Get your seat belt on, because 2008 is going to be a rough year as liquidity evaporates and bank-dependent builders struggle to stay alive. As pressures mount, banks will be forced to re-evaluate real estate holdings and make tough decisions on loans. During that process, banks should be fairly amenable toward builders who violate covenants that have unsecured borrowings, assuming asset values exceed debt levels and cash flow is adequately prevalent to make payments. On the other hand, some banks—looking to reduce their exposure to residential loans—are expected to shut down lending in select markets, move loans into workout, and foreclose on many projects. The reality is that the banks hold the cards, and many industry participants will not survive this downturn.
Recent land transactions that have occurred at severely discounted prices have provided a catalyst for banks to remargin loans, move loans into asset recovery programs, and even foreclose where the builder is still performing on the loan.
Private builders that are primarily project-financed are feeling the greatest pain as many are forced to repay the banks each time a home is sold, and in some cases the payment is more than the closing price. This makes it difficult for the private builders to stay competitive from a pricing standpoint.
As liquidity evaporates from the market, the old, familiar bull tenet repeatedly conveyed by the public builders during the boom—that their capital structure gave them a major advantage—is finally coming to fruition. However, the publics are by no means out of the woods, with many currently attempting to renegotiate bank agreements as covenants are violated primarily due to continued asset impairments and losses on land sales. In addition, all of the publics are still suffering with trough-level absorptions and pressure on home prices. Nevertheless, the publics are still better positioned than most private builders as the majority of their long-term debt is not coming due for a few years, and their short-term borrowings are from unsecured working capital lines backed by a consortium of banks.
I do expect the banks to be more lenient with the publics, as most of them have unsecured revolvers with already impaired asset values that still exceed total debt and little to nothing outstanding on the lines. Therefore, as long as the builder is making payments and working to reduce its debt burden, the banks have no motivation to force it into bankruptcy. A reorganization would only put the short-term creditors on par with the long-term senior bond holders, who would also be attempting to recover their investments in that scenario. The more favorable action by the banks would be to use the renegotiation process as an opportunity to get better terms such as higher pricing, reducing the size of the credit line, or prioritizing the builder’s use of cash flow to repay bank debt first. If all else fails, I believe the builder could securitize a portion, or all, of its revolver against its assets.
While privates and a few select publics are very much at the mercy of the banks as the housing market continues to deteriorate, I believe the crisis in the market could ultimately be used to a builder’s advantage, as well-capitalized builders find themselves able to accumulate option contracts at very favorable terms or even begin to purchase discounted land when the time is right. B