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October 19, 2007 at 2:48 PM in reply to: Ground Floor Observations on Construction and Local Banks #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.
October 19, 2007 at 2:48 PM in reply to: Ground Floor Observations on Construction and Local Banks #90216Participantpw, 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.
October 19, 2007 at 11:40 AM in reply to: Ground Floor Observations on Construction and Local Banks #90163ParticipantIf 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.
October 19, 2007 at 11:40 AM in reply to: Ground Floor Observations on Construction and Local Banks #90173ParticipantIf 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.
Participantgolfgal, if there were an award given for verbosity en route to unintelligible gibberish, I would nominate you. And, believe me, there’s plenty of competition here on the internet.
Despite all of the obfuscation in your recent posts, this issue is really simple. You made a point. It’s patently clear to anyone at a high school reading level the point you were trying to make. When I clearly revealed that your point was ridiculous, you then proceeded to backpedal and re-characterize what you originally said as something different (and less ridiculous). This, as opposed to just admitting, “Oh, I guess I was wrong.”
No amount of econo-babble is going to change this fact. But in a perverse way, I’m enjoying reading as you expand the hole you’re digging for yourself in various directions. Don’t stop now.
Participantgolfgal, if there were an award given for verbosity en route to unintelligible gibberish, I would nominate you. And, believe me, there’s plenty of competition here on the internet.
Despite all of the obfuscation in your recent posts, this issue is really simple. You made a point. It’s patently clear to anyone at a high school reading level the point you were trying to make. When I clearly revealed that your point was ridiculous, you then proceeded to backpedal and re-characterize what you originally said as something different (and less ridiculous). This, as opposed to just admitting, “Oh, I guess I was wrong.”
No amount of econo-babble is going to change this fact. But in a perverse way, I’m enjoying reading as you expand the hole you’re digging for yourself in various directions. Don’t stop now.
October 18, 2007 at 4:47 PM in reply to: Ground Floor Observations on Construction and Local Banks #90008ParticipantActually, 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.
October 18, 2007 at 4:47 PM in reply to: Ground Floor Observations on Construction and Local Banks #90017ParticipantActually, 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.
Participantgolfgal, first off, I didn’t call you an idiot. I said that what you wrote was idiotic. Which it is, as I’ve explained in very clear terms. You may be a genius for all I know. But that doesn’t change the fact that there are some pretty big holes in your understanding of economics.
Secondly, your previous post is a text book example of what is known as the Straw Man Fallacy. You didn’t address the point of my post directly – that net/net wealth is often destroyed (which in your previous post you suggested was a ridiculous notion). Instead you addressed a straw man argument of your own invention – that wealth isn’t destroyed “1=1” (unit for unit, I assume) – an idea that I NEVER suggested at all in my post. In fact, I made a specific point in my BK mortgage company example of how there would generally be some (positive wealth) offset even when an asset value tanked. So to address your straw man argument directly, yeah, of course wealth destruction events aren’t 1 for 1. That’s offering up a blinding glimpse of the obvious. You’re trying to divert attention away from my response to the point that you DID make by re-characterizing my response into something I DIDN’T say. Again, classic Straw Man response.
I don’t think you need to write disclaimers, golfgal (although I often do for clarity’s sake). I just think you need to write more clearly and, more importantly, just admit when you’re wrong. I don’t have a problem with either. Somehow I manage to write more clearly than you do while at the same time using fewer words. And anyone who’s read a lot of my posts here knows that I’ve often ended posts with the following (or some derivation of it): “But I could be wrong; it wouldn’t be the first time.” Words to live by, in my opinion.
Participantgolfgal, first off, I didn’t call you an idiot. I said that what you wrote was idiotic. Which it is, as I’ve explained in very clear terms. You may be a genius for all I know. But that doesn’t change the fact that there are some pretty big holes in your understanding of economics.
Secondly, your previous post is a text book example of what is known as the Straw Man Fallacy. You didn’t address the point of my post directly – that net/net wealth is often destroyed (which in your previous post you suggested was a ridiculous notion). Instead you addressed a straw man argument of your own invention – that wealth isn’t destroyed “1=1” (unit for unit, I assume) – an idea that I NEVER suggested at all in my post. In fact, I made a specific point in my BK mortgage company example of how there would generally be some (positive wealth) offset even when an asset value tanked. So to address your straw man argument directly, yeah, of course wealth destruction events aren’t 1 for 1. That’s offering up a blinding glimpse of the obvious. You’re trying to divert attention away from my response to the point that you DID make by re-characterizing my response into something I DIDN’T say. Again, classic Straw Man response.
I don’t think you need to write disclaimers, golfgal (although I often do for clarity’s sake). I just think you need to write more clearly and, more importantly, just admit when you’re wrong. I don’t have a problem with either. Somehow I manage to write more clearly than you do while at the same time using fewer words. And anyone who’s read a lot of my posts here knows that I’ve often ended posts with the following (or some derivation of it): “But I could be wrong; it wouldn’t be the first time.” Words to live by, in my opinion.
Participantpr, I can be pretty lenient where completely idiotic posts are concerned so long as the poster doesn’t (a) hold themselves up as some kind of expert in the field (as golfgal has) and (b) belittle a particular idea when, in fact, the complete opposite is true (as golfgal did). If she wants us to believe that she holds some degree of expertise in the world of finance and that her opinions should be taken seriously then she shouldn’t post ideas that are 100% completely at odds with reality. As I’ve reiterated on occasion since I started posting here a couple of years ago, I’m often an unrepentant prick. But, then again, I’ve never had any interest in winning popularity contests.
Participantpr, I can be pretty lenient where completely idiotic posts are concerned so long as the poster doesn’t (a) hold themselves up as some kind of expert in the field (as golfgal has) and (b) belittle a particular idea when, in fact, the complete opposite is true (as golfgal did). If she wants us to believe that she holds some degree of expertise in the world of finance and that her opinions should be taken seriously then she shouldn’t post ideas that are 100% completely at odds with reality. As I’ve reiterated on occasion since I started posting here a couple of years ago, I’m often an unrepentant prick. But, then again, I’ve never had any interest in winning popularity contests.
Participantpr, I haven’t seen studies with all of these factors included. I’m sure Jeremy Grantham has a bunch of them stored away in some folder on one of his servers at GMO that we’ll never see.
To get back to this 1.36% number for a second, the other issue is that this is a REAL annualized increase in property prices. If you add in inflation, that number becomes more like 4% (or more). So, if you lever 5 to 1, borrow at 7%, come anywhere close to breaking even on a cash flow basis, and your asset value increases at 4%/year, that’s a 20% return on equity. Assume some friction and you’re down to 15%. That doesn’t seem too bad to me. Now, you gotta buy the property right, of course, which you haven’t been able to do here in SD for five years or so. But I think you see my point. In a “normal” market, real estate can be a reasonably high return, moderate risk investment. It just hasn’t been that way in SoCal for several years now. But I suspect those days will return within a few years.
Participantpr, I haven’t seen studies with all of these factors included. I’m sure Jeremy Grantham has a bunch of them stored away in some folder on one of his servers at GMO that we’ll never see.
To get back to this 1.36% number for a second, the other issue is that this is a REAL annualized increase in property prices. If you add in inflation, that number becomes more like 4% (or more). So, if you lever 5 to 1, borrow at 7%, come anywhere close to breaking even on a cash flow basis, and your asset value increases at 4%/year, that’s a 20% return on equity. Assume some friction and you’re down to 15%. That doesn’t seem too bad to me. Now, you gotta buy the property right, of course, which you haven’t been able to do here in SD for five years or so. But I think you see my point. In a “normal” market, real estate can be a reasonably high return, moderate risk investment. It just hasn’t been that way in SoCal for several years now. But I suspect those days will return within a few years.
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