Land Deposits

We purchase finished lots under fixed price purchase agreements that require deposits that may be forfeited if we fail to perform under the contract. The deposits are in the form of cash or letters of credit in varying amounts and represent a percentage of the aggregate purchase price of the finished lots. We maintain an allowance for losses on contract land deposits that reflects our judgment of the present loss exposure in the existing contract land deposit portfolio at the end of the reporting period. To analyze contract land deposit impairments, we utilize a loss contingency analysis that is conducted each quarter. In addition to considering market and economic conditions, we assess contract land deposit impairments on a community-by-community basis pursuant to the purchase contract terms, analyzing, as applicable, current sales absorption levels, recent sales' gross profit, the dollar differential between the contractual purchase price and the current market price for lots, a developer's financial stability, a developer's financial ability or willingness to reduce lot prices to current market prices, and the contract's default status by either us or the developer along with an analysis of the expected outcome of any such default. Our analysis is focused on whether we can sell houses profitably in a particular community in the current market with which we are faced. Because we do not own the finished lots on which we had placed a contract land deposit, if the above analysis leads to a determination that we cannot sell homes profitably at the current contractual lot price, we then determine whether we will elect to default under the contract, forfeit our deposit and terminate the contract, or whether we will attempt to restructure the lot purchase contract, which may require us to forfeit the deposit to obtain contract concessions from a developer. We also assess whether an impairment is present due to collectability issues resulting from a developer's non-performance because of financial or other conditions. Although we consider the allowance for losses on contract land deposits reflected on the June 30, 2014 condensed consolidated balance sheet to be adequate (see Note 2 to the accompanying condensed consolidated financial statements), there can be no assurance that this allowance will prove to be adequate over time to cover losses due to unanticipated adverse changes in the economy or other events adversely affecting specific markets or the homebuilding industry. Excess Reorganization Value Reorganization value in excess of identifiable assets ("excess reorganization value") is an indefinite-lived intangible asset that was created upon our emergence from bankruptcy on September 30, 1993. Based on the allocation of our reorganization value, the portion of our reorganization value which was not attributed to specific tangible or intangible assets has been reported as excess reorganization value, which is treated similarly to goodwill. Excess reorganization value is not subject to amortization. Rather, excess reorganization value is subject to an impairment assessment on an annual basis or more frequently if changes in events or circumstances indicate that impairment may have occurred. Because excess reorganization value was based on the reorganization value of our entire enterprise upon emergence from bankruptcy, the impairment assessment is conducted on an enterprise basis based on our total equity compared to the market value of our outstanding publicly-traded common stock. We do not believe that excess reorganization value is impaired at this time. However, changes in strategy or continued adverse changes in market conditions could impact this judgment and require an impairment loss to be recognized if our book value, including excess reorganization value, exceeds the fair value. 37



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Warranty/Product Liability Accruals

Warranty and product liability accruals are established to provide for estimated future costs as a result of construction and product defects, product recalls and litigation incidental to our business. Liability estimates are determined based on our judgment considering such factors as historical experience, the likely current cost of corrective action, manufacturers' and subcontractors' participation in sharing the cost of corrective action, consultations with third party experts such as engineers, and evaluations by our General Counsel and outside counsel retained to handle specific product liability cases. Although we consider the warranty and product liability accrual reflected on the June 30, 2014 condensed consolidated balance sheet to be adequate (see Note 11 to the accompanying condensed consolidated financial statements), there can be no assurance that this accrual will prove to be adequate over time to cover losses due to increased costs for material and labor, the inability or refusal of manufacturers or subcontractors to financially participate in corrective action, unanticipated adverse legal settlements, or other unanticipated changes to the assumptions used to estimate the warranty and product liability accrual.



Equity-Based Compensation Expense

Compensation costs related to our equity-based compensation plans are recognized within our income statement. The costs recognized are based on the grant date fair value. Compensation cost for equity-based grants is recognized on a straight-line basis over the requisite service period for the entire award (from the date of grant through the period of the last separately vesting portion of the grant). For the recognition of equity-based compensation expense, the Options which are subject to a performance condition are treated as a separate award from the "service-only" Options, and compensation expense for Options subject to a performance condition is recognized when it becomes probable that the stated performance target will be achieved. We calculate the fair value of our non-publicly traded, employee stock options using the Black-Scholes option-pricing model. While the Black-Scholes model is a widely accepted method to calculate the fair value of options, its results are dependent on input variables, two of which, expected term and expected volatility, are significantly dependent on management's judgment. We have concluded that our historical exercise experience is the best estimate of future exercise patterns to determine an option's expected term. To estimate expected volatility, we analyze the historical volatility of our common stock over a period equal to the option's expected term. Changes in management's judgment of the expected term and the expected volatility could have a material effect on the grant-date fair value calculated and expensed within the income statement. In addition, we are required to estimate future grant forfeitures when considering the amount of stock-based compensation costs to record. We have concluded that our historical forfeiture rate is the best measure to base our estimate of future forfeitures of equity-based compensation grants. However, there can be no assurance that our future forfeiture rate will not be materially higher or lower than our historical forfeiture rate, which would affect the aggregate cumulative compensation expense recognized. In addition, when recognizing stock based compensation cost related to "performance condition" option grants, we are required to make a determination as to whether the performance conditions will be met prior to the completion of the actual performance period. The performance metric is based on our return on capital performance during 2014 through 2016. While we currently believe that this performance condition will be satisfied at the target level and are recognizing compensation expense related to such Options accordingly, our future expected activity levels could cause us to make a different determination, resulting in a change to the compensation expense to be recognized related to performance condition option grants that would otherwise have been recognized to date. Although we believe that the compensation costs recognized during the three and six month periods ended June 30, 2014 are representative of the cumulative ratable amortization of the grant-date fair value of unvested options outstanding and expected to be exercised, changes to the estimated input values such as expected term and expected volatility and changes to the determination of whether performance condition grants will vest, could produce widely different fair values. 38



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Mortgage Loan Loss Allowance

We originate several different loan products to our customers to finance the purchase of their home. We sell all of the loans we originate into the secondary mortgage market generally within 30 days from origination. All of the loans that we originate are underwritten to the standards and specifications of the ultimate investor. Insofar as we underwrite our originated loans to those standards, we bear no increased concentration of credit risk from the issuance of loans, except in certain limited instances where early payment default occurs. Those underwriting standards are typically equal to or more stringent than the underwriting standards required by FNMA, VA and FHA. We employ a quality control department to ensure that our underwriting controls are effectively operating, and further assess the underwriting function as part of our assessment of internal controls over financial reporting. We maintain an allowance for losses on mortgage loans originated that reflects our judgment of the present loss exposure in the loans that we have originated and sold. The allowance is calculated based on an analysis of historical experience and exposure. Although we consider the allowance for loan losses reflected on the June 30, 2014 condensed consolidated balance sheet to be adequate, there can be no assurance that this allowance will prove to be adequate over time to cover losses due to unanticipated changes to the assumptions used to estimate the mortgage loan loss allowance.


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