M/I Homes - 10-K annual report

 

We advertise using newspapers, magazines, direct mail, billboards, radio and television. The particular marketing mediums used differ from division to division based on area demographics and other competitive factors. We have also significantly increased advertising on the worldwide web through expansion of our website at www.mihomes.com and through a third party’s website at www.homebuilder.com . In addition, we encourage independent broker participation and, from time to time, utilize various promotions and sales incentives to attract interest from these brokers. Our commitment to quality design and construction, along with our reputation for superior customer service, has resulted in a strong referral base and numerous repeat buyers.

One way that we enhance the selling process is by operating design centers in the Cincinnati, Columbus, Orlando, Tampa and Indianapolis markets. These design centers are staffed with interior design specialists who assist customers in selecting interior and exterior colors, standard options and upgrades. In our other markets, this selection process is handled directly by our sales consultants. We also add to the selling process by offering financing to our customers through our wholly-owned subsidiary, M/I Financial, which has branches in all of our markets except Washington, D.C. M/I Financial originates loans for purchasers of our homes. The loans are then sold, along with the servicing rights, to outside mortgage lenders. Title-related services are provided to purchasers of our homes in the majority of our markets through affiliated entities.

We generally do not commence construction of a home until we obtain a sales contract and preliminary oral advice from the customer’s lender that financing should be approved. However, in certain markets, contracts may be accepted contingent upon the sale of an existing home and construction may be authorized through a certain phase prior to satisfaction of that contingency. In addition, a limited, controlled number of speculative, or "spec", homes (i.e., homes started in the absence of an executed contract) may be built to facilitate delivery of homes on an immediate-need basis and to provide presentation of new products.

Design and Construction

We devote significant resources to the research, design and development of our homes in order to fulfill the needs of homebuyers in all of our markets. Experienced and qualified in-house professionals use modern computer-aided technology to design virtually all of our floor plans and elevations. We offer approximately 500 different floor plans and elevations that are tailored to meet the requirements of each of our markets. We spent $1,637,000, $1,553,000 and $1,479,000 in 2003, 2002 and 2001, respectively for research and development of our homes.

The construction of each home is supervised by a construction supervisor who reports to a production manager, both of whom are employees of the Company. Customers are introduced to their construction supervisor prior to commencement of home construction at a pre-construction "buyer/builder conference." The purpose of this conference is to review the home plans and all relevant construction details with the customer and to explain the construction process and schedule. Every customer is given a hard hat at the conference as an open invitation to visit the site of his or her home at any time during the course of construction. We want customers to be involved in order to understand the construction of their home and see the quality being built into their home. All of this is part of our exclusive "confidence builder program" which, consistent with our business philosophy, is designed to "put the customer first" and enhance the total homebuying experience.

Homes generally are constructed according to standardized designs and meet applicable Federal Housing Authority ("FHA") and Veterans Administration ("VA") requirements. To allow maximum design flexibility, we limit the use of pre-assembled building components. The efficiency of the building process is enhanced through the use of standardized materials available from a variety of sources. We utilize independent subcontractors for the installation of site improvements and the construction of our homes. These subcontractors are supervised by our on-site construction supervisors. All subcontractor work is performed pursuant to written agreements. The agreements are generally short-term, with terms from six to twelve months, and specify a fixed price for labor and materials. The agreements are struc tured to provide price protection for a majority of the higher-cost phases of construction for homes in our backlog. We seek to build in large volume to reduce the per unit cost of each home due to advantages achieved by lower unit prices paid to subcontractors for labor and materials. The construction of our homes typically takes approximately four to six months from the start of the home to completion, depending on the size and complexity of the particular home being built. As of December 31, 2003, we had a total of 2,658 homes in backlog in various stages of completion, including homes that are under contract but for which construction has not yet begun.

Warranty

We provide a variety of warranties in connection with our homes and have a program to perform several inspections on each home that we sell. Immediately prior to closing and again approximately three months after a home is delivered, we inspect each home with the customer. Upon the customer’s request, we will also provide a one-year drywall inspection. We offer a two-year limited warranty on materials and workmanship and a thirty-year limited warranty against major structural defects. To increase the value of the two and thirty-year warranties, both are transferable in the event of the sale of the home. We also pass along to our customers all warranties provided by the manufacturers or suppliers of components installed in each home. Our warranty expense was approximately 1.2%, .8% and .9% of total land and housing costs and expenses for each of the years ended December 2003, 2002 and 2001, respectively.

Markets

Our operations are organized into eleven homebuilding divisions, each of which is managed by a division president, to maximize operating efficiencies and use of local management. Our current divisional operating structure is as follows:

Columbus is the capital of Ohio, with federal, state and local governments providing significant and stable employment. Columbus is also the home of The Ohio State University, one of the largest universities in the world. Columbus continues to be a stable market with diverse economic and employment bases. Single-family permits reached nearly 11,700 in 2003. Since 1994, we have had three separate operating divisions in Columbus.

Cincinnati is characterized by a stable economic environment and a diverse employment base. Employers include Proctor & Gamble, Kroger, the University of Cincinnati and General Electric. In addition, Cincinnati has a vibrant financial services industry. Single-family permits reached over 10,800 in 2003.

Indianapolis is a market noted for its diverse industrial and relatively young population. Significant industries include health and pharmaceutical, distribution and services. Housing activity continued to be stable in 2003 with over 13,000 single-family permits.

Tampa’s housing market is strong, anchored by financial and other back-office operations, tourism and conventions. In-migration remains steady as a result of on-going business expansions and relocations. Single-family housing permits reached over 20,000 in 2003.

Orlando’s economy continues to be stable and offer significant growth potential. Predominant industries include tourism, high-tech and manufacturing. Single-family permits reached over 22,000 in 2003.

West Palm Beach is one of the more affluent markets in the United States. Job gains in 2003 were led by the construction, retail, tourism, healthcare and service sectors. Housing activity continued to be strong in 2003 with over 10,800 single-family permits.

Charlotte is home to firms in the banking industry, as well as a growing presence of corporate headquarters and the addition of some new manufacturing operations. The demographics continue to support long-term growth with strong in-migration and an educated workforce. In 2003, construction activity continued to be steady with over 17,000 single-family permits.

The Raleigh market continues to be stable with state government, three major universities and growth in the pharmaceutical and biotech industries contributing to its significant and stable employment base. Housing activity continued to be stable in 2003 with over 14,000 single-family permits.

The Washington, D.C. metro economy continues to be favorable with major contributions from the construction, technology and government sectors. Housing activity continues to be robust, with over 30,000 single-family permits issued in 2003. Our operations are located throughout the Maryland and Virginia suburbs of Washington, D.C.

Product Lines

On a regional basis, we offer homes ranging in base sales price from approximately $95,000 to $1,300,000 and ranging in square footage from approximately 1,100 to 5,000 square feet. There are approximately 500 different floor plans and elevations across all product lines. In addition, we offer a line of attached townhomes exclusively in the Washington, D.C. market that have approximately 2,000 square feet of living space. By offering a wide range of homes, we are able to attract first-time, move-up, empty-nester and luxury homebuyers. It is our goal to sell more than one home to our customers, and we have been very successful in this area.

In each of our home lines, upgrades and options are available to the homebuyer for an additional charge. Major options include fireplaces, additional bathrooms and higher quality flooring, cabinets and appliances. The options are typically more numerous and significant on more expensive homes.

Land Acquisition and Development

Our land development activities and land holdings have increased significantly during the past few years. We develop a majority of our land internally because we believe it is prudent to do so in order to maximize our ability to secure the best locations. We continue to purchase finished lots, on a limited basis, from outside developers under option contracts, when possible, to limit our risk; however, we constantly evaluate our alternatives to satisfy the need for lots in the most cost effective manner. At the present time, approximately 87% of lots in our inventory have been internally developed. We seek to limit our investment in undeveloped land and lots to the amount reasonably expected to be sold in the next three to five years. Although we purchase land and engage in land development act ivities primarily for the purpose of furthering our homebuilding activities, we have, on a very select basis, developed land with the intention of selling a portion of the lots to outside homebuilders in certain markets.

 

To limit the risk involved in the development of raw land, we acquire land primarily through the use of contingent purchase contracts. These contracts require the approval of our corporate land committee and condition our obligation to purchase land upon approval of zoning, utilities, soil and subsurface conditions, environmental and wetland conditions, traffic patterns, market analysis, development costs, title matters and other property-related criteria. Only after this thorough evaluation has been completed do we make a commitment to purchase undeveloped land.

From time to time, on a limited basis, we enter into land joint ventures. At December 31, 2003, we had interests varying from 33% to 50% in each of 25 joint ventures and limited liability companies ("LLCs"), all located in Columbus, Ohio. These joint ventures and LLCs develop raw ground into lots and, typically, we receive our percentage interest in the form of a distribution of developed lots. These joint ventures and LLCs are equity financed except where seller financing is available on attractive terms.

During the development of lots, we are required by some municipalities and other governmental authorities to provide completion bonds or letters of credit for sewer, streets and other improvements. At December 31, 2003, $42.5 million of completion bonds were outstanding for these purposes, as well as $9.3 million of letters of credit.

We seek to balance the economic risk of owning lots and land with the necessity of having lots available for our homes. At December 31, 2003, we had 3,112 developed lots and 712 lots under development in inventory. We also owned raw land expected to be developed into approximately 7,203 lots.

In addition, at December 31, 2003, our interest in lots held by joint ventures and LLCs consisted of 189 lots under development, and raw land zoned for 692 lots.

At December 31, 2003, we had purchase contracts to acquire 2,428 developed lots and raw land to be developed into approximately 8,749 lots for a total of 11,177 lots, with an aggregate current purchase price of approximately $315 million. Purchase of these properties is often contingent upon satisfaction of certain requirements by us and the sellers, such as zoning approval, completion of development and availability of building permits.

 

 

 

The following table sets forth our land position in lots (including our interest in joint ventures and LLCs) at December 31, 2003:

Financial Services

We provide mortgage financing services to purchasers of our homes through our wholly-owned subsidiary, M/I Financial. M/I Financial provides financing services in all of our housing markets except Washington, D.C. During the year ended December 31, 2003, in the markets served, we captured 87% of the available business from purchasers of our homes, originating approximately $650 million of mortgage loans. The mortgage loans originated by M/I Financial are generally sold to a third party within two weeks of originating the loan.

M/I Financial has been approved by the Department of Housing and Urban Development ("HUD") and the VA to originate mortgages that are insured and/or guaranteed by these entities. In addition, M/I Financial has been approved by the Federal Home Loan Mortgage Corporation and by the Federal National Mortgage Association ("FNMA") as a seller and servicer of mortgages.

We also provide title services to purchasers of our homes through majority-owned subsidiaries, TransOhio Residential Title Agency, Ltd., M/I Title Agency, Ltd. and Washington/Metro Residential Title Agency, LLC and through a joint venture with Stewart Title Agency of Columbus. Through these entities, we serve as a title insurance agent by providing title insurance policies, examination and closing services to purchasers of homes that we build in all of our housing markets except Raleigh, Charlotte and West Palm Beach. We assume no underwriting risk associated with the title policies.

Corporate Operations

Our corporate operations and home office are located in Columbus, Ohio, where we perform the following functions at a centralized level:

Competition

The homebuilding industry is highly competitive. In each of our markets, we compete with numerous national, regional and local homebuilders, some of which have greater financial, marketing, land acquisition and sales resources. Builders of new homes compete not only for homebuyers, but also for desirable properties, financing, raw materials and skilled subcontractors. In addition, there is competition with the resale market for existing homes. We believe that we have a very strong competitive position in the markets in which we operate because of our commitment to both quality and customer service.

Regulation and Environmental Matters

The homebuilding industry, including the Company, is subject to various local, state and federal (including FHA and VA) statues, ordinances, rules and regulations concerning zoning, building, design, construction, sales and similar matters. These regulations affect construction activities, including types of construction materials that may be used, certain aspects of building design, sales activities and dealings with consumers. We are required to obtain licenses, permits and approvals from various governmental authorities for development activities. In many areas, we are subject to local regulations which impose restrictive zoning and density requirements in order to limit the number of homes within the boundaries of a particular locality. We strive to reduce the risks of restrictive zoning and density requirements by using contingent land purchase contracts, which state that land must meet various requirements, including zoning, prior to our purchase.

Development may be subject to periodic delays or precluded entirely due to building moratoriums. Generally, these moratoriums relate to insufficient water or sewage facilities or inadequate road capacity within specific market areas or subdivisions. The moratoriums we have experienced have not been of long duration and have not had a material effect on our business.

Each of the states in which we operate has a wide variety of environmental protection laws. These laws generally regulate developments which are of substantial size and which are in or near certain specified geographic areas. Furthermore, these laws impose requirements for development approvals which are more stringent than those that land developers would have to meet outside of these geographic areas.

Additional requirements may be imposed on homebuilders and developers in the future, which could have a significant impact on us and the industry. Although we cannot predict the effect, such requirements could result in time-consuming and expensive compliance programs. In addition, the continued effectiveness of current licenses, permits or development approvals is dependent upon many factors, some of which may be beyond our control.

Employees

At January 31, 2004 we employed 978 people (including part-time employees), of which 253 were employed in sales, 422 in construction and 303 in management, administrative and clerical positions. We consider our employee relations to be very good. No employees are represented by a collective bargaining agreement.

We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the "SEC"). These filings are available to the public over the internet on the SEC’s website at http://www.sec.gov. You may also read and copy any document we file at the SEC’s public reference room located at 450 Fifth S treet NW, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room.

Our principal internet address is www.mihomes.com. We make available free of charge on or through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K that are furnished or filed, and amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The contents of our website are not part of this report.

ITEM 2. PROPERTIES

We own and operate an approximately 85,000 square foot office building for our home office and lease all of our other offices.

Due to the nature of our business, a substantial amount of property is held as inventory in the ordinary course of business. See "ITEM 1. BUSINESS – Land Acquisition and Development."

ITEM 3. LEGAL PROCEEDINGS

We are involved in routine litigation incidental to our business. Management does not believe that any of this litigation is material to our consolidated financial statements.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the fourth quarter of 2003, no matters were submitted to a vote of security holders.

The Company’s common stock is traded on the New York Stock Exchange under the symbol "MHO." As of February 27, 2004, there were approximately 350 record holders of the Company’s common stock. At that time there were 17,626,123 shares issued and 14,033,063 shares outstanding. The table below presents the highest and lowest prices for the Company’s common stock during each of the quarters presented:

The highest and lowest prices for the Company’s common stock from January 1, 2004 through February 27, 2004 were $45.24 and $35.92.

The Company typically declares dividends on a quarterly basis, as approved by the Board of Directors. Total dividends paid were approximately $1.5 million for each of the years ended December 31, 2003 and 2002. On November 11, 2003 and March 8, 2004, the Board of Directors approved a $0.025 per share cash dividend payable to shareholders of record of its common stock on January 2 and April 1, 2004, payable on January 22, 2004 and April 22, 2004, respectively.

On December 10, 2002, the Board of Directors authorized the repurchase of up to $50 million worth of outstanding common stock. This repurchase program replaces and supercedes the unused portions of all of the repurchase programs that have previously been authorized. As of March 8, 2004, the Company had purchased 1,077,700 shares at an average price of $31.53 per share and had approximately $16.0 million remaining available for repurchase under this Board-approved repurchase program.

 

ITEM 6. SELECTED FINANCIAL DATA

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

Our reportable segments are strategic business units that offer different products and services. The business segments are defined as homebuilding and financial services. The homebuilding operations include the development of land, the sale and construction of single-family attached and detached homes and the occasional sale of lots to third parties. The homebuilding segment includes similar operations in several geographic regions that have been aggregated for segment reporting purposes. The financial services operations include the origination and sale of mortgage loans and title services for purchasers of the Company’s homes.

In conformity with Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosure about Segments of an Enterprise and Related Information," the Company’s segment information is presented on the basis that the chief operating decision makers use in evaluating segment performance. The accounting policies of the segments, in total, are the same as those described in the Summary of Significant Accounting Policies. Intersegment revenue primarily represents the elimination of revenue included in financial services for fees paid by the homebuilding operations relating to loan origination fees for its homebuyers and the reclassification of certain amounts from internal reporting classifications to proper presentation in conformity with accounting principles generally accepted in the United States of America ("GAAP"). Homebuilding income before income taxes includes an interest charge on the Company’s net investment in the segment using an interest rate of 14% for housing and 9% for land, as well as an allocation for programs and services administered centrally. A management decision was made for 2004 that this interest rate will be adjusted to 12% for housing and 6% for land to more closely reflect our actual costs, which will result in a lower allocation of interest to homebuilding, and therefore, higher income before taxes within the homebuilding segment. Corporate and other income before income taxes includes selling, general and administrative costs that are viewed by management as not specifically related to either the homebuilding or financial services segment, income resulting from the allocation of interest and other costs to those segments, the elimination of revenue and cost of sales between the homebuilding and financial services segments and adjustments necessary t o reclassify certain amounts from internal reporting classifications to proper presentation in conformity with GAAP.

Consolidated Results of Operations

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Revenue. Total revenue for 2003 was $1.1 billion, an increase of $36.5 million over 2002. The increase was primarily the result of an increase of $32.3 million in homebuilding revenue and an increase of $4.9 million in financial services revenue. The increase in homebuilding was the result of growth of $35.4 million and 3.6% in housing revenue offset slightly by a decrease of $3.2 million in land revenue. Housing revenue increa sed as a result of a 3.4% increase in the average sales price of homes delivered, from $238,000 in 2002 to $246,000 in 2003, led by our Florida region. The number of homes delivered remained constant in 2003 compared to 2002. The decrease in land revenue was primarily due to a decrease in lot sales in our Washington, D.C. and Orlando markets of $7.2 million and $2.3 million, respectively. These decreases were partially offset by increases of $3.2 million in Charlotte, $2.0 million in Columbus, and $1.5 million in Raleigh. Land revenue can vary significantly from year to year, given that management opportunistically determines the particular land or lots to be sold directly to third parties. The increase in financial services revenue was primarily attributable to increases in revenue earned from the sale of loans and the related activities.

Gross and Operating Margins. Gross margin, as a percentage of revenue, increased from 24.1% to 25.5% and operating margin increased from 11.9% to 13.5%. The increase in gross margin is partially attributable to higher selling prices, due to homebuyers purchasing more upgrades and options that generally carry higher margins. Financial services also had higher profits as a result of generating more revenues from the sale of loans, primarily because of the full year effect of being able to offer more fixed rate loans to the third parties that purchase the loans. In addition to the factors described above, the operating margin increase was also attributable to lower g eneral and administrative expenses, mainly due to the $4.2 million favorable impact over 2002 from our interest rate swaps that will mature in 2004. There is no assurance that the Company will be able to maintain the current margin levels if interest rates were to increase, as homebuyers are usually able to afford to purchase more options when interest rates are low, and more homebuyers select variable rate loans, which may result in lower profits for financial services when the loans are sold to third parties.

Income Before Income Taxes. Income before income taxes increased $25.9 million over 2002, representing a 23.7% increase. The increase related to both homebuilding and financial services, which experienced increases of $9.9 million (12.1% increase), and $4.5 million (28.9% increase), respectively. The increase in homebuilding income was primarily due to the 3.4% increase in the average sales price of homes delivered with approximately the same number of total homes delivered, an improvement in housing gross margins from 21.7% to 22.4% due primarily to pric ing increases in certain markets and the mix of homes delivered, including the impact of customer’s selecting more options, which generally have higher margins. The increase in financial services income was primarily the result of increased income from the sale of loans and the related activities, with a relatively fixed operating expense base. In addition, corporate and other income before taxes increased $11.5 million primarily due to a $5.1 million increase in the net interest income from allocations to the homebuilding segment, resulting mainly from higher inventory balances within homebuilding, and a $3.0 million favorable market adjustment on our interest rate swaps in 2003, which was $1.2 million unfavorable in 2002. Our interest rate swaps will mature in the third quarter of 2004.

Interest Expense. Interest expense for 2003 decreased to $9.6 million from $13.8 million in 2002. Interest expense was lower in 2003 primarily due to an 8.2% decrease in the average borrowings outstanding during the year and higher interest capitalization due to higher inventory balances in 2003.

Income Taxes. The effective tax rate increased from 39.0% to 39.5% from 2002 to 2003. The increase is primarily attributed to higher state taxes in 2003.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Revenue. Total revenue for 2002 was $1.0 billion, an increase of $56.3 million over 2001. The increase was the result of an increase of $55.9 million in homebuilding revenue and an increase of $1.6 million in financial services revenue. The increase in homebuilding was the result of $42.8 million growth in housing revenue and $13.0 million in land revenue. Housing revenue increased as a result of a 6.7% increase in the average sales price of homes delivered. This was offset by a 2.1% decrease in the number of homes delivered. The increase in land revenue was primarily due to an increase in lot sales related to our exit from the Phoenix market. We also experienced increases in land sales in our Cincinnati, Orlando and Washington, D.C. markets. These increases were partially offset by decreases in Columbus and Indianapolis. The increase in financial services revenue was primarily attributable to increases in revenue earned from the sale of loans and increased earnings from title services.

Gross and Operating Margins. Gross margin, as a percentage of revenue, increased from 22.7% to 24.1% and operating margin increased from 10.4% to 11.9%. The increase in gross margin is partially attributable to higher selling prices due to homebuyers purchasing more upgrades and options that generally carry higher margins. Financial services also had higher profits as a result of generating more revenues from the sale of loans, primarily because of being able to offer more fixed rate loans to the third parties that purchase the loans. In addition to the factors described above, the operating margin increase was also attributable to lower general and administrative expenses in 2002, as 2001 expenses included amounts relating to exiting the Phoenix market that were not incurred in 2002.

Income Before Income Taxes. Income before income taxes increased $24.2 million over 2001. The increase related to both homebuilding and financial services, which experienced increases of $15.8 million and $1.7 million, respectively. The increase in homebuilding income was primarily due to increases in the average sales price of homes delivered and housing gross margins. The increase in financial services income was primarily the result of increased income from the sale of loans and the favorable interest rate environment during 2002. The increase in corpo rate and other amounts from 2001 to 2002 was primarily due to certain administrative expenses recognized in 2001 related to exiting the Phoenix market that were not recognized in 2002.

For the year ended December 31, 2001, the cumulative effect of a change in accounting principle resulted in an increase in income of $2.7 million, net of income taxes. This accounting change was the result of the January 1, 2001 adoption of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which required us to record the value of interest rate swaps, certain loan commitments and forward sales of mortgage-backed securities at fair value.

Interest Expense. Interest expense for 2002 decreased to $13.8 million from $16.2 million in 2001. Interest expense was lower in 2002 primarily due to a 32.1% decrease in the average borrowings outstanding offset somewhat by a slightly higher interest rate.

Income Taxes. The effective tax rate increased from 38.1% to 39.0% from 2001 to 2002. The increase is primarily attributed to higher state taxes in 2002.

Seasonality and Variability in Quarterly Results

We have experienced, and expect to continue to experience, significant seasonality and quarter-to-quarter variability in homebuilding activity levels. In general, homes delivered increase substantially in the third and fourth quarters. We believe that this seasonality reflects the tendency of homebuyers to shop for a new home in the spring with the goal of closing in the fall or winter, as well as the scheduling of construction to accommodate seasonal weather conditions. The following tables reflect this cycle for the Company during the four quarters of 2003 and 2002:

Homebuilding Segment

The following table sets forth certain information related to our homebuilding segment:

A home is included in "new contracts" when our standard sales contract is executed. "Homes delivered" represents homes for which the closing of the sale has occurred and risk has transferred to the buyer. "Backlog" represents homes for which the standard sales contract has been executed, but which are not included in homes delivered because closings for these homes have not yet occurred as of the end of the period specified. Most cancellations of contracts for homes in backlog occur because customers cannot qualify for financing and usually occur prior to the start of construction. Since we arrange financing with guaranteed rates for some of our customers, the incidence of cancellations after the start of construction is low. Unsold speculative homes, which are in various stages of construct ion, totaled 99, 125 and 105 at December 31, 2003, 2002 and 2001, respectively.

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Revenue. Revenue for the homebuilding segment was $1.0 billion, an increase of 3.2%, or $32.3 million from 2002. This increase was due to a 3.6% increase in housing revenue, offset partially by a 10.3% decrease in land revenue. The increase in housing revenue was due to an increase of 3.4% in the average sales price of homes delivered, from $238,000 in 2002 to $246,000 in 2003. The average sales price of homes delivered increased in all of our markets except Raleigh and Washington, D.C. The number of homes delivered remained relatively constant from 2002 to 2003; however, there were more homes delivered in Columbus, Tampa, Orlando and Charlotte in 2003 compared to 2002, offset by fewer homes delivered in other markets. The decrease in land revenue was primarily due to a decrease in lot sales in our Washington, D.C., Orlando and Cincinnati markets of $7.2 million, $2.3 million and $1.7 million, respectively. These decreases were partially offset by increases of $3.2 million in Charlotte, $2.0 million in Columbus, and $1.5 million in Raleigh. Land revenue can vary significantly from year to year, given that management opportunistically determines the particular land or lots to be sold directly to third parties.

Home Sales and Backlog. New contracts recorded in 2003 increased 8.6% over the prior year. New contracts increased in Columbus, Tampa, Orlando and West Palm Beach due to both the economic conditions in those markets and the availability of new subdivisions in exclusive or high demand locations. The number of new contracts recorded in future periods will be dependent on numerous factors, including future economic conditions, timing of land acquisitions and development, consumer confidence, number of subdivisions and interest rates available to potential homebuyers.

At December 31, 2003, the total sales value of our backlog of 2,658 homes was approximately $704.0 million, representing a 24.2% increase in sales value and a 14.5% increase in units compared to the levels recorded at December 31, 2002. The average sales price of homes in backlog increased 8.6%, from $244,000 at December 31, 2002 to $265,000 at December 31, 2003, with increases occurring in all of our markets except Charlotte.

Gross Margin. The gross margin for the homebuilding segment was 22.4% for 2003, compared to 21.3% for 2002. Housing gross margin increased from 21.7% to 22.4% and land gross margin increased from 8.3% to 22.2% The increase in housing’s gross margin was mainly due to the increase in sales prices in excess of cost increases within certain markets, due to demand, with the largest impact in the West Palm Beach and Washington, D.C. markets. Several other markets showed lower increases in gross margin percentage as a result of changes in mix of homes delivered, including the impact of customer’s selecting more options, which generally have higher margins, alon g with operating efficiencies. The increase in land’s gross margin was due primarily to lots sold in Charlotte and Columbus. Land gross margins can vary significantly from year to year depending on the sales price, the cost of the subdivision and the stage of development in which the sale takes place.

General and Administrative Expenses. General and administrative expenses increased from $27.1 million in 2002 to $28.9 million in 2003. As a percentage of revenue, general and administrative expenses increased slightly from 2.7% of revenue in 2002 to 2.8% of revenue in 2003. The increase was primarily due to higher overall payroll- related costs in the current year due to the increase in operations.

Selling Expenses. Selling expenses increased from $64.6 million in 2002 to $67.9 million in 2003; however, selling expenses remained constant at 6.4% of total revenue. The increase in expense was due to increases in sales commissions paid to outside realtors and an increase in bonuses paid to sales management due to the increase in the number of new contracts in the current year.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Revenue. Revenue for the homebuilding segment was $1.0 billion, an increase of 5.8%, or $55.9 million from 2001. This increase was due to a 4.5% increase in housing revenue and a 74.1% increase in land revenue. The increase in housing revenue was due to an increase of 6.7% in the average sales price of homes delivered. The average sales price of homes delivered increased in all our markets. The number of homes delivered decreased by 2.1% from 2001 to 2002. The largest decreases occurred in our Tampa, Charlotte and Phoenix markets. The increase in land revenue of $13.0 million was primarily attributable to lot sales relating to our exit from the Phoenix market. We also experienced increases in land sales in our Cincinnati, Orlando and Washington, D.C. markets that were partially offset by decreases in Columbus and Indianapolis. Land revenue can vary significantly from year to year, given that management opportunistically determines the particular land or lots to be sold directly to third parties.

Home Sales and Backlog. New contracts recorded in 2002 decreased 7.1% over the prior year. New contracts decreased in the majority of our markets due primarily to economic conditions and fewer subdivisions.

 

At December 31, 2002, the total sales value of our backlog of 2,321 homes was approximately $567.0 million, representing a 1.4% increase in sales value and a 0.4% decrease in units compared to the levels recorded at December 31, 2001. The average sales price of homes in backlog increased 1.7% from $240,000 at December 31, 2001 to $244,000 at December 31, 2002, with increases occurring in all of our markets except Raleigh and Washington, D.C.

Gross Margin. The gross margin for the homebuilding segment was 21.3% for 2002, compared to 20.7% for 2001. Housing gross margin increased from 20.9% to 21.7% and land gross margin decreased slightly from 8.7% to 8.3%.  The increase in housing’s gross margin was the result of acquiring and developing lots in premier locations, favorable housing economic conditions including low mortgage rates and improved operating efficiencies. The decrease in land gross margin was due primarily to lots sold related to our exit from the Phoenix market. Lot and land gross margins can vary significantly from year to year depending on the sales price, the cost of the sub division and the stage of development in which the sale takes place.

General and Administrative Expenses. General and administrative expenses increased from $26.7 million in 2001 to $27.1 million in 2002. As a percentage of revenue, general and administrative expenses decreased slightly from 2.8% of revenue in 2001 to 2.7% of revenue in 2002. The increase in dollars was primarily the result of increased incentive compensation due to increased earnings and homeowners’ association dues to support our increase in operations.

Selling Expenses. Selling expenses increased from $62.5 million, or 6.5% of total revenue, in 2001 to $64.6 million, or 6.4% of total revenue, in 2002. The increase in expense was due to increases in sales commissions paid to outside realtors and internal salespeople as a result of the increase in the average sales price of homes delivered. Advertising expenses also increased slightly.

Financial Services Segment

The following table sets forth certain information related to our financial services segment:

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Revenue. Revenue for the year ended December 31, 2003 was $28.7 million, a 20.7% increase over the $23.8 million recorded for 2002. The increase in revenue is attributable to various factors, including a higher average loan amount ($198,000 in 2003 compared to $187,000 in 2002), the impact of the interest rate environment resulting in favorability due to selling loans with higher rates than market because of customers locking rates early in the sale process and favorability due to the mix of fixed versus variable interest rate loans closed during 2003, and increased revenue from the sale of servicing rights on government loans. At December 31, 2003, M/I Financial was operating in eight of our nine markets. In these eight markets, 87% of our homes delivered that were financed were through M/I Financial.

General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2003 were $8.6 million, a 5.1% increase over 2002. The increase was primarily the result of higher payroll related costs in the current year due mainly to normal cost increases.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Revenue. Revenue for the year ended December 31, 2002 was $23.8 million, a 7.1% increase over the $22.2 million recorded for 2001. The increase in revenue is attributable to various factors, including a higher average loan amount ($187,000 in 2002 compared to $173,000 in 2001) and increased revenues from title services. At December 31, 2002, M/I Financial was operating in eight of our nine markets. In these eight markets, 90% of our homes delivered that were financed were through M/I Financial.

 

General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2002 were $8.2 million, a 1.7% decrease from 2001. The decrease was a result of various general and administrative expenses decreasing, primarily lower outside expenses associated with loan applications.

Intersegment, Corporate and Other

Intersegment, corporate and other includes selling, general and administrative costs that are not viewed by management as specifically related to the operations of either the homebuilding or the financial services segment, income resulting from the allocation of interest and other costs to those segments, the elimination of revenue and cost of sales between the homebuilding and financial services segments and adjustments necessary to reclassify certain amounts from internal reporting classifications to proper presentation in conformity with GAAP.

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Intersegment Revenue. Intersegment revenue eliminations and reclassifications increased to $6.6 million in 2003 compared to $5.9 million in 2002. The largest component of this amount is the elimination of revenue that financial services recorded from homebuilding for loan origination fees, accounting for $4.9 million and $4.7 million in 2003 and 2002, respectiv ely. The amount also includes $1.8 million and $1.3 million reclassifications in 2003 and 2002, respectively, relating to amounts included in revenue within the homebuilding segment that must be reported in cost of sales for proper presentation in accordance with GAAP.

Intersegment Cost of Sales Eliminations and Adjustments. Intersegment cost of sales eliminations and adjustments increased from $15.5 million in 2002 to $16.3 million in 2003. This amount includes primarily eliminations and reclassifications relating to the homebuilding segment, and includes the elimination of fees charged by financial services of $4.9 million and $4.7 million in 2003 and 2002, respectively, the elimination of amounts allocated to homebuilding for various corporate services of $3.5 million and $3.4 million in 2003 and 2002, respectively, and the reclassification of previously capitalized interest from cost of sales to interest expense of $4.8 million and $5.6 million in 2003 and 2002, respectively.

Corporate Selling, General and Administrative Expenses. Corporate selling, general and administrative expenses decreased from $27.5 million in 2002 to $22.9 million in 2003. As a percentage of total Company revenue, corporate selling, general and administrative expenses decreased from 2.7% in 2002 to 2.1% in 2003. The decrease was primarily due to the impact of a $3.0 million favorable market adjustment on our interest rate swaps in 2003 compared to a $1.2 million unfavorable market adjustment in 2002. In addition, self-insurance costs were lower in 2003 tha n in 2002; however, payroll costs were higher in 2003.

Interest. Interest income from allocations to homebuilding, net of interest incurred, was $6.8 million higher in 2003 than in 2002. The increase was primarily the result of a $5.1 million higher allocation of interest to the homebuilding segment, mainly resulting from the increase in homebuilding inventory. In addition, total interest incurred decreased slightly from the prior year mainly due to lower average borrowings in 2003 than in 2002; however, there was a slightly higher average borrowing rate in the current year. A management decision was made for 200 4, that this interest rate will be adjusted to 12% for housing and 6% for land, which will result in a lower allocation of interest to homebuilding, and therefore, higher income before taxes within the homebuilding segment in 2004.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Intersegment Revenue. Intersegment revenue eliminations and reclassifications increased to $5.9 million in 2002 compared to $4.8 million in 2001. The largest component of this amount is the elimination of revenue that financial services recorded from homebuilding for loan origination fees, accounting for $4.7 million in both 2002 and 2001. In 2002, this amount also includes a $1.3 million reclassification relating to amounts included in revenue within homebuilding that must be reported in cost of sales for proper presentation in accordance with GAAP.

Intersegment Cost of Sales Eliminations and Adjustments. Intersegment cost of sales eliminations and adjustments increased from $5.6 million in 2001 to $15.5 million in 2002. This amount includes primarily eliminations and reclassifications relating to the homebuilding segment, and includes the elimination of fees charged by financial services of $4.7 million in both 2002 and 2001, the elimination of amounts allocated to homebuilding for various corporate services of $3.4 million and $3.2 million in 2002 and 2001, respectively, and the reclassification of previously capitalized interest from cost of sales to interest expense of $5.6 million and $4.2 million in 2002 and 2001, respectively. Also recorded in this amount in 2001, partially offsetting the items above, was a $3.0 million charge associated with the exit from the Phoenix market and a $2.5 million elimination of deferred profit for land transferred to housing that was not yet sold to a third party.

Corporate Selling, General and Administrative Expenses. Corporate selling, general and administrative expenses increased from $23.3 million in 2001 to $27.5 million in 2002. As a percentage of total Company revenue, corporate selling, general and administrative expenses increased from 2.4% in 2001 to 2.7% in 2002. The increase was primarily due to the impact of a $1.2 million unfavorable market adjustment on our interest rate swaps in 2002.

Interest. Interest income from allocations to homebuilding, net of interest incurred, was $2.1 million higher in 2002 than in 2001. The increase was primarily the result of a decrease in interest incurred, mainly due to lower average borrowings.

Liquidity and Capital Resources

For the year ended December 31, 2003, we experienced $38.7 million negative cash flows from operations as a result of a significant investment in land during 2003 and an increase in our investment in mortgage loans held for sale, due to the significant number of loans closed during the fourth quarter of 2003, that were not yet sold to a third party as of December 31, 2003. We acquired approximately $220 million of land during the current year, funded by both our cash generated from operations as well as through proceeds from bank borrowings, which were $90.2 million in 2003, net of repayments. In addition to the purchase of land, $25.7 million of cash was used to invest in our joint ventures (net of distributions) and for the purchase of the Company airplane and other property and equipment, and another $21.9 million was used to repurchase outstanding shares to be held as treasury stock.

Our financing needs depend on sales volume, asset turnover, land acquisition and inventory balances. We have incurred substantial indebtedness, and may incur substantial indebtedness in the future, to fund the growth of our homebuilding activities. Our principal source of funds for construction and development activities has been from internally generated cash and from bank borrowings, which are primarily unsecured. Included in the table below is a summary of future amounts payable under contractual obligations. Management believes that the Company’s available financing is adequate to support operations through mid-2005. Please see our Safe Harbor Statement for further discussion of factors that could impact our source of funds.

 

Notes Payable Banks. At December 31, 2003, we had $95 million of bank borrowings outstanding under our Bank Credit Facility. The Bank Credit Facility permits borrowing base indebtedness not to exceed the lesser of $315 million or our borrowing base. This includes a maximum amount of $50 million in letters of credit. The Bank Credit Facility matures in March 2006. The $95 million increase in notes payable banks-homebuilding operations from December 31, 2002 to December 31, 2003 reflects increased borrowings primarily used for the acquisition of land.

We had $24 million outstanding as of December 31, 2003 under the M/I Financial loan agreement, which permits borrowings of $30 million to finance mortgage loans initially funded by M/I Financial for our customers. The Company and M/I Financial are co-borrowers under the M/I Financial loan agreement. This agreement limits the borrowings to 95% of the aggregate face amount of certain qualified mortgages. The agreement terminates in April 2004.

At December 31, 2003, we had the right to borrow up to $345 million under our credit facilities, including $30 million under the M/I Financial loan agreement. At December 31, 2003, we had $218 million of unused borrowing availability under our loan agreements.

Subordinated Notes. At December 31, 2003, there were outstanding $50 million of Senior Subordinated Notes. The Notes bear interest at a fixed rate of 9.51% through August 2004 and at a slightly higher rate for two additional years, and mature in August 2006.

Mortgage Notes Payable. At December 31, 2003, mortgage notes payable outstanding were $10.6 million, secured by an office building, lots and land with a recorded book value of $14.8 million.

Land and Land Development. Single-family lots, land and land development inventory increased from $269.9 million at December 31, 2002 to $366.0 million at December 31, 2003. We also intend to purchase an additional $300 million of land during 2004, using cash generated from operations and our existing line of credit. We continue to purchase some lots from outside developers under contracts. However, we are strategically focusing on increasing raw ground purchases. We will continue to evaluate all of our alternatives to satisfy our increasing demand for lots in the most cost-effective manner.

We have interests in joint ventures and limited liability companies that engage in land development activities and are recorded using the equity method of accounting. These entities have no long-term debt on their balance sheets.

Universal Shelf Registration. In April 2002, we filed a $150 million universal shelf registration statement with the Securities and Exchange Commission. Pursuant to the filing, we may, from time to time over an extended period, offer new debt and/or equity securities. Of the equity shares, up to 1 million common shares may be sold by certain shareholders who are considered selling shareholders. This shelf registration should allow us to expediently access capital markets in the future. The timing and amount of offerings, if any, will depend on market and general business conditions. No debt or equity securities have been offered for sale as of December 31, 2003.

Purchase of Treasury Shares. On December 10, 2002, our Board of Directors authorized the repurchase of up to $50 million worth of shares of outstanding common stock. As of March 8, 2004, the Company had purchased 1,077,700 shares at an average price of $31.53 per share under this Board approved repurchase program, and had approximately $16.0 million remaining available for repurchase.  This repurchase program replaces and supercedes the unused portions of all of the repurchase programs that have previously been authorized. The purchases may occur in the open market and/or in privately negotiated transactions as market conditions warrant .

Critical Accounting Policies

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. On an ongoing basis, management evaluates such estimates and judgments and makes adjustments as deemed necessary. Actual results could differ from these estimates using different estimates and assumptions, or if conditions are significantly different in the future. Listed below are those policies that we believe are critical and require the use of complex judgment in their application.

Segment Information. Our reportable business segments consist of homebuilding and financial services. Our homebuilding segment derives a majority of its revenue from constructing single-family housing in nine markets in the United States. The financial services segment generates revenue by originating and selling mortgages and by collecting fees for title services. Segment information included herein is presented in accordance with SFAS No. 131, and is presented on the basis that the chief operating decision makers use in evaluating segment performance.

Revenue Recognition. Revenue from the sale of a home is recognized when the closing has occurred and the risk is transferred to the buyer. All associated homebuilding costs are charged to cost of sales in the period when the revenues from home closings are recognized. Homebuilding costs include land and land development costs, home construction costs (including an estimate of the costs to complete construction), previously capitalized indirect costs and estimated warranty costs. Sales commissions are included in selling expense when the closing has occurred. All other costs are expensed as incurred.

We recognize the majority of the revenues associated with our mortgage loan operations when the mortgage loans and related servicing rights are sold to third-party investors.  We defer the application and origination fees, net of costs, and recognize them as revenue, along with the associated gains or losses on the sale of the loans and related servicing rights, when the loans are sold to third-party investors, in accordance with SFAS 91. The revenue recognized is reduced by the fair value of the related guarantee provided to the investor.  The guarantee fair value is recognized in revenue when the Company is released from its obligation under the guarantee.  Generally, all of the financial services mortgage loans and related servicing rights are sold to third-party inves tors within two weeks of origination. We recognize financial services revenues associated with our title operations as homes are closed, closing services are rendered and title polices are issued, all of which generally occur simultaneously as each home is closed. All of the underwriting risk associated with title insurance policies is transferred to third-party insurers.

When a home is closed, we typically have not yet recorded and paid all incurred costs necessary to complete the home. As homes close, we compare the home construction budget to actual recorded costs to date to estimate the additional costs to be incurred from our subcontractors related to the home. We record a liability and a corresponding charge to cost of sales for the amount we estimate will ultimately be paid related to that home. We monitor the accuracy of such estimate by comparing actual costs incurred in subsequent months to the estimate. Although actual costs to complete in the future could differ from the estimate, our method has historically produced consistently accurate estimates of actual costs to complete closed homes.

Warranty. Warranty liabilities are established by charging cost of sales and crediting a warranty liability for each home closed. The amounts charged are estimated by management to be adequate to cover expected warranty-related costs for materials and labor required under the Company’s warranty programs. Our warranty cost accruals are based upon historical warranty cost experience and are adjusted as appropriate. Actual future warranty costs could differ materially from our currently estimated amount.

Self-insurance. Self-insurance accruals are made for estimated liabilities associated with employee health care, workers’ compensation and general liability insurance. The accruals related to employee health care and workers compensation are based on historical experience and open cases. The general liability accrual estimate is based on an actuarial evaluation of our past history of claims and other industry specific factors. Because of the high degree of judgment required in determining these estimated reserve amounts, actual future costs could differ from our currently estimated amounts.

To meet financing needs of our home-buying customers, M/I Financial is party to interest rate lock commitments ("IRLCs"), which are extended to customers who have applied for a mortgage loan and meet certain defined credit and underwriting criteria. In accordance with SFAS No. 133 and related Derivatives Implementation Group conclusions, the Company classifies and accounts for IRLCs as non-designated derivative instruments at fair value with gains and losses recorded to current revenue. M/I Financial manages interest rate risk related to its IRLC loans through the use of forward sales of mortgage-backed securities ("FMBS"), use of best-efforts whole loan delivery commitments and the occasional purchase of options on FMBS in accordance with Company policy. These instruments are considered non - -designated derivatives and are accounted for at fair value with gains or losses recorded in current earnings. SFAS No. 133 requires interest rate swaps to be recorded in the consolidated balance sheet at fair value. Changes in their value are recorded in the consolidated statement of income. The fair value of the Company’s interest rate swap is recorded in other liabilities and the change in their fair value is recorded in general and administrative expense.

Off-Balance Sheet Arrangements

In addition to the above, the Company also enters into option and contingent purchase contracts with third parties to acquire land and developed lots, which may qualify as VIEs under Financial Accounting Standards Board ("FASB") Interpretation 46 (revised December 2003), "Consolidation of Variable Interest Entities" ("FIN 46") . At December 31, 2003, the Company had option and contingent purchase contracts to acquire land and developed lots with an aggregate purchase price of approximately $315.0 million. With regard to the contracts, the Company has no legal title to the assets, the Company’s maximum exposu re to loss is limited to, in most cases, the amount of deposits or letters of credit placed with these entities, and creditors, if any, have no recourse against the Company. The Company has performed an evaluation of the contracts that were entered into between February 1, 2003 and September 30, 2003 in accordance with the original release of FIN 46, and has determined that consolidation of these VIEs is not necessary because the Company is not the primary beneficiary of any of the VIEs. The Company is still evaluating the option and contingent purchase contracts entered into prior to February 1, 2003 and subsequent to September 30, 2003 in accordance with FIN 46, and expects to complete this evaluation by March 31, 2004; however, the Company does not anticipate a significant impact on the Company’s financial position or results of operations .

Completion Bonds and Letters of Credit. At December 31, 2003, the Company had outstanding approximately $65.7 million of completion bonds and standby letters of credit, which serve as completion bonds for development work in progress, deposits on land and lot purchase contracts, and miscellaneous deposits that expire through July 2009.

Guarantees and Indemnities. In the ordinary course of business, M/I Financial, enters into agreements that guarantee purchasers of its mortgage loans that M/I Financial will repurchase a loan if certain conditions occur, primarily if the mortgagor does not meet specific conditions of the loan within the first six months after the sale of the loan. As of December 31, 2003, loans totaling approximately $378.0 million were covered under the above gua rantee. A portion of the revenue paid to the Company for providing the guarantee on the above loans was deferred at December 31, 2003, and will be recognized in income as the Company is released from its obligation under the guarantee.

M/I Financial has not repurchased any loans under the above agreements in 2003 or 2002, but has provided indemnifications to third party investors in lieu of repurchasing certain loans. The total of these loans indemnified is approximately $4.5 million as of December 31, 2003 relating to the above agreements. The Company has also guaranteed the collectibility of certain loans to third-party insurers of those loans for periods ranging from five years to thirty years. The maximum potential amount of future payments is equal to the outstanding loan value less the value of the underlying asset plus administrative costs incurred related to foreclosure on the loans, should this event occur. As of December 31, 2003, the fair value of future payments that M/I Financial could be required to pay under these guarantees is $5.5 million. The risk associated with the guarantees and indemnities above is offset by the value of the underlying assets. The Company has accrued management’s best estimate of the probable loss on the above loans as of December 31, 2003.

In addition, the Company has also provided an environmental indemnification to an unrelated third-party seller of land in connection with the purchase of that land by the Company.

As of December 31, 2003, the Company has accrued $3.4 million, which is management’s best estimate of the fair value of the Company’s liability for the guarantees and indemnities described above.

Impact of New Accounting Standards

In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, " Rescission of FASB Statements 4, 44, and 64, Amendment of FASB Statement 13, and Technical Corrections." This statement rescinded SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt," and an amendment of that statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." This statement also rescinded SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers." This statement amended SFAS No. 13, "Accounting for Leases" to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This statement also amended other authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. This statement was effective for the quarter ended March 31, 2003. The adoption of SFAS No. 145 did not have a significant impact on the consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 addressed financial accounting and reporting for costs associated with exit or disposal activities included in restructurings. This statement eliminated the definition and requirements for recognition of exit costs as defined in Emerging Issues Task Force ("EITF") Issue 94-3, and required that liabilities for exit activities be recognized when incurred instead of at the exit activity commitment date. This statement was effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a significant impact on the consolidated financial statements.

In November 2002, the FASB issued FASB Interpretation 45, "Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires a guarantor to recognize a liability, at the inception of the guarantee, for the fair value of obligations it has undertaken in issuing the guarantee and also includes more detailed disclosures with respect to guarantees. FIN 45 was effective for guarantees issued or modified starting January 1, 2003 and required additional disclosures for the year ended December 31, 2002. The adoption of FIN 45 did not have a significant impact on the consolidated financial statements.

In November 2002, the EITF issued EITF No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor". EITF 02-16 requires the recognition of a rebate or refund that is payable pursuant to a binding arrangement to be recognized as a reduction of the cost of the purchased items if it is both probable that the rebate will be paid and the amount is reasonably estimable. The rebate should be recognized using a systematic approach as the related purchases are made. EITF 02-16 was effective for all rebate arrangements entered into or modified after November 21, 2002. The adoption of EITF 02-16 did not have a significant impact on the consolidated financial statements.

 

Prior to the issuance of FIN 46, entities were generally consolidated by an enterprise when it had a controlling financial interest through ownership of a majority voting interest in the entity. FIN 46, as originally released, applied immediately to variable interest entities created after January 31, 2003. The December revision of FIN 46 resulted in an extension of time to apply FIN 46 to March 31, 2004 for companies with a calendar quarter end. The Company has evaluated all joint venture agreements and land option contracts entered into between February 1, 2003 and September 30, 2003 in accordance with FIN 46. Based on this evaluation, management has determined that the Company is not the primary ben eficiary as defined in FIN 46 and, therefore, the Company has not consolidated any of its joint ventures or option contracts entered into during that time period. The Company is in the process of assessing its interests in VIEs in existence prior to February 1, 2003 as well as those interests obtained subsequent to September 30, 2003. Depending on the specific terms or conditions of such entities, the Company may be required to consolidate these VIEs for the quarter ending March 31, 2004. The Company has not completed its assessment but does not anticipate a significant impact on the Company’s financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies financial accounting and reporting for derivative instruments and hedging activities for decisions made by the FASB as part of the Derivative Implementation Group. This statement was effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a significant impact on the consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." This statement requires that certain financial instruments that were previously classified as equity under FASB Concepts Statement No. 6, "Elements of Financial Statements," be classified as liabilities (or assets in some circumstances). This statement was effective July 1, 2003. The adoption of SFAS No. 150 did not have a significant impact on the consolidated financial statements.

Interest Rates and Inflation

Our business is significantly affected by general economic conditions of the United States of America and, particularly, by the impact of interest rates. Higher interest rates may decrease our potential market by making it more difficult for homebuyers to qualify for mortgages or to obtain mortgages at interest rates that are acceptable to them. The impact of increased rates can be offset, in part, by offering variable rate loans with lower interest rates.

In conjunction with our mortgage-banking operations, hedging methods are used to reduce our exposure to interest rate fluctuations between the commitment date of the loan and the time the loan closes.

In recent years, we have generally been able to raise prices by amounts at least equal to our cost increases and, accordingly, have not experienced any detrimental effect from inflation. When we develop lots for our own use, inflation may increase our profits because land costs are fixed well in advance of sales efforts. We are generally able to maintain costs with subcontractors from the date construction is started on a home through the delivery date. However, in certain situations, unanticipated costs may occur between the time of start and the delivery date, resulting in lower gross profit margins.

Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995, and all of our forward-looking statements are expressly qualified in their entirety by the cautionary statements contained or referenced in this section.

General Real Estate, Economic and Other Conditions Could Adversely Affect Our Business. The homebuilding industry is significantly affected by changes in national and local economic and other conditions. Many of these conditions are beyond our control. These conditions include employment levels, changing demographics, availability of financing, consumer confidence and housing demand. In addition, homebuilders are subject to risks related to competitive overbuilding, availability and cost of building lots, availability of materials and labor, adverse weather conditions which can cause delays in construction schedules, cost overruns, changes in governmental regulati ons and increases in real estate taxes and other local government fees.

Availability and Affordability of Residential Mortgage Financing Could Adversely Affect Our Business. Our business is significantly affected by the impact of interest rates. Higher interest rates may decrease our potential market by making it more difficult for homebuyers to qualify for mortgages or to obtain mortgages at interest rates that are acceptable to them. Mortgage rates are currently close to historically low levels. If mortgage interest rates increase, our business could be adversely affected.

Material and Labor Shortages Could Adversely Affect Our Business. The residential construction industry has, from time to time, experienced significant material and labor shortages in insulation, drywall, brick, cement and certain areas of carpentry and framing, as well as fluctuations in lumber prices and supplies. Continued shortages in these areas could delay construction of homes that could adversely affect our business. At this time, we are not experiencing any significant material or labor shortages and, therefore, do not anticipate a material effect for the year 2004.

We Commit Significant Resources to Land Development Activities Which Involve Significant Risks. We develop the lots for a majority of our subdivisions. Therefore, our short-term and long-term financial success will be dependent upon our ability to develop these subdivisions successfully. Acquiring land and committing the financial and managerial resources to develop a subdivision involves significant risks. Before a subdivision generates any revenue, we may make material expenditures for items such as acquiring land and constructing subdivision infrastructure (roads and util ities).

We Are Dependent on a Limited Number of Markets. We have operations in Columbus and Cincinnati, Ohio; Indianapolis, Indiana; Tampa, Orlando and West Palm Beach, Florida; Charlotte and Raleigh, North Carolina; and the Virginia and Maryland suburbs of Washington, D.C. Adverse general economic conditions in these markets could have a material impact on our operations. For 2003, approximately 40% of our operating income was derived from operations in the Columbus market.

Competition. The homebuilding industry is highly competitive. We compete in each of our local markets with numerous national, regional and local homebuilders, some of which have greater financial, marketing, land acquisition, and sales resources than we do. Builders of new homes compete not only for homebuyers, but also for desirable properties, financing, raw materials and skilled subcontractors. We also compete with the resale market for existing homes that provide certain attractions for homebuyers over the new home market.

Governmental Regulation and Environmental Considerations Could Adversely Affect Our Business. The homebuilding industry is subject to increasing local, state and federal statutes, ordinances, rules and regulations concerning zoning, resource protection, building design and construction, and similar matters. This includes local regulations that impose restrictive zoning and density requirements in order to limit the number of homes that can eventually be built within the boundaries of a particular location. Such regulation also affects construction activities, including construction materials that must be used in certain aspects of building design, as well as sales activities and other dealings with homebuyers. We must also obtain licenses, permits and approvals from various governmental agencies for our development activities, the granting of which are beyond our control. Furthermore, increasingly stringent requirements may be imposed on homebuilders and developers in the future. Although we cannot predict the impact on us to comply with any such requirements, such requirements could result in time-consuming and expensive compliance programs. In addition, we have been, and in the future may be, subject to periodic delays or may be precluded from developing certain projects due to building moratoriums. These moratoriums generally relate to insufficient water supplies or sewage facilities, delays in utility hookups or inadequate road capacity within the specific market area or subdivision. These moratoriums can occur prior to, or subsequent to, commencement of our operations without notice or recourse.

We are also subject to a variety of local, state and federal statutes, ordinances, rules and regulations concerning the protection of health and the environment. The particular environmental laws that apply to any given project vary greatly according to the project site and the present and former uses of the property. These environmental laws may result in delays, cause us to incur substantial compliance costs (including substantial expenditures for pollution and water quality control) and prohibit or severely restrict development in certain environmentally sensitive regions. Although there can be no assurance that we will be successful in all cases, we have a general practice of requiring resolution of environmental issues prior to purchasing land in an effort to avoid major environmental i ssues in our developments. In addition, M/I Financial is subject to a variety of laws and regulations concerning the underwriting, servicing and sale of mortgage loans.

Significant Voting Control by Principal Shareholders. As of the date of this report, members of the Schottenstein family, including the Chairman, Chief Executive Officer and President and Chief Operating Officer, owned approximately 23% of the Company’s outstanding common shares. Therefore, members of the Schottenstein family have significant voting power.

Our primary market risk results from fluctuations in interest rates. We are exposed to interest rate risk through the borrowings under our unsecured revolving credit facilities that permit borrowings up to $345 million. To minimize the effects of interest rate fluctuations, we have interest rate swap agreements with certain banks for a total notional amount of $75 million, for which we pay fixed rates of interest.

Our interest rate swaps were not designated as hedges under SFAS No. 133 when it was adopted. We are exposed to market risk associated with changes in the fair values of the swaps, and such changes are reflected in our income statements.  At December 31, 2003, the fair value adjustment resulted in the Company recording a $3.0 million asset.

The following table provides the expected future cash flows and current fair values of our other assets and liabilities that are subject to market risk as interest rates fluctuate, as of December 31, 2003 and 2002: