Ground Floor Observations on Construction and Local Banks

[davelj]

I had a board meeting the other day where a lot of time was spent on local construction conditions and its impact on local banks.

The main issue addressed was the fact that we know that a lot of projects aren’t selling, most of the small ones (30 units and under) are locally financed, but yet the loans aren’t yet showing up as NPAs (nonperforming assets) yet.

The reason almost all of these loans “appear” to be performing revolves around the construction financing cycle. An example for purposes of illustration:

I’m going to use very round numbers for simplicity’s sake. Let’s assume we’re looking at a $10 million (cost) condo construction project that broke ground on June 1, 2005 (the peak of the boom). Typically, the developers and his co-investors put up $2 million in equity and the bank put up the other $8 million in the form of a loan. $7 million of the loan will go toward real construction costs (materials and labor) while the other $1 million will get placed in an undistributed “interest reserve” to be drawn down to pay the interest on the loan over its life. Theoretically, after 18 months or so, the project is finished and almost all of the $10 million has been spent, save for what remains of the interest reserve. In a perfect world, the developer sells off the units over the following 12 months (hopefully a decent percentage were pre-sold), paying down the principal loan balance and eventually the interest reserve disappears after the loan is completely paid off. In normal times there will be $1.5 – $2 million in profit for the builders and its equity investors after the loan has been paid off.

The problem, of course, is what happens when the developer can’t sell the units as originally planned. One would think that after the project is finished and less than 20% of the units are sold that the bank would notice the problem and classify the loan as an NPA. The problem is that at this stage of the cycle, most of the developers, although they haven’t sold many units, are still technically current on their payments because they’re continuing to draw down the interest reserve account. Paydowns on the principal balance are WAY behind but the interest payments are technically current, so the bank looks the other way for financial reporting purposes. Then, several months later, when the interest reserve is tapped out, everyone is “shocked” that the loan has to be classified as an NPA.

Now, the loan can be “extended.” But the problem here is that in order to get a construction loan extended there has to be a new appraisal or it won’t pass muster with the regulators. So, what do you think has happened to the appraised value of the project since June 30, 2005? Right. It’s gone in the crapper.

So, what we’re going to see over the next 12-18 months is a bunch of bad construction loans that are already technically in default actually get classified as defaults. And then things will get really interesting.

[patientlywaiting]

Excellent post, davelj. That’s pretty much how i see as well.

Local banks like to look the other way. In the 1990s I was involved with an electronics manufacturer that was in trouble. As long as the interest payments are made, the banks would bend backwards to make accomodations.

It will be interesting indeed. Time will tell.

[patientlywaiting]

Excellent post, davelj. That’s pretty much how i see as well.

Local banks like to look the other way. In the 1990s I was involved with an electronics manufacturer that was in trouble. As long as the interest payments are made, the banks would bend backwards to make accomodations.

It will be interesting indeed. Time will tell.

[Stu949]

Interesting post davelj.

On a side note and not directly related.

My father is still in the construction industry. He’s worked as a soils engineer for approx 40 years. Been through a couple of down cycles (90s – he was temporarily laid off but has stayed with the same company his entire life). I did a little work for his company throughout the years, but started doing small jobs when I was 16.

At 16, I was digging holes and helping out with soils tests in an around Irvine. Today, Standard Pacific has the start of a community, but obviously they’re having trouble selling. My point being that in that particular location, someone started researching the viability of building on that land some 12 years ago – with actual construction just starting last year. At the time, they were avocado and orange groves.

Granted, not all jobs start that far out, but my dad’s company has no jobs to bid on. He’s been in San Diego for the last 10 years, as they’ve done many of the big residential projects and many commercial projects you all see today.

Being that they do the soil testing and supervise the grading, they’re pretty much the first step or phase in the construction process.

There is nothing even on the horizon for them to bid on. Nothing, zilch, nada… The 90s was slow, but he said there was still work. This is one of the first times they’ve ever seen where there are virtually no commercial or residential projects planned at all. The only thing out there is government contracts, but there’s more red tape with bidding on those and they’re not in abundance. His firm stoped competing for them a few years back because they were flying high on the commercial/residential bubble.

Any sign of a turn around will start with the soils engineering firms. We hear a lot about starts and permits…Many of those permits had the soils work done months ago. Not that it is a surprise to anyone here, but the permits should see even more declines in the next 6 to 9 months. When the turnaround comes (whenever that happens), permits will lag the start of the soils grading by about 6 months to a year.

[Stu949]

Interesting post davelj.

On a side note and not directly related.

My father is still in the construction industry. He’s worked as a soils engineer for approx 40 years. Been through a couple of down cycles (90s – he was temporarily laid off but has stayed with the same company his entire life). I did a little work for his company throughout the years, but started doing small jobs when I was 16.

At 16, I was digging holes and helping out with soils tests in an around Irvine. Today, Standard Pacific has the start of a community, but obviously they’re having trouble selling. My point being that in that particular location, someone started researching the viability of building on that land some 12 years ago – with actual construction just starting last year. At the time, they were avocado and orange groves.

Granted, not all jobs start that far out, but my dad’s company has no jobs to bid on. He’s been in San Diego for the last 10 years, as they’ve done many of the big residential projects and many commercial projects you all see today.

Being that they do the soil testing and supervise the grading, they’re pretty much the first step or phase in the construction process.

There is nothing even on the horizon for them to bid on. Nothing, zilch, nada… The 90s was slow, but he said there was still work. This is one of the first times they’ve ever seen where there are virtually no commercial or residential projects planned at all. The only thing out there is government contracts, but there’s more red tape with bidding on those and they’re not in abundance. His firm stoped competing for them a few years back because they were flying high on the commercial/residential bubble.

Any sign of a turn around will start with the soils engineering firms. We hear a lot about starts and permits…Many of those permits had the soils work done months ago. Not that it is a surprise to anyone here, but the permits should see even more declines in the next 6 to 9 months. When the turnaround comes (whenever that happens), permits will lag the start of the soils grading by about 6 months to a year.

[davelj]

Actually, I didn’t mention it, but I’m confident that this is going on at the national level as well. In fact, in a way the situation could be worse at the bigger banks. At the local level, the bank’s President probably knows what’s going on with most of the bank’s loans, particularly the larger ones. So, there’s delayed recognition of problems, but it’s a “consciously” delayed recognition. At the national level, however, there’s a lot more bureaucracy between the top of the pile and the lenders on the ground. Consequently, there’s a more “unconscious” delayed recognition of loan problems. The challenge for the local banks is that they don’t have the advantage of geographic diversification that the larger banks do. So they live and die by the local economy.

[davelj]

Actually, I didn’t mention it, but I’m confident that this is going on at the national level as well. In fact, in a way the situation could be worse at the bigger banks. At the local level, the bank’s President probably knows what’s going on with most of the bank’s loans, particularly the larger ones. So, there’s delayed recognition of problems, but it’s a “consciously” delayed recognition. At the national level, however, there’s a lot more bureaucracy between the top of the pile and the lenders on the ground. Consequently, there’s a more “unconscious” delayed recognition of loan problems. The challenge for the local banks is that they don’t have the advantage of geographic diversification that the larger banks do. So they live and die by the local economy.

[HereWeGo]

Yikes. There’s a world of hurt for some downtown builders.

How does the loan payback model work with commercial RE, both office space and retail?

[HereWeGo]

Yikes. There’s a world of hurt for some downtown builders.

How does the loan payback model work with commercial RE, both office space and retail?

[Mr_Brightside]

This is a very interesting topic. We have been discussing a specific project on the thread below. On it I came to the conclusion that this particular project would not cease construction based on some research I did. Any other opinions or insight are always welcome. I do think this type of problem will be the source of additional weakness but that each project is very specific.

http://www.sdlookup.com/Forums/General/tabid/57/forumid/617/tpage/1/view/topic/postid/5953/Default.aspx#5953

[Mr_Brightside]

This is a very interesting topic. We have been discussing a specific project on the thread below. On it I came to the conclusion that this particular project would not cease construction based on some research I did. Any other opinions or insight are always welcome. I do think this type of problem will be the source of additional weakness but that each project is very specific.

http://www.sdlookup.com/Forums/General/tabid/57/forumid/617/tpage/1/view/topic/postid/5953/Default.aspx#5953

[Mr_Brightside]

I’ll add to this that I know of new an eight unit project downtown that’s on the edge of foreclosure. I’m putting together a blog post for it so stay tuned.

[Mr_Brightside]

I’ll add to this that I know of new an eight unit project downtown that’s on the edge of foreclosure. I’m putting together a blog post for it so stay tuned.

[Bugs]

The operating margins on these local lenders aren’t large enough to sustain $1,000,000 losses, so you can imagine that it doesn’t take much in the way of exposure to create some really devastating problems.

I often look at some of these commercial condo projects that are springing up all over the place and marvel at the fact that in each case some appraiser developed and supported in their appraisal report an absorption analysis that projected how long it would take to complete the project, market it and get out.

What I find annoying is the fact that the commercial condo market has been around for a while and compared to other property types it was always a bit of a dog. Given the alternatives, most small companies that would occupy such a space could only justify it if the prices were in line with the rents, and over the long haul a $0.90/SF rent doesn’t economically support a sale price in excess of $100/SF. Duh.

Fortunately for me, I was smart enough not to allow myself to get caught up in these unrealistic projects. I lost some clients to other appraisers who were more “cooperative”, but now I don’t have to worry about the federal banking regulators associating my name with those bad deals.

[Bugs]

The operating margins on these local lenders aren’t large enough to sustain $1,000,000 losses, so you can imagine that it doesn’t take much in the way of exposure to create some really devastating problems.

I often look at some of these commercial condo projects that are springing up all over the place and marvel at the fact that in each case some appraiser developed and supported in their appraisal report an absorption analysis that projected how long it would take to complete the project, market it and get out.

What I find annoying is the fact that the commercial condo market has been around for a while and compared to other property types it was always a bit of a dog. Given the alternatives, most small companies that would occupy such a space could only justify it if the prices were in line with the rents, and over the long haul a $0.90/SF rent doesn’t economically support a sale price in excess of $100/SF. Duh.

Fortunately for me, I was smart enough not to allow myself to get caught up in these unrealistic projects. I lost some clients to other appraisers who were more “cooperative”, but now I don’t have to worry about the federal banking regulators associating my name with those bad deals.

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