Bank of America, the largest bank in the United States, is currently looking at fewer than 10 deals nationwide where it is being asked to provide financing for residential development or construction.
That in a nutshell is the state of AD&C financing for the housing industry, a topic of great concern for nearly every active builder across the country. NAHB’s new chairman Robert Nielsen recently told Builder that finding more capital sources for builders is at the top of his agenda this year.
It wasn’t surprising, then, that a seminar titled “Obtaining Financing in Today’s Market” drew an overflow crowd at the International Builders’ Show in Orlando, Fla., on Thursday morning. What that audience heard, though, was not exactly encouraging.
Yes, builders with compelling projects are finding funding for vertical and horizontal construction. And yes, capital is steadily, if slowly, returning to the housing sector. But that capital, in the main, isn’t coming from banks, and is not likely to for a few years more. The capital that is available from other investor sources can be pretty expensive and comes with strings attached that include fairly high return-on-investment expectations.
“Can you make money lending to the home building industry? That’s the big question,” said Thomas Farrell, an executive with BofA’s Home Builder division, who was one of the seminar’s panelists. He said his company is seeing more banks showing interest again in the housing markets in Texas, Northern California, and Washington, D.C., “and we’ve actually lost four or five deals to competitors.” That being said, BofA isn’t seeing a lot of AD&C action it’s been ready to jump at, especially when “builders are looking at hundreds of these deals and can’t make them work out.”
Farrell told his audience they would need to be “patient” about banks getting back into residential financing again with regularity. AD&C financing “is just rough out there,” confirmed Jeff Gersh, an area vice president with the Florida division of Shea Homes, the industry’s largest private builder. He said lenders in general are exercising far greater caution and applying “more conservative fundamentals” to justify the price of deals. And he couldn’t say with any certainty when this situation would reverse.
Nevertheless, Shea has done two deals so far this year with financing partners: it acquired 324 finished lots within an active-adult community in Lacey, Wash., near Seattle for $10.5 million via a partnership with the investment firm Angelo Gordon & Co.; and it acquired 790 finished lots in Florida with partial amenities in place for $5.3 million. (Gersh didn’t identify the financing partner in the Florida deal.)
With bank financing in short supply, builders and developers like Shea are turning with greater frequency to private equity and debt to finance their projects. The challenge for builders, Gersh explained, is matching the financing needs of a given project with the expectations of investors. And the seminar provided some insight into what criteria these providers use to decide whether a deal is worth their time and money.
John Gaghan, director of residential investments at Grosvenor Investment Management in Philadelphia, said that a fund his company raised in 2007 to invest in residential development is currently about 70% invested in 13 projects, all of which are constructing homes. His company favors investing between $3 million and $10 million in projects with between 10 and 130 lots. It expects a 20% investment rate of return (IRR) and focuses on markets “where there’s already an established price for homes.”
Gaghan noted that perhaps the single greatest impediment to his company supporting a residential project financially is the inability of the builder or developer to provide sufficient information about their project in a way that would pique Grosvenor’s interest. “Our local partners [i.e., builders or developers] might know a lot about their markets, but they aren’t as good at putting that on paper,” he explained.
“As a homebuilder, you have to give us a compelling reason why your project is going to work,” said Farrell, “because we have to be careful we’re not creating another bad loan for our portfolio.”
Charles Schwartz, co-founder of Avanti Properties Group in Winter Park, Fla., which specializes in land investment, said pretty much the same thing as Gaghan and Farrell about the need for builders and developers to pitch their projects with deeper information when they’re asking for money. Avanti, which has more than 20 financing sources and is active in 35 states, is a bit different from other investors in that it prefers longer-term investments, ranging from three to 12 years, “Our average hold is four to seven years,” said Schwartz. Avanti also expects at least 20% IRR and wants to double its investment over the term of the loan. (It’s averaging 2.4 times its investment on recent deals.)
For example, it recently paid $5 million for a 1.5-acre parcel in Atlanta that has the potential for 700,000 square feet of density. Schwartz said Avanti expects to sell this project for between $15 million and $20 million.
Farrell said the deals BofA has evaluated lately are typically for 10 to 50 infill lots that require vertical construction. The bank has been lending at a 65% loan-to-value rate for horizontal construction and 70% for vertical. As for land financing, “good luck with that,” he laughed. “That’s not a good place for our bank to go right now,” especially when the entitlement risks are high.
All of the panelists agreed that they’d do business with builders or developers that have been foreclosed on by other lenders or even themselves. “People who have lost money on land can still be good, quality people,” said Schwartz. To which Farrell added “what we look for today is character, credit and collateral.” Gaghan said that by the time his company is talking with borrowers, “most of their legacy issues have been cleared up.”
This “new beginning” mentality is what the panelists agreed would eventually lure capital back into the housing arena. “The population of the country continues to grow, so there’s going to be pent-up demand,” said Schwartz, who concedes that much of the current financing problems stem from an industry that had been overbuilding since 1996. “We’re still in a digestive period, but I think we’re close to some kind of normalization.”
Consequently, Gaghan thinks there could be “a lot of opportunity” for capital to find a home in the housing sector over the next several years. He also thinks banks will eventually get back into the picture. “But it’s going to take a long time—maybe never—to get back to the way it was.”
John Caulfield is senior editor for BUILDER magazine.
Learn more about markets featured in this article: Orlando, FL.