In exchange for the loan of a cart load of limestone and shale, the builder offered the quarry master his old and faithful mule. "I shall pay thee threefold on the morrow and regain my mule." But that night it rained on the cart, and he lost his ass. Best Defense: Multiply Your Money Sources.

Money Talks

Financing is simply too critical to trust to just one banker, even when times are good.

By Alison Rice

To Jim Pugash, few home-building financing horror stories can compare with the reality of the early 1990s.

"The investors were running out of money--the S&Ls were going bankrupt," says Pugash, CEO of Hearthstone, an institutional residential real estate investment firm based in San Francisco. "The builders couldn't get any more money, but they couldn't get control of the project either."

Luckily for builders, that's no longer the case. But financing still presents its own challenges for an industry as capital-intensive as home building.

For small builders, banking mergers and acquisitions often result in the abrupt severing of a long-term relationship with a single banker. "What lenders encourage builders to do now is foster relationships with several different people--the loan officer, the secretary, the president--because not only are human beings disappearing [because of mergers], but the decisions are also being made miles away," says Michelle Hamecs, assistant staff vice president in housing finance at the NAHB.

Fatal FlawsContents

Banking consolidation has hit big builders, too. "Once you get very large, banks are harder to find," says Pugash. "We have two bank lines of $500 million, and there are only three bank syndicates that are that large. And they're lending to every builder we know." (Public builders, of course, have more and longer-term financing options.)

Finally, many banks are moving away from the riskiest sector of home building: land acquisition and development, just as builders become caught in the land crunch.

To avoid financial extinction, builders need to get informed. "There are so many banking opportunities that don't get down to the level of the builder," says Gage Prichard Sr., president of Gage Homes in Dallas and a member of the NAHB's Housing Finance Committee. "[Builders] either don't know about them, or the banker doesn't push them because of the risk associated with real estate."

Here's what builders can do:

Research and negotiate. This applies primarily to small builders in rural areas, who may end up paying higher interest rates than their metropolitan counterparts because of limited competition. "When you hear about builders paying prime or LIBOR [the London Interbank Offering Rate, which has fixed interest]," Prichard says, "you can visit your banker with a little more knowledge."

Develop new relationships. Don't rely on just one bank for all your financing needs.

Establish a line of credit. Constantly negotiating for financing on a deal-by-deal basis costs you time and fees.

Shift risk to the home buyer. Financing options such as construction-to-permanent loans combine the builder's construction costs with the buyer's mortgage, rolling them into one transaction. "You take the carrying costs off the books, and the risk is on the customer, not [the builder]," says Stuart Tyrie, vice president of Des Moines, Iowa-based Wells Fargo Home Mortgage's national builder division.

Depending on the project, though, builders may want to explore alternatives to commercial banks, especially if they do affordable housing. For such product, government and nonprofit funding may supplement or replace bank financing entirely.

In the Black--or the Red?

The debt-to-equity ratios of large public builders usually run 1:1 or less, but it's a different story with their private counterparts. "Private builders are rarely that low," says Hearthstone's Jim Pugash, who has seen ratios as high as 10:1.

But that ratio is only a starting point for evaluating a builder's financial health, Pugash says. "How much cash is available? What is the builder invested in? If he's all in land, that's not good. What price segment is a builder in? Is he building entry-level, which is the thickest part of the market, or is he doing $5 million spec homes?"

In the end, even if an investor approves, the builder still needs to decide whether to accept the deal. "You can get overextended," Pugash says.

"Most of the money is geared toward making the unit cheaper, so the land is written down, and the builder gets an ordinary profit rate," says William Apgar, senior scholar at Harvard University's Joint Center for Housing Studies in Cambridge, Mass. "No one expects anyone to build these for free."

Government money. State and local housing finance agencies may have money to lend for projects geared toward low- to moderate-income buyers. These programs may also include home buyer financing. "There's a little bit of hassle here, and the money's not guaranteed," admits Apgar. "But a lot of builders are finding the affordable market can be profitable."

Community development funding. Banks may fund affordable projects; federal regulations require them to meet mortgage and credit needs of low- and moderate-income consumers. The Federal Home Loan Bank system, for example, provides roughly $300 million annually for affordable housing.

Nonprofit organizations. Many nonprofits focus primarily on buyers, but these programs (such as Sacramento, Calif.-based Nehemiah Corp., which provides down-payment assistance to home buyers through sellers' contributions) may help builders sell properties more quickly, reducing carrying costs.

Mezzanine debt. This isn't the best option for affordable projects because of the costs involved, but it works for higher-margin product. If a builder needs just slightly more money than a bank's willing to lend, he could explore mezzanine debt, or gap financing, which has a fixed interest rate with a share of the profits. "For a small- to medium-sized builder, it makes a lot of sense," says Steven Friedman with Ernst & Young in McLean, Va.

Equity investment. For large projects, builders may want to seek an equity investor such as Hearthstone, which covers 95 percent to 100 percent of the project's costs. Do your own due diligence, though, so neither you nor your investor is surprised by higher-than-expected amenity costs, zoning or land development issues, endangered species habitat, or late-breaking lawsuits. "This can be fairly technical stuff, but it can be killer," Pugash says.

Financing Sources

Builders' primary source of construction credit.

Commercial banks 83%
Mortgage companies 9%
Finance companies 4%
Others 4%
Gone to the bank:

Commercial banks provide the lion's share of construction financing for builders. Builders

also look to banks for land acquisition (82.4 percent cite banks as their

primary source of such financing) and land development (73.3 percent), according

to a late-2001 NAHB survey.

Note: The above figures do not add up to 100 percent due to rounding.

Source: NAHB Quarterly Financing Survey, 4Q 2001