Remember the early '90s? Builders went bankrupt, as did savings and loans. In the end, the federal government took over real estate and auctioned it off for pennies on the dollar. There's no way this cycle could be as bad, right?
The recent chaos in the capital markets has flipped a switch that could, in worst-case scenarios, lead to the same nightmare industry veterans went through in the early '90s: the days of the Resolution Trust Corporation.
Already, slow sales and declining land prices have bounced highly leveraged builders back to their banks to renegotiate covenants that they've tripped. So far, the banks have cooperated. But with the capital crunch leading to stringent oversight from their regulators, home-sale cancellation rates rising, and sales rates slowing even more, builders are exposed to more risk than they have been in over a decade.
Those in the best condition are the well-capitalized builders who took the profits they collected through 2005 and hoarded them. They're just waiting for land prices to fall so they can snatch up real estate for the market rebound that most believe is bound to materialize, at least at some point during the next two to five years.
"The smart builders understood what was developing and knew it wasn't going to last forever," says Bert Ely, a Reston, Va.-based home building industry consultant. "They had to hunker down and get ready to ride through a tough patch."
For those home building companies that overextended themselves by scooping up too many assets, trouble could be imminent. "If a builder is highly leveraged, there are questions about their value and liquidity; then you're going to have a serious problem," Ely says. "This is the time a conservative balance sheet pays off in terms of getting credit."
Highly leveraged builders are doing whatever it takes to keep their businesses viable, including renegotiating debt covenants, selling off assets, closing offices, and laying off employees. However, one more market move downward could land their businesses in bankruptcy.
"There's going to be a significant transference of wealth," says Jamie M. Pirrello, CEO of Vision Homes in Ft. Myers, Fla. "If you get caught in a downturn and you run out of capital, then it could be all over. This is going to be a difficult time for home builders and their lenders." Still, Pirrello notes that there is opportunity for opportunism. "Those who have capital can buy at pennies on the dollar," he says.
Steps to Recovery
Many builders became more closely acquainted with their lenders in early 2007. The reason: Lenders reassessed lot values in response to the sluggish market, and prices came back much lower than they were in 2005 and 2006. That left some builders with serious problems.
"Banks are asking for new appraisals on any assets owned," says Vision Homes CEO Jamie M. Pirrello. "As prices go down for land and homes, all of a sudden you have a situation where you may be borrowing more money than you're technically allowed to, based on the new, lower appraised value. That creates what's almost like a margin call."
That was seven or eight months ago. Now, after the capital markets stumbled in August, banks are starting to take an even harder stance with some of their builder-borrowers.
"There are a lot more questions, a lot more analysis, and a lot more thought, and a little more head scratching as we get new requests," says R. Bird Anderson, Jr., senior vice president for Wachovia Real Estate Financial Services.
But banks aren't bailing on builders yet. "Banks are always more than willing to work with builders when they know the builder will do what it takes to get the project done, is on the jobsite keeping it moving, and is making sure it looks good," Anderson says.
In other words: If your bank is still talking to you, it's a good sign.
"When the bank says no, that's an indication that they don't find you to be credible and that they've lost trust," Pirrello says.
How to avoid that first "no?"
Based on interviews with builders and lenders, here are 10 strategies to keep the bank at bay:
1 Early Warning: When you see that traffic or sales are moving slower then you anticipated, make sure your lender knows. "The earlier we can be made aware of situations that are unexpected or not up to the original expectation, the better," Anderson says.
2 Be Open: In troubled times, banks stick by the builders they can trust. To earn that faith, you may need to open up your books or invite the lender in to watch your operation. That's what Ken Neumann, CEO of Chicago-based Neumann Homes, did when he faced difficulty. "When things get tough, people wonder what you're really doing," he says. "I told them, 'You guys are welcome to put someone inside my business any day you want.'"
3 Show Discipline: Banks are also more likely to trust builders they think are regimented. "The builder needs to look at overhead by proposing cuts and making changes to lower their monthly payments," Pirrello says.
4 Shrink Your Debt: Sometimes banks will feel better about your risk situation if you lower your line of credit or the amount of assets you control. "The builder's first approach is not to give anything," Pirrello says. "The builder asks, 'Why don't we change the maximum I can borrow or change how many lots I can control?'"
5 Add Something: For most builders, the time to tweak covenants by cutting credit limits passed earlier this year. As the market situation worsens, the banks want more skin in the game. Unless a deal is lowly leveraged, the builder will probably have to contribute something. "The builder may have to bring in some other form of collateral," Anderson says. "They may need to bring in additional capital to serve an interest reserve."
6 Fire Sale: In this climate, many private builders don't have a lot of capital to give the bank. That means they have to dump their homes and lots, even if it's for a fraction of the original asking price. "Start cutting prices, and try to move homes to generate cash," Pirrello says. "You'll get absorption and get the cash out of your homes under construction."
7 Don't Sugarcoat It: Going through covenant renegotiation, it's best to stay conservative when you pro forma future sales. "The builder needs to create a new forecast and projections that are realistic," Pirrello says. "Don't paint a rosy picture. Even though it feels counterintuitive, you're better off being very realistic in your numbers."
8 Build for a Fee: Even if the bank does have to take over the builder's assets, the builder may still be able to finish out the project. "If the builder doesn't have cash, the smartest thing the bank can do–if they have confidence in him–is to have him become a fee builder," says John Burns of Irvine, Calif.-based John Burns Real Estate Consulting. "Pay him a little money to finish the project, and give all proceeds to the bank."
9 Consider Other Capital: There's a lot of private equity looking to partner with distressed builders–for the right return. To some, these guys are lifesavers. To many builders, they're vultures. "Private builders will try to find partners to bring in capital," Pirrello says. "They'll sell all or a portion of the company."
10 Avoid Default: If you want to stay in business, do whatever you can to avoid defaulting. "You don't want to be put into default," Pirrello says. "If there are any defaults, it's a house of cards."