"Most of the time, when a bank owns something and sells it, they take about a 20-30% haircut in the market," Weigel said. "Then they're going to be exposed to additional costs for warranty and other obligations that continue after those houses are sold."
Weigel highlighted the case of a hypothetical builder whose numbers were based on what Shinn Consulting's clients are facing. That builder has seven closed homes, 10 more under construction, and six under contract that haven't been started yet. The builder also has seven spec homes and a second phase of development of 30 lots that are about 60% of the way toward entitlement.
Looking at the 10 homes under construction (each with an approximate price tag of $200,000): the builder owes its lender $925,000 of debt on them, and it will cost the builder another $675,000 to complete the homes, making the lenders' exposure $1.6 million. If the builder were allowed to complete the homes and sell them, they could generate $2 million to pay back the bank and have money left over. However, if the bank took the development, it could cost that bank as much as an additional $1 million, on top of its $1.6 million loan, with a maximum return of $2 million.
That is the case, Weigel said, that builders must make to their banks.
The builder's 30 lots under development have already lost 50% of their value from their peak and are now worth only $25,000 when entitled. But since they are only partially entitled, it will cost another $300,000 to finish developing those 30 lots. So that $300,000 has to be subtracted from their value, leaving their current value at $400,000 total, or $15,000 a lot.
If the lots were sold to a developer who would take on the project and have to build its own overhead and profit costs into the project, then the value decreases further. With Weigel's calculations, selling those partially developed lots in this market could yield maybe $190,000, or $3,700 per lot, just 15% of the potential value of the lots if they were sold as finished, and just 7.4% of their peak value of $50,000.
Raw land that has not been improved at all is now literally worthless, Weigel said. The cost to develop raw dirt in many places is either equal to or greater than the potential value of the land.
Weigel advised builders to try to tailor their business models to acquire land just in time, instead of buying, holding, and developing land, as has been the standard model in home building and a practice that has led to countless builder failures and massive debt loads.
Weigel also gave a last bit of advice, about how to tell when the market is coming back. He suggested that the builders track existing neighborhoods that tend to sell well in their areas and calculate the price per square foot on a monthly basis of similar homes that have sold.
"Once those per-square-foot values start increasing just a little bit, then you've probably turned around," Weigel said.
Ethan Butterfield is senior editor, business, for BUILDER magazine.