Pay to Play

AMCAL MULTI-HOUSING, A LONG-TIME home builder in Southern California, decided in 1997 to leave the for-sale business. The company wanted to concentrate its efforts on building affordable rental projects that it had financed through the state's highly competitive and complicated low-income tax credit program.

But a new project—and a new financing option—lured Amcal back to the for-sale market. Last year, as the company planned to build a rental project on seven acres in downtown Los Angeles adjacent to the city's subway system, the city asked Amcal to dedicate part of the development to for-sale housing.

Amcal knew how to build and sell the for-sale units from its earlier days, but it needed financial backing. That's when Percy Vaz, Amcal's president, turned to the Phoenix Realty Group, managers of the Genesis LA Workforce Housing Fund. The $100 million fund is believed to be the first to focus exclusively on housing geared toward people earning between 80 percent and 200 percent of the Los Angeles area's median income.

For Amcal, the fund is a great fit. The $6 million Phoenix kicked in for the 165-unit project closed the gap between a bank loan and the builder's own equity, and the Avenue 26 condominium project, the Los Angeles development, will move the builder closer to its goal of closing 2,000 units a year by 2009 (it closed about 900 in 2004 and expects to deliver the Avenue 26 units in late 2005 and early 2006).

OPPURTUNITY KNOCKS: Investment from a new workforce housing fund facilitated Amcal Multi-Housing's Avenue 26 condominum project, which is being built on the former site of a furniture factory.

What's more, the Genesis LA Work-force Housing Fund and others like it represent new financing options for mid-sized builders. Too small to acquire other builders and uninterested in growing by becoming part of larger ones, these companies sometimes struggle to find the funding they need to be able to grow at the pace they want. Often, they find they can't rely only on the capital sources they've used as start-ups.

Banks traditionally will not lend a project's full value, and a network of friends and family taps out quickly when builders look to increase production by 100 units a year. Even in these days of rapid profit increases, retained earnings usually fail to provide sufficient capital for builders who want to branch out to new markets or double capacity within a few years' time.

But there's good news for these hungry builders: Their access to institutional sources of capital like the Genesis fund, has increased substantially. After the stock market tumbled, investors began looking for new vehicles, and they've funneled millions into real estate. “Real estate has very much become a favored asset class for pension funds because it's perceived to be safe,” says Nicole McAllister, executive director of development and external affairs at the University of Southern California's Lusk Center for Real Estate.

Mid-sized builders have been lucky, too, that low interest rates have made it less expensive for them to take on mezzanine debt, which many of those new funds issue as short-term, three- to five-year loans. Though it generally comes with higher rates than senior bank debt—which must be repaid first—it makes many projects possible by bridging the gap between bank loans and builders' retained earnings.

Builders can expect tough competition for those dollars, though. One factor weighs more than most others for both institutional investors and bankers evaluating possible deals. “We think a home builder organization is no better or worse than its management team,” says Bob Johnson, division executive in Bank of America's home builder division of commercial real estate banking.

Bank of America works with 1,700 home builders nationwide, from the smallest local builders to national companies. Regardless of how much institutional capital mid-sized builders can access, they will always need relationships with banks to bankroll large portions of their projects. Johnson's division issues senior debt with a variety of loans for land acquisition, development, and construction.

His division is augmented by institutional funds available through a corporate sibling, Banc of America Securities investment bank. “[Senior] debt is key, but it's not enough,” Johnson says. (The bank also has an interest in offering other investment options, which generate more income than standard senior construction loans.) The investment bank makes home building deals that involve institutional term debt—debt on par with traditional senior debt but packaged and sold in a secondary market to investors—mezzanine debt, and pure equity plays.

The combination of finance products offered by a bank suffices for some builders. For Stephen Anderson, president and owner of Wilmington, Del.–based Anderson Homes, it makes sense to stick with his hometown bank, Wilmington Trust. The lender knew Anderson from his days heading a division of Pulte and trusted his success would carry over to his own company. It was right: Now in its fifth year, Anderson Homes closes about 250 homes a year and posted about $75 million in revenue last year.

“They are my sole source of financing to this day [because] they were there when I opened. They're more like a partner than they are a bank,” Anderson says. There's an added benefit to the choice, too. “The money made here stays here. It's an opportunity for them to invest in the community,” he adds.

Hearthstone no doubt tops many builders' lists of financiers they'd love to work with. But Hearthstone, the nation's largest institutional investor in residential real estate, can afford to be discerning.

Projects geared toward a wide cross section of buyers are most likely to pass Hearthstone's muster, says Anthony Botte, senior vice president for Hearthstone's western U.S. region. “We do evaluate project by project,” he says. “But we like the core market kind of deals. They're a little more predictable.”

Hearthstone compares potential builder partners against high standards. Almost all the builders Hearthstone chooses gross at least $50 million annually; most make more than $200 million. “We're looking for longer track records, with solid financial success over an extended period of time,” explains James Pugash, Hearthstone's chairman and CEO.

Once Hearthstone has evaluated the builder itself, it considers market conditions, the project location, and the duration of the investment. “We don't mind [projects] being large, between 500 and 700 lots, but we want to see multiple product types so they will be completed in 36 to 48 months,” Pugash says.

Builders venturing into new product types may be encouraged by the fact that Hearthstone, too, has increased its backing of infill and multifamily projects (for sale, not for rent).

But there's a wrinkle—or two: At most, Hearthstone works with two or three new builders a year. What's more, the company makes a deal only if it sees potential for multiple deals in the future. It's crucial, Pugash explains, that builders approaching Hearthstone want more than money—that they want a relationship. “There are quite a few builders who would meet our criteria, but they only come to us with an urgent need to get a deal that they haven't been able to get done anywhere else,” he says.

Hearthstone recently inked a $15.8 million deal with first-time partner Capital Pacific Homes to build 100 homes in Lompoc, Calif. The Newport Beach, Calif.–based builder, with operations in five western markets, is a good match for Hearthstone because of its strong knowledge of the market and solid operations, Botte says.

Capital Pacific, which has financed similar projects through a syndicated line of credit and other joint venture and equity deals, approached Hearthstone after talking with them for several years. “We know the kinds of deals they'd be comfortable with,” says Steve Spelman, the company's CFO. “This one fits the bill.” The homes will be priced from the high $400,000s to $600,000, and deliveries will begin in early 2006.

When Phoenix Realty Group began examining the Los Angeles market, it found land affordable enough on which to build entry-level homes. CEO Michael Fried and his colleagues also found builders taking advantage of those opportunities—but on a scale too small to make a real dent in the need for workforce housing in the area. “They were capital constrained,” Fried explains. “And there was no institutional source for that equity.”

Fried saw his firm's skill in being able to bridge institutional investors and mid-market builders, and Phoenix has gotten a good start. In addition to the Genesis LA Workforce Housing Fund, the firm also manages the San Diego Smart Growth Fund. When fully capitalized, it will have $60 million to invest in residential and commercial redevelopment projects in San Diego.

The firm has done well to fill in the gap Fried noticed: Each of Phoenix's deals thus far has been in the $3 million to $6 million range.

Builders that most interest Phoenix already work in the market and know how to maneuver through the process of building infill or redevelopment projects, though the product—for-sale condos, for example—may differ slightly from what they've done in the past.

Phoenix closed its second deal through the Genesis fund with Urban Pacific Builders, a five-year-old company, based in Long Beach, Calif., that's projecting a “monumental jump” to more than 300 closings in 2005. CityView Lofts, a conversion of a historic building in downtown Los Angeles to 40 live/work lofts, is similar to two other loft projects Urban Pacific has done, but the financing improved greatly, says Scott Choppin, managing partner of Urban Pacific.

In its first loft project four years ago, Urban Pacific cobbled together tax-exempt bonds, state funding for downtown redevelopment projects, and low-income tax credits. “It was the only way we were going to get the deal done,” Choppin recalls.

When the builder moved on to its second loft project a year ago, the capital markets had matured enough to allow Urban Pacific to move beyond bonds and tax credits to more conventional debt and equity, but the project type still encountered some resistance. “On the debt side, we had a tougher time convincing people of the viability of the market,” Choppin says.

But this time was different. Bank of America eagerly put up the construction loan, and Phoenix filled in the rest. “Urban housing is more mainstream than it was five years ago,” Choppin says. “But with the Phoenix money, we're going to be able to do deals that are a little more urban, a little grittier than the more institutional mentality.”

The factors that broadened access to capital for more mid-sized builders—namely, faith in a stable housing market and low interest rates—may be fading. Rates are edging up, and some economists fear prices may be on their way down in some markets.

Botte is keeping his eye on deals in the Southern California market. “There comes a point where the amount of runup and people's incomes have not kept up,” he says.

The risks associated with potential builder partners in those markets will be analyzed even more closely, Botte says, and he expects to close smaller deals, both in terms of units and dollars. “We're looking toward three years or less. We can judge the here and now,” he adds.

Bank of America's Johnson believes the positive changes he's seen in the housing market are here to stay. “At the end of the day, it becomes a question of end demand. It seems that in the intermediate and long term, the industry has a bright future,” he says, adding hopefully, “We have interest in that being the case because we've put a lot of capital into the industry.”

A crash course on real estate development helps executives learn the business.

Success in real estate development comes from more than skill in construction, finance, and sales. Twice a year, classes of about 25 real estate professionals learn just that in the University of Southern California's Lusk Center for Real Estate's Ross Minority Program in Real Estate, designed to teach the ins and outs of urban development.

Students—most of whom have prior experience in some aspect of real estate—learn about a wide range of topics such as feasibility analyses and delivering units. Finance comprises much of the curriculum, but the program takes participants beyond books; real investors interested in making deals attend the sessions as guest speakers and meet students over networking dinners.

“The most important part of the program is creating the network,” says Nicole McAllister, the Lusk Center's executive director of development and external affairs, who adds that having more than 300 fellow alumni gives participants a ready supply of colleagues from which to build development teams.