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Bugs.
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AuthorPosts
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October 18, 2007 at 4:13 PM #10667
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October 18, 2007 at 4:31 PM #90000
patientlywaiting
ParticipantExcellent 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.
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October 18, 2007 at 4:47 PM #90008
davelj
ParticipantActually, 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.
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October 18, 2007 at 4:47 PM #90017
davelj
ParticipantActually, 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.
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October 18, 2007 at 7:03 PM #90042
Raybyrnes
ParticipantSo 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-
October 19, 2007 at 11:40 AM #90163
davelj
ParticipantIf 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.
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October 19, 2007 at 11:40 AM #90173
davelj
ParticipantIf 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.
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October 18, 2007 at 7:03 PM #90051
Raybyrnes
ParticipantSo 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
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October 18, 2007 at 4:31 PM #90009
patientlywaiting
ParticipantExcellent 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.
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October 18, 2007 at 4:40 PM #90006
Stu949
ParticipantInteresting 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.
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October 18, 2007 at 4:49 PM #90010
HereWeGo
ParticipantYikes. 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?
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October 18, 2007 at 4:49 PM #90019
HereWeGo
ParticipantYikes. 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?
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October 18, 2007 at 5:57 PM #90026
Mr_Brightside
ParticipantThis 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.
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October 18, 2007 at 6:04 PM #90030
Mr_Brightside
ParticipantI’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.
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October 18, 2007 at 6:04 PM #90039
Mr_Brightside
ParticipantI’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.
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October 18, 2007 at 6:16 PM #90034
Bugs
ParticipantThe 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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October 18, 2007 at 6:26 PM #90036
Mr_Brightside
ParticipantThe 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.
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October 18, 2007 at 6:26 PM #90045
Mr_Brightside
ParticipantThe 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.
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October 18, 2007 at 6:16 PM #90043
Bugs
ParticipantThe 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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October 18, 2007 at 5:57 PM #90035
Mr_Brightside
ParticipantThis 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.
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October 18, 2007 at 4:40 PM #90015
Stu949
ParticipantInteresting 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.
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October 19, 2007 at 1:02 PM #90183
FoamFinger1
ParticipantGreat 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.
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October 19, 2007 at 2:11 PM #90193
patientlywaiting
ParticipantHeads 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.
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October 19, 2007 at 2:48 PM #90205
davelj
Participantpw, 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.
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October 19, 2007 at 3:05 PM #90209
patientlywaiting
ParticipantGreat 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.
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October 19, 2007 at 3:05 PM #90220
patientlywaiting
ParticipantGreat 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.
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October 19, 2007 at 3:12 PM #90211
Bugs
ParticipantGreat 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.
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October 19, 2007 at 4:35 PM #90235
HereWeGo
ParticipantI think I’d want an emoticon where my jaw bounces off the floor. I had no idea underwriting collapsed in the CRE realm.
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October 19, 2007 at 6:04 PM #90247
patientlywaiting
ParticipantBugs, 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.
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October 19, 2007 at 7:19 PM #90266
Bugs
ParticipantThe 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.
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October 19, 2007 at 7:19 PM #90275
Bugs
ParticipantThe 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.
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October 19, 2007 at 6:04 PM #90258
patientlywaiting
ParticipantBugs, 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.
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October 19, 2007 at 4:35 PM #90246
HereWeGo
ParticipantI think I’d want an emoticon where my jaw bounces off the floor. I had no idea underwriting collapsed in the CRE realm.
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October 19, 2007 at 3:12 PM #90222
Bugs
ParticipantGreat 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.
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October 19, 2007 at 2:48 PM #90216
davelj
Participantpw, 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.
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October 19, 2007 at 2:11 PM #90204
patientlywaiting
ParticipantHeads 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.
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October 19, 2007 at 1:02 PM #90194
FoamFinger1
ParticipantGreat 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.
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