NVR - 10-Q quarterly report FY

11700 Plaza America Drive, Suite 500
Reston, Virginia 20190
(703) 956-4000

(Not Applicable)

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of October 20, 2006 there were 5,588,179 total shares of common stock outstanding.

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

     The accompanying unaudited, condensed consolidated financial statements include the accounts of NVR, Inc. (“NVR” or the “Company”) and its subsidiaries and certain other entities in which the Company is deemed to be the primary beneficiary (see note 2 to the condensed consolidated financial statements). Intercompany accounts and transactions have been eliminated in consolidation. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. Because the accompanying condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America, they should be read in conjunction with the financial statements and notes thereto included in the Company’s 2005 Annual Report on Form 10-K. In the opinion of management, all adjustments (consisting only of normal recurring accruals except as otherwise noted herein) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

     For the three and nine-month periods ended September 30, 2006 and 2005, comprehensive income equaled net income; therefore, a separate statement of comprehensive income is not included in the accompanying financial statements. Certain prior year balances have been reclassified to conform to the current year presentation. The reclassifications have no impact on the net income or retained earnings previously reported.

     In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 (“FIN 46R”), Consolidation of Variable Interest Entities, which was effective for NVR as of March 31, 2004. FIN 46R requires the primary beneficiary of a variable interest entity to consolidate that entity in its financial statements. The primary beneficiary of a variable interest entity is the party that absorbs a majority of the variable interest entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual, or other financial interests in the entity. Expected losses are the expected negative variability in the fair value of an entity’s net assets, exclusive of its variable interests, and expected residual returns are the expected positive variability in the fair value of an entity’s net assets, exclusive of its variable interests. As discussed below, NVR evaluates the provisions of FIN 46R as it relates to NVR’s finished lot acquisition strategy.

     NVR does not engage in the land development business. Instead, the Company typically acquires finished building lots at market prices from various development entities under fixed price purchase agreements. The purchase agreements require deposits that may be forfeited if NVR fails to perform under the agreement. The deposits required under the purchase agreements are in the form of cash or letters of credit in varying amounts, and typically range up to 10% of the aggregate purchase price of the finished lots. As of September 30, 2006, the Company controlled approximately 98,000 lots with deposits in cash and letters of credit totaling approximately $594,000 and $17,000, respectively.

     The Company believes that this lot acquisition strategy reduces the financial requirements and risks associated with direct land ownership and land development. NVR may, at its option, choose for any reason and at any time not to perform under these purchase agreements by delivering notice of its intent not to acquire the finished lots under contract. NVR’s sole legal obligation and economic loss for failure to perform under these purchase agreements is limited to the amount of the deposit pursuant to the liquidating damage provisions contained within the purchase agreements. In other words, if NVR does not perform under a purchase agreement, NVR loses only its deposit. NVR does not have any financial or specific performance guarantees, or completion obligations, under these purchase agreements, with the exception of two specific performance contracts pursuant to which the Company is committed to purchasing approximately seven finished lots at an aggregate purchase price of approximately $130. None of the creditors of any of the development entities with which NVR enters fixed price purchase agreements have recourse to the general credit of NVR. Except as described below, NVR also does not share in an allocation of either the profit earned or loss incurred by any of these entities with which NVR enters fixed price purchase agreements.

     On a very limited basis, NVR also obtains finished lots using joint venture limited liability corporations (“LLC’s”). All LLC’s are structured such that NVR is a non-controlling member and is at risk only for the amount invested. NVR is not a borrower, guarantor or obligor on any of the LLC’s debt. NVR enters into a standard fixed price purchase agreement to purchase lots from the LLC’s.

     At September 30, 2006, NVR had an aggregate investment in twelve separate LLC’s totaling approximately $14,000, which controlled approximately 800 lots. NVR recognizes its share of the earnings of the LLC’s as an adjustment of the cost basis of the lots at the time that the lot and related home is settled with an external customer. During the nine months ended September 30, 2006 and 2005, NVR adjusted cost of sales by approximately $260 and $240, respectively, which represented NVR’s share of the earnings of the LLC’s.

     Forward contracts, such as the fixed price purchase agreements utilized by NVR to acquire finished lot inventory, are deemed to be “variable interests” under FIN 46R. Therefore, the development entities with which NVR enters fixed price purchase agreements, including the LLC’s, are examined under FIN 46R for possible consolidation by NVR of such development entities on NVR’s financial statements. NVR has developed a methodology to determine whether it, or conversely, the owner(s) of the applicable development entity is the primary beneficiary of a development entity. The methodology used to evaluate NVR’s primary beneficiary status requires substantial management judgment and estimation. These judgments and estimates involve assigning probabilities to various estimated cash flow possibilities relative to the development entity’s expected profits and losses and the cash flows associated with changes in the fair value of finished lots under contract. Although management believes that its accounting policy is designed to properly assess NVR’s primary beneficiary status relative to its involvement with the development entities from which NVR acquires finished lots, changes to the probabilities and the cash flow possibilities used in NVR’s evaluation could produce widely different conclusions regarding whether NVR is or is not a development entity’s primary beneficiary.

     The Company has evaluated all of its fixed price purchase agreements and LLC arrangements and has determined that it is the primary beneficiary of twenty-eight of those development entities with which the agreements and arrangements are held. As a result, at September 30, 2006, NVR has consolidated such development entities in the accompanying condensed consolidated balance sheet. Where NVR deemed itself to be the primary beneficiary of a development entity created after December 31, 2003 and the development entity refused to provide financial statements to NVR, NVR utilized estimation techniques to perform the consolidation. The effect of the consolidation under FIN 46R at September 30, 2006 was the inclusion on the balance sheet of $262,534 as Assets not owned, consolidated per FIN 46R, with a corresponding inclusion of $207,579 as Liabilities related to assets not owned, consolidated per FIN 46R, after elimination of intercompany items. Inclusive in these totals were assets of approximately $25,000 and liabilities of approximately $20,000 estimated for five development entities created after December 31, 2003 that did not provide financial statements.

     Following is the consolidating schedule at September 30, 2006:

     Under FIN 46R, an enterprise with an interest in a variable interest entity or potential variable interest entity created before December 31, 2003, is not required to apply FIN 46R to that entity if the enterprise, after making an “exhaustive effort”, is unable to obtain the information necessary to perform the accounting required to consolidate the variable interest entity for which it is determined to be the primary beneficiary. At September 30, 2006, NVR has been unable to obtain the information necessary to perform the accounting required to consolidate seven separate development entities created before December 31, 2003 for which NVR determined it was the primary beneficiary. NVR has made, or has committed to make, aggregate deposits, totaling approximately $8,200 to these seven separate development entities, with a total aggregate purchase price for the finished lots of approximately $69,000. The aggregate deposit made or committed to being made is NVR’s maximum exposure to loss. As noted above, because NVR does not have any contractual or ownership interests in the development entities with which it contracts to buy finished lots (other than the limited use of the LLC’s as discussed above), NVR does not have the ability to compel these development entities to provide financial or other data to NVR. Because NVR has no ownership rights in any of these seven development entities, the consolidation of such entities has no impact on NVR’s net income or earnings per share for the three and nine months ended September 30, 2006. Aggregate activity with respect to the seven development entities is included in the following table:

     During the three and nine month periods ended September 30, 2006, the Company incurred pre-tax charges of approximately $80,800 and $114,000, respectively, related to the impairment of contract land deposits due to deteriorating market conditions in the homebuilding industry. These impairment charges were recorded in cost of sales on the accompanying condensed, consolidated statement of income. The contract land deposit asset is shown net of a $110,000 and $31,919 impairment valuation allowance at September 30, 2006, and December 31, 2005, respectively.

     On January 1, 2006 (the “Effective Date”), the Company adopted Statement of Financial Accounting Standards (“SFAS”) 123R, Share-Based Payment, which revised SFAS 123, Accounting for Stock-Based Compensation. Prior to fiscal year 2006 and the adoption of SFAS 123R, NVR followed the intrinsic value method in accounting for its stock-based employee compensation arrangements as defined by Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees.

     SFAS 123R requires an entity to recognize an expense within its income statement for all share-based payment arrangements, which includes employee stock option plans. The expense is based on the grant-date fair value of the options granted, and is recognized ratably over the requisite service period. NVR adopted SFAS 123R under the modified prospective method. Under the modified prospective method, SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after the required Effective Date, as well as to the unvested portion of awards outstanding as of the required Effective Date. The Company’s stock options are accounted for as equity awards.

     NVR’s option plans provide for the granting of stock options to certain key employees of the Company to purchase shares of common stock. The exercise price of options granted is equal to the market value of the Company’s common stock on the date of grant. Options are granted for a ten-year term, and vest in separate tranches over periods of 7 to 9 years, depending upon the plan from which the shares were granted. For options granted prior to May 2005, vesting was predicated solely on continued employment over a long-term vesting schedule (“service-only” options). For options granted in May 2005 and thereafter, option vesting is contingent first on the Company achieving an aggregate four-year diluted earnings per share target, and if that target is met, then on continued employment over a five year period subsequent to the conclusion of the performance period (“performance condition” options). At September 30, 2006, there was an aggregate of 2,761,433 options outstanding, and an additional 261,058 options were available for grant, under existing stock option plans.

     The following table provides additional information relative to NVR’s stock option plans:

     To estimate the grant-date fair value of its stock options, the Company uses the Black-Scholes option-pricing model. The Black-Scholes model estimates the per share fair value of an option on its date of grant based on the following: the option’s exercise price; the price of the underlying stock on the date of grant; the estimated dividend yield; a “risk-free” interest rate; the estimated option term; and the expected volatility. For the “risk-free” interest rate, the Company uses a U.S. Treasury Strip due in a number of years equal to the option’s expected term. NVR has concluded that its historical exercise experience is the best estimate of future exercise patterns to determine an option’s expected term. To estimate expected volatility, NVR analyzed the historic volatility of its common stock. The estimated fair value of the options granted under SFAS 123R during the first nine months of 2006 was calculated using the following assumptions:

     Compensation cost for “service-only” option 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). Compensation cost for “performance condition” option grants is recognized on a straight-line basis over the requisite service period for each vesting tranche of the award as if the award was, in substance, multiple awards (graded vesting attribution method). Of the 2,761,433 options outstanding at September 30, 2006, 2,334,795 vest solely based on a service condition, and 426,638 vest based on a combined performance and service condition. Compensation cost is recognized in the income statement in the same expense line as the cash compensation paid to the respective employees. SFAS 123R also requires the Company to estimate forfeitures in calculating the expense related to stock-based compensation. NVR has concluded that its historical forfeiture rate is the best measure to estimate future forfeitures of granted stock options. The impact on compensation costs due to changes in the expected forfeiture rate will be recognized in the period that they become known.

     The effect of adopting SFAS 123R on the period ended September 30, 2006 is as follows:

     As of September 30, 2006, the total unrecognized compensation cost for outstanding unvested stock option awards equals approximately $258,000, and the weighted-average period over which the unrecognized compensation will be recorded is equal to approximately 5.3 years.

     Because NVR adopted SFAS 123R using the modified prospective basis, the prior interim periods have not been restated. The following table sets forth the effect on net income and basic and diluted earnings per share as if the Company had applied the fair value recognition provisions for its stock-based compensation arrangements for the three- and nine-month periods ended September 30, 2005:

     The Company settles option exercises by issuing shares of treasury stock to option holders. Shares are relieved from the treasury account based on the weighted average cost of treasury shares acquired. During the three and nine-month periods ended September 30, 2006, 21,061 and 305,698 options to purchase shares of the Company’s common stock were exercised, respectively. Information with respect to the exercised options is as follows:

     The Company has elected the alternative transition method pursuant to FASB Staff Position SFAS 123R-3 to establish the beginning balance of the additional paid-in capital pool available to absorb any future write-offs of deferred tax benefits associated with stock-based compensation.

     The following weighted average shares and share equivalents are used to calculate basic and diluted earnings per share for the three and nine months ended September 30, 2006 and 2005:

     As discussed in note 4, NVR adopted SFAS 123R on the modified prospective basis. Prior period amounts have not been restated. Beginning in 2006 with the adoption of SFAS 123R, the assumed proceeds used in the treasury method for calculating NVR’s diluted earnings per share includes the amount the employee must pay upon exercise, the amount of compensation cost attributed to future services and not yet recognized, and the amount of tax benefits that would be credited to additional paid-in capital assuming exercise of the option. Beginning in 2006, the assumed amount credited to additional paid-in capital equals the tax benefit from assumed exercise after consideration of the intrinsic value upon assumed exercise less the actual stock-based compensation expense to be recognized in the income statement in 2006 and future periods. During 2005 when the Company was still accounting for its stock-based compensation under APB 25, there was no compensation cost attributed to future services included in the assumed proceeds calculation, and the amount assumed to be credited to additional paid-in capital equaled the full assumed tax benefit resulting from the intrinsic value of the options upon the assumed exercise.

     “Service-only” options to purchase 237,146 and 120,852 shares of common stock during the three and nine months ended September 30, 2006, respectively, and 1,750 shares of common stock during the nine months ended September 30, 2005, were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive. There were no anti-dilutive options for the three-month period ended September 30, 2005. In addition, the 376,350 options outstanding under the 2005 Stock Option Plan, 9,055 options outstanding under the 1998 Directors’ Long-Term Stock Option Plan, 26,555 options outstanding under the 2000 Broadly-Based Stock Option Plan, and 14,678 options outstanding under the 1998 Management Long-Term Stock Option Plan are considered performance-based equity compensation, and accordingly, have been excluded from the computation of diluted earnings per share because the performance target has not been achieved as of September 30, 2006, pursuant to the requirements of SFAS 128, Earnings Per Share.

     SFAS 142, Goodwill and Other Intangible Assets, requires goodwill and reorganization value in excess of amounts allocable to identifiable assets (“excess reorganization value”) to be tested for impairment on an annual basis subsequent to the year of adoption. The Company completed the annual assessment of impairment during the first quarter of 2006, and as of September 30, 2006, management believes that goodwill, indefinite life intangibles, and excess reorganization value were not impaired.

     The Company increased its commitment under its existing revolving credit agreement by $45,000 and by $155,000 in the first and third quarters of 2006, respectively, increasing the total commitment to $600,000. There were no changes made to any other terms of the credit agreement.

     During the third quarter of 2006, NVR’s mortgage revolving warehouse credit facility (“Warehouse Credit Facility”) was amended, extending the expiration date to August 23, 2007 and decreasing the interest rate to LIBOR plus 1.00%. The Warehouse Credit Facility provides for borrowings up to $175,000, of which the Company had $168,062 outstanding at September 30, 2006. The other terms and conditions of the facility are materially the same as the previous Warehouse Credit Facility.

     A summary of changes in shareholders’ equity is presented below:

     The Company repurchased approximately 289,000 shares of its common stock during the nine months ended September 30, 2006.

     The Company establishes warranty and product liability reserves to provide for estimated future expenses as a result of construction and product defects, product recalls and litigation incidental to NVR’s homebuilding business. Liability estimates are determined based on management’s 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 discussions with our general counsel and outside counsel retained to handle specific product liability cases. The following table reflects the changes in the Company’s warranty reserve during the three and nine months ended September 30, 2006 and 2005:

     NVR’s operations are classified in two reportable segments: homebuilding and mortgage banking. Corporate general and administrative expenses are fully allocated to the homebuilding and mortgage banking segments in the information presented below.

     The staff of the Securities and Exchange Commission (the “SEC Staff”) recently completed a periodic review of the Company’s Annual Report on Form 10-K as of December 31, 2005 (“2005 Form 10-K”) and issued a letter requesting supporting information regarding the Company’s aggregation of its homebuilding operations into one reportable segment. The Company has provided the SEC Staff detailed support for its position. The SEC Staff does not agree with our position and has asked that we revise our segment disclosure within the 2005 Form 10-K to disaggregate the results of our homebuilding operations. The Company continues to believe that it has appropriately reported its homebuilding operations in one reportable segment and is considering whether it will appeal the SEC Staff’s position to the Office of the Chief Accountant, and as a result, the issue remains unresolved. If the appeal is unsuccessful, or if the Company elects not to file an appeal, the Company may be required to amend certain prior filings to provide additional disaggregated segment reporting footnote disclosure.

     In 2006 and 2005, NVR received requests for information pursuant to Section 308(a) of the Clean Water Act (the “Act”) from Regions 3 and 4 of the United States Environmental Protection Agency (the “EPA”). The requests sought information regarding the Company’s storm water management discharge practices in North Carolina, Pennsylvania, Maryland and Virginia during the homebuilding construction process. NVR has provided the EPA with information in response to each of its requests. Additionally, in 2005, the EPA notified the Company of alleged storm water management violations under the Act at a homebuilding site in Pennsylvania, and that the Company may potentially be subject to administrative fines of up to $157 for the alleged violations. The Company has completed its building activity at the homebuilding site alleged to be in violation. NVR cannot predict the outcome of the EPA’s review of our storm water management practices. Further, it is not known at this time whether the EPA will seek to take legal action or impose penalties in connection with the alleged violation at the construction site in Pennsylvania.

     Some of the statements in this Form 10-Q, as well as statements made by NVR in periodic press releases and 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. 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 variations thereof or comparable terminology, or by discussion of strategies, each of which involves risks and uncertainties. All statements other than those of historical facts included herein, including those regarding market trends, NVR’s financial position, business strategy, projected plans and objectives of management for future operations, are forward-looking statements. 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 any future results, performance or achievements expressed or implied by the forward-looking statements. Such risks, uncertainties and other factors include, but are not limited to, general economic and business conditions (on both a national and regional level), interest rate changes, access to suitable financing, 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 moratoria, governmental regulation, the ability of NVR to integrate any acquired business, fluctuation and volatility of stock and other financial markets and other factors over which NVR has little or no control. NVR has no obligation to update such forward-looking statements. For additional information regarding risk factors, see Part II, Item 1(a) of this Report.

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

     Our primary business is the construction and sale of single-family detached homes, townhomes and condominium buildings. To fully serve our homebuilding customers, we also operate a mortgage banking and title services business. We operate in the following markets:

     We believe that we operate our business with a conservative operating strategy. We do not engage in land development and primarily construct homes on a pre-sold basis. This strategy allows 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. In addition, 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 management believes contributes to minimizing the adverse effects of regional economic cycles and provides growth opportunities within these markets.

     Because we are not active in the land development business, our continued success is contingent upon our ability to control an adequate supply of finished lots at current market prices on which to build, and on our developers’ ability to timely deliver finished lots to meet the sales demands of our customers. We acquire finished lots from various development entities under fixed price purchase agreements (“purchase agreements”). These purchase agreements require deposits in the form of cash or letters of credit that may be forfeited if we fail to perform under the purchase agreement. However, we believe this lot acquisition strategy reduces the financial requirements and risks associated with direct land ownership and development. As of September 30, 2006, we controlled approximately 98,000 lots with deposits in cash and letters of credit totaling approximately $594,000 and $17,000, respectively.

     The current home sales environment is characterized by an increase in the number of existing and new homes available for sale, higher mortgage interest rates (which are beginning to moderate to year ago levels), and declining homebuyer confidence. As a result of these market conditions, new orders for the third quarter of 2006 declined by 18% from the third quarter of 2005, with significant declines occurring in our Baltimore, North and Washington markets, which declined 38%, 24% and 18%, respectively. Year to date new orders for 2006 have declined 8% from the same period in 2005. In addition to lower sales, the current market conditions are exerting downward pressure on selling prices, and in response, we have increased incentives to homebuyers and reduced prices in many of our markets. These selling price pressures resulted in our overall average selling price declining 9% in the third quarter of 2006 compared to the year ago quarter, negatively impacting gross profit margins in the current period. We expect that these reduced selling prices will further negatively impact gross profit margins in future periods. Additionally, our new order cancellation rate increased to 27% in the current quarter from 15% during the same period in 2005 and 13% in the second quarter of 2006. Increased cancellations led to a higher unsold inventory balance at September 30, 2006 of approximately $89,800, as compared to approximately $53,300 at September 30, 2005 and $60,400 at December 31, 2005.

     The Company is actively involved in implementing other strategic steps to address the currently challenging homebuilding market. In certain communities, we are seeking concessions from our developers to reduce lot purchase prices to current market values and/or to defer scheduled lot purchases. In communities where we are unsuccessful in negotiating necessary concessions, we may exit the community and forfeit our deposit. During the quarter ended September 30, 2006, we recorded a contract land deposit impairment charge of approximately $80,800, and for the year to date period we recorded contract land deposit impairment charges of approximately $114,000. For the nine-month 2005 period, our contract land deposit impairments totaled $7,700. See note 3 to the condensed consolidated financial statements included herein for additional information regarding contract land deposits.

      During the quarter we adjusted staffing levels to size our organization to meet the current expected level of sales activity, and we consolidated certain of our homebuilding profit centers. We plan to continue to assess our staffing levels and organizational structure as conditions warrant.

     For the quarter ended September 30, 2006, consolidated revenues increased 13% from the same period in 2005 due to higher settlement volume and a higher average settlement price per unit. However, net income and diluted earnings per share in the current quarter decreased 32% and 19%, respectively, as compared to the third quarter of 2005. For the nine months ended September 30, 2006, consolidated revenues increased 25% from the same period in 2005. Net income decreased 5% over the same comparative periods, while diluted earnings per share increased 12% period over period as a result of our continuing share repurchase program.

     We implemented Statement of Financial Accounting Standards (“SFAS”) 123R in the first quarter of 2006, which resulted in a consolidated pre-tax charge of $41,010 for the nine months ended September 30, 2006. See note 4 to the condensed consolidated financial statements for additional information regarding stock based compensation.

     The following table summarizes homebuilding settlements, new orders and backlog unit activity by region for the three and nine months ended September 30, 2006 and 2005:

     The following table summarizes the results of operations for the homebuilding segment:

     Homebuilding revenues increased 13% for the third quarter of 2006 from the same period in 2005 as a result of an 8% increase in the number of units settled and a 5% increase in the average settlement price. The increase in units settled is attributable to a higher backlog turnover rate quarter over quarter.

     Gross profit margins in the third quarter of 2006 declined as compared to the third quarter of 2005 as a result of an increase in contract land deposit impairment charges of approximately $78,000. These land deposit impairments negatively impacted gross profit margins by 529 basis points for the quarter. In addition, gross profit margins were negatively impacted by the downward pressure on selling prices experienced during 2006, resulting from higher selling incentives required to generate sales, and higher lot and certain commodity costs, excluding lumber. We expect continued gross profit margin pressure over at least the next several quarters due to the current market conditions.

     New orders for the third quarter of 2006 decreased 18% from the same period in 2005. New orders in the Baltimore, North and Washington markets declined 38%, 24% and 18%, respectively. The new order reduction was primarily a result of an increasingly competitive sales environment driven by affordability issues partially resulting from higher mortgage interest rates quarter over quarter, and higher levels of new and existing home inventory for sale as discussed in the Overviewsection above. Net new orders were also unfavorably impacted by an increase in our cancellation rate for the current quarter to 27% from 15% in the third quarter of 2005. The increase in the cancellation rate was driven by higher cancellations in our largest markets, Washington and Baltimore. Cancellation rates in the Washington market were 39% in the current quarter compared to 19% in the third quarter of 2005 and 21% in the second quarter of 2006. In the Baltimore market the cancellation rate was 24% in the current quarter as compared to 11% and 14% in the third quarter of 2005 and the second quarter of 2006, respectively. The average sales price of new orders decreased 9% from the third quarter of 2005. The decline is a result of a 25% decline in average new order price in Washington, and to a lesser extent, to a shift in new orders into lower priced markets from our higher priced Washington and Baltimore markets.

      Selling, general and administrative (“SG&A”) expenses for the third quarter increased by approximately $8,900, but as a percentage of revenue remained consistent with the prior year at approximately 6.3%. The increase in SG&A expenses is primarily attributable to an increase in marketing costs and the recording of compensation costs associated with the implementation of SFAS 123R in 2006, offset partially by lower management incentive compensation costs. Marketing costs increased approximately $4,900 due primarily to an 18% increase in the average number of active communities to 609 in the third quarter of 2006, from 518 for the same period in 2005. During the third quarter of 2006, we recognized approximately $12,500 in SG&A compensation costs related to outstanding stock options compared to approximately $2,400 in the third quarter of 2005 (see note 4 to the condensed consolidated financial statements included herein for additional discussion). Management incentive compensation costs were $7,200 lower in the current quarter.

     Homebuilding revenues increased 25% for the nine months ended September 30, 2006 from the prior year due to a 16% increase in the number of units settled and an 8% increase in the average settlement price. The increase in the number of units settled is attributable to a 13% higher number of homes in backlog entering 2006 as compared to the same period in 2005. Additionally, we have experienced a higher backlog turnover rate year over year. The increase in the average settlement price is primarily attributable to a 12% higher average price of homes in the beginning backlog period over period.

     Gross profit margins in the first nine months of 2006 declined as compared to the first nine months of 2005 as a result of an increase in contract land deposit impairments of approximately $106,000 period over period. These land deposit impairments reduced gross profit margins by 256 basis points for the year to date period ended September 30, 2006. In addition, gross profit margins were negatively impacted by the downward pressure on selling prices experienced during 2006, resulting from higher selling incentives required to generate sales, and higher lot and certain commodity costs, excluding lumber. As previously discussed, we expect gross profit margins to continue to be negatively impacted by the current market conditions.

     New orders for the nine months ended September 30, 2006 decreased by 8% from the same period in 2005. New orders in Washington and Baltimore declined 20% and 19%, respectively, primarily as a result of an increasingly competitive sales environment driven by affordability issues partially resulting from higher mortgage interest rates year over year, and higher levels of new and existing home inventory for sale as discussed in the Overview. Net new orders were also unfavorably impacted by an increase in our cancellation rate to 18% in the first nine months of 2006 from 11% in the same period 2005. The average sales price of new orders decreased 6% as a result of a shift in new orders into lower priced markets in our North and South markets, and an 11% decline in average new order price in Washington.

     SG&A expenses for the nine-month period ended September 30, 2006 increased approximately $85,900 as compared to the same period in 2005, and as a percentage of revenue increased to 7.4% from 6.9% for the respective periods. The increase in SG&A expenses is attributable to an increase in marketing costs of approximately $26,200 attributable to a 20% increase in the average number of active communities year over year and an approximate $12,900 increase in personnel costs due to higher average staffing levels year over year. We have reduced approximately 10% of our employee base in the first nine months of 2006, which will result in cost savings in the fourth quarter and future periods. Additionally, as a result of the implementation of SFAS 123R in 2006, we recognized approximately $37,000 in SG&A compensation costs related to outstanding stock options compared to approximately $2,400 for the nine months ended September 30, 2005 (see note 4 to the condensed consolidated financial statements for additional discussion).

     Backlog units and dollars were 7,388 and $3,132,419, respectively, as of September 30, 2006 compared to 8,875 and $3,831,608 as of September 30, 2005. The decrease in backlog units is attributable to the aforementioned decrease in new orders coupled with an improved backlog turnover rate year over year. Backlog dollars are 18% lower primarily as a result of the 17% decrease in backlog units.

     We conduct our mortgage banking activity through NVR Mortgage Finance, Inc. (“NVRM”), a wholly owned subsidiary. NVRM focuses exclusively on serving the homebuilding segment’s customer base.