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.

[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.

[Raybyrnes]

So I would assume that if you can’t sell the units the next thing to do is start collecting some income to keep up with the interest payments and rent the units out.

I listened to the President of McMillan talk about doing this during the last real estate downturn.

Davlj
Superb Post, Extremely enlightening

[davelj]

If the developer has deep enough pockets to add more equity to the deal then they can do that – rent out the units until the market improves. In these cases, however, the loan must be re-underwritten as an apartment project with a new appraisal, etc. The reason this won’t work in the majority of cases is that the price paid for the underlying land and the cost of construction were so high that renting out the units will not cover the building’s overhead and the interest on the loan. Ultimately, however, the real problem is that most developers simply don’t have enough additional equity to put into the project. These projects are typically structured as LLCs, with no recourse to the developer or equity investors, and more often than not they’d rather just walk away from the project. Also, lets not forget that the developer generally covers his equity investment and gets a small payday through developer fees that he’s been paying himself throughout the project. Heads the developer wins; tails the bank (and non-developer equity investors) loses.

[davelj]

If the developer has deep enough pockets to add more equity to the deal then they can do that – rent out the units until the market improves. In these cases, however, the loan must be re-underwritten as an apartment project with a new appraisal, etc. The reason this won’t work in the majority of cases is that the price paid for the underlying land and the cost of construction were so high that renting out the units will not cover the building’s overhead and the interest on the loan. Ultimately, however, the real problem is that most developers simply don’t have enough additional equity to put into the project. These projects are typically structured as LLCs, with no recourse to the developer or equity investors, and more often than not they’d rather just walk away from the project. Also, lets not forget that the developer generally covers his equity investment and gets a small payday through developer fees that he’s been paying himself throughout the project. Heads the developer wins; tails the bank (and non-developer equity investors) loses.

[Raybyrnes]

So I would assume that if you can’t sell the units the next thing to do is start collecting some income to keep up with the interest payments and rent the units out.

I listened to the President of McMillan talk about doing this during the last real estate downturn.

Davlj
Superb Post, Extremely enlightening

[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.

[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]

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.

[Mr_Brightside]

The major problem with a commercial condo is any decent business will need both capital for the actual business and will probably outgrow their space if they are successful.

Both of these are pretty much in conflict with buying a commercial condo.

If they were cheap enough to buy and rent out then that’s a different story. For some reason w/o even looking and the numbers I suspect that’s not going to pencil out.

[Mr_Brightside]

The major problem with a commercial condo is any decent business will need both capital for the actual business and will probably outgrow their space if they are successful.

Both of these are pretty much in conflict with buying a commercial condo.

If they were cheap enough to buy and rent out then that’s a different story. For some reason w/o even looking and the numbers I suspect that’s not going to pencil out.

[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.

[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

[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.

[FoamFinger1]

Great post Davelj, I posted several weeks ago regarding the Avalon condo project in Pacific Beach. This project and the Balboa Park project by Mayfair Homes seems to fit your observation perfectly.

[patientlywaiting]

Heads the developer wins; tails the bank (and non-developer equity investors) loses.

1) Why doesn't the bank ask for a personal guarantee?  

2) Are there usually loan requirements such as  pre-construction sales targets, and periodic principal paydown, that, if not met, would allow the bank to call the loan.  

3) What are the criteria for lending to the local developers?  Reputation? Net-worth of the principal?  I heard that, in Florida, one developer borrowered several hundred million dollars and failed without building much.  He had limited experience but was a good talker. 

[davelj]

pw, all very logical questions. Indeed, how does this situation come about? One word: Competition.

I’ll elaborate.

Six+ years ago if Bill Developer wanted a loan from Joe Banker, Bill had to put up 20% equity, a personal guarantee, limit his own developer fees and offer up a very detailed absorption (sales) schedule, etc. etc. But as more and more potential projects sprouted up, and as competition got really stiff on plain vanilla CRE loans (the bread and butter for local lenders), banks started into the construction lending arena barrells a blazin’, and started relaxing terms and covenants for construction loans such that by 2005 the underwriting was a joke. As of 2005 the typical construction loan required just 10% equity, no personal guarantee, no material limitation regarding developer fees, etc. Basically, competition for the loans led to crappy underwriting. Now, just as in the SFR market, construction underwriting is returning to something resembling the prudence of yore. The problem, of course, is that – as usual – the barn door is being shut long after the horses have crossed the Canadian border.

What are the criteria for developers? Well, there is an appraisal. These are of varying quality. As I explained, the developer does have to put up equity, although that percentage hit is trough in 2005. Other than these purely financial issues, the experience of the borrower is probably the most critical issue. If the developer has a lot of successful projects it can point to, it helps a lot. The problem is that there are a LOT of developers – especially here in SoCal – that have nine financial lives. They did a few good projects in the late-80s then blew up in the 90s. Then they re-invented themselves and did some good projects in the late-90s and early-2000s and now they’ll blow up their bankers again. Then they’ll be back to the trough in about five years to do it all over again… sad but true. Memories tend to be very short in the financial world. Just look at the stock market.

[patientlywaiting]

Great post. Thanks for sharing.

I guess the easy money permeated all sectors of the real estate industry (and the economy as a whole). It’ll be interesting to see how this unfolds.

[patientlywaiting]

Great post. Thanks for sharing.

I guess the easy money permeated all sectors of the real estate industry (and the economy as a whole). It’ll be interesting to see how this unfolds.

[Bugs]

Great explanation. If Rich had emoticons on this board I’d be looking for the one that applauds.

What really gets me is the perception out there that the commercial markets are somehow more stable or even disconnected from the residential markets. Idiots.

[HereWeGo]

I think I’d want an emoticon where my jaw bounces off the floor. I had no idea underwriting collapsed in the CRE realm.

[patientlywaiting]

Bugs, you made an interesting point when you said “I don’t have to worry about the federal banking regulators associating my name with those bad deals.”

As we all know, appraisers were key in making deals happen.

I wonder if lenders are developing risk management systems to better underwrite future loans so they can identify deals from realtors, brokers, appraisers, and mortgage brokers, whose transactions consistently go in default.

We rate our schools, teachers and principals by graduation rates; so why not rate the people who initiate real estate transactions the same way by?

The US government uses software to track down terrorists and you’re guilty by association.

Could the FBI not track down the fraudsters the same way? For example if 90% of a Realtor’s transactions end up in foreclosure, that should immediate raise a red flag. By triangulating, law enforcement could easily identify the people who facilitated fraud and put them jail.

If anything, Banks should develop internal risk management systems so they can avoid writing loans on transactions initated by “at risk” individuals.

[Bugs]

The way I see it we’re in the information age and I’m a vendor in the information business. I’ve always operated off the assumption that these bankers and these regulators can and will develop those types of analyses when it suits them to do so. If/when that happens they’re going to have a long memory, and I don’t want to be part of bad memories at the institutional level.

[Bugs]

The way I see it we’re in the information age and I’m a vendor in the information business. I’ve always operated off the assumption that these bankers and these regulators can and will develop those types of analyses when it suits them to do so. If/when that happens they’re going to have a long memory, and I don’t want to be part of bad memories at the institutional level.

[patientlywaiting]

Bugs, you made an interesting point when you said “I don’t have to worry about the federal banking regulators associating my name with those bad deals.”

As we all know, appraisers were key in making deals happen.

I wonder if lenders are developing risk management systems to better underwrite future loans so they can identify deals from realtors, brokers, appraisers, and mortgage brokers, whose transactions consistently go in default.

We rate our schools, teachers and principals by graduation rates; so why not rate the people who initiate real estate transactions the same way by?

The US government uses software to track down terrorists and you’re guilty by association.

Could the FBI not track down the fraudsters the same way? For example if 90% of a Realtor’s transactions end up in foreclosure, that should immediate raise a red flag. By triangulating, law enforcement could easily identify the people who facilitated fraud and put them jail.

If anything, Banks should develop internal risk management systems so they can avoid writing loans on transactions initated by “at risk” individuals.

[HereWeGo]

I think I’d want an emoticon where my jaw bounces off the floor. I had no idea underwriting collapsed in the CRE realm.

[Bugs]

Great explanation. If Rich had emoticons on this board I’d be looking for the one that applauds.

What really gets me is the perception out there that the commercial markets are somehow more stable or even disconnected from the residential markets. Idiots.

[davelj]

pw, all very logical questions. Indeed, how does this situation come about? One word: Competition.

I’ll elaborate.

Six+ years ago if Bill Developer wanted a loan from Joe Banker, Bill had to put up 20% equity, a personal guarantee, limit his own developer fees and offer up a very detailed absorption (sales) schedule, etc. etc. But as more and more potential projects sprouted up, and as competition got really stiff on plain vanilla CRE loans (the bread and butter for local lenders), banks started into the construction lending arena barrells a blazin’, and started relaxing terms and covenants for construction loans such that by 2005 the underwriting was a joke. As of 2005 the typical construction loan required just 10% equity, no personal guarantee, no material limitation regarding developer fees, etc. Basically, competition for the loans led to crappy underwriting. Now, just as in the SFR market, construction underwriting is returning to something resembling the prudence of yore. The problem, of course, is that – as usual – the barn door is being shut long after the horses have crossed the Canadian border.

What are the criteria for developers? Well, there is an appraisal. These are of varying quality. As I explained, the developer does have to put up equity, although that percentage hit is trough in 2005. Other than these purely financial issues, the experience of the borrower is probably the most critical issue. If the developer has a lot of successful projects it can point to, it helps a lot. The problem is that there are a LOT of developers – especially here in SoCal – that have nine financial lives. They did a few good projects in the late-80s then blew up in the 90s. Then they re-invented themselves and did some good projects in the late-90s and early-2000s and now they’ll blow up their bankers again. Then they’ll be back to the trough in about five years to do it all over again… sad but true. Memories tend to be very short in the financial world. Just look at the stock market.

[patientlywaiting]

Heads the developer wins; tails the bank (and non-developer equity investors) loses.

1) Why doesn't the bank ask for a personal guarantee?  

2) Are there usually loan requirements such as  pre-construction sales targets, and periodic principal paydown, that, if not met, would allow the bank to call the loan.  

3) What are the criteria for lending to the local developers?  Reputation? Net-worth of the principal?  I heard that, in Florida, one developer borrowered several hundred million dollars and failed without building much.  He had limited experience but was a good talker. 

[FoamFinger1]

Great post Davelj, I posted several weeks ago regarding the Avalon condo project in Pacific Beach. This project and the Balboa Park project by Mayfair Homes seems to fit your observation perfectly.

[Author]

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