Ground Floor Observations on Construction and Local Banks

[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.

[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

[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.

[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.

[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. 

[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.

[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.

[Author]

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