Financially Troubled Builders Weigh Their Options

Credit: Jon Krause

The adage “he who hesitates is lost” could be this year’s bumper sticker for the growing legion of distressed builders wondering if they can save their companies through bankruptcy protection.

A housing industry well into its fourth year of a downturn and second year of economic recession is littered with builders who waited too long to address problems that ultimately rendered their companies insolvent. “By the time they get to Chapter 11, most builders are already at the liquidating stage,” observes Becky Roof, a director with AlixPartners, a New York–based firm whose bankrupt clients include Kimball Hill Homes and Caruso Homes.

As 2008 ground to its ignominious conclusion, untold scores of builders had liquidated their assets and closed their doors without filing bankruptcy. And Chapter 11 hasn’t exactly been a path to operational viability for builders that have tried it. Still, a handful are using bankruptcy protection to wind down businesses or to restructure debt, pay creditors, reorganize, and—they hope—start building homes again.

Unfortunately, absent sufficient liquidity or an end-game strategy going in, builders will experience Chapter 11 as a costly exercise in futility, say experts, especially if lenders continue to play hardball about renegotiating debt and financing the completion of projects.

Not For Everyone

The end game for one regional builder, which fell out of compliance with a loan covenant in January, could be a steep ramp down of its operations. The builder wants lenders to adjust the terms of its loan by ­accepting writeoffs, equity, or convertible debt. If the lenders balk, the builder might say “here are the keys,” says Harold Bordwin, managing director with KPMG ­Corporate Finance, the New York–based consulting firm that’s working with the builder. There’s general agreement among experts that builders who haven’t personally guaranteed their companies’ debt have greater leverage with creditors.

Only a minuscule number of distressed builders ever file, says Jim Weigel of Shinn Consulting, which in early December presented a webinar on bankruptcy to which more than 50 builders listened. “For builders, Chapter 11 is not impossible, but it’s risky and has led to a loss in value,” adds Natasha Labovitz, restructuring partner with the law firm Kirkland & Ellis, which represents several bankrupt builders including TOUSA. She urges clients to talk first to creditors about out-of-court restructuring. The threat of filing, she says, can be effective to gain creditors’ cooperation.

“Chapter 11 is not a solution in itself,” adds Andrew Hede, managing director with Alvarez & Marsal, a leading restructuring consultant that is also working with several at-risk builders. “It might do more harm than good because it is disruptive and expensive.” The way builders typically finance their projects—using multiple lenders and cross-collateralization—makes debt restructuring under Chapter 11 difficult, say experts, because it’s tougher for lenders with competing claims to reach consensus. (On the other hand, Village Homes of Colorado filed bankruptcy in November partly because its primary lender, a syndicate of four banks, couldn’t agree on a course of ­action, says Garry Appel, an attorney representing the builder in this proceeding.)

Credit: Jon Krause

Because of the complications, lots of builders are skipping bankruptcy on their way to liquidation. Davis Homes and ­Taylor-Morley Homes, to name two, found the money to finish homes under contract before they closed their doors. Other builders, such as M.W. Johnson and Wensmann Homes in Minnesota, simply turned off the lights. But you better have sympathetic lenders, trades, and customers if you try to settle financial matters without Chapter 11’s legal protections. Dave Brown, owner of Brown Family Communities in Arizona, says he spoke to bankruptcy attorneys but decided instead to shut his doors in October. “Now,” he says with dark humor, “I’m holding off subs with a baseball bat and having someone start my car every morning.”

Every builder is struggling and, therefore, should be seeking professional counsel, recommends Bordwin, who sees Chapter 11 as a “tactic” to help builders restructure debt. But for larger builders, with complicated balance sheets and armies of creditors, it may be the only option. Levitt & Sons, which was forced to enter Chapter 11 in the fall of 2007, appears close to finally liquidating its assets. TOUSA, which filed a year ago, has a reorganization plan on the table that eliminates more than $1 billion in bondholder debt and turns over the company’s ownership to its banks.

While dozens of companies have filed for bankruptcy protection, very few have emerged from the process to build again.

As of late December, only one prominent ­company—Marnella Homes of Milwaukie, Ore.—that had filed Chapter 11 has been granted court approval to execute a reorganization plan. Through the sale of homes and land, Marnella will repay $17 million to two lenders and $600,000 to subs and suppliers over a three- to five-year period. It will also complete construction of a 115-unit neighborhood called Volare.

Renaissance Homes in Oregon told the Portland Business Journal that it would file its reorganization plan on Jan. 23 and ­re-emerge as a smaller company by April. (Renaissance did not return several calls from Builder seeking comment.) Another Portland-based builder, Legend Homes/Matrix Development, expects to file its plan for reorganization by March 31 and have the court approve that plan by early June, one year after it filed Chapter 11, says Legend’s president Jim Chapman. On the opposite side of the country, Caruso Homes in December sought court permission to hire KPMG Corporate Finance to liquidate land beyond 45 minutes of its Crofton, Md., headquarters, which will be its core market if and when it emerges from Chapter 11.

Misplaced Optimism

Credit: Jon Krause

Jeff Caruso thinks his company could emerge from bankruptcy this spring, six months later than he had originally estimated. When he filed last June, Caruso said he expected to be out within 120 days. But the sheer mechanics of the bankruptcy ­process have been more complicated and time-consuming than he imagined. That’s a common mistake that optimistic builders make about their companies’ turnarounds. A few days after his company filed in November with $56 million in debt, Kevin Wann, CEO of Pacific Lifestyle Homes in Oregon, told an incredulous radio interviewer that he expected his company to emerge from Chapter 11 by this summer. “I’d tell anyone considering Chapter 11 to expect it to take twice as long as you think,” says Matt Osborn, a senior vice president with Village Homes.

As they stumble into bankruptcy, one big mistake builders make, says Hede, is filing without a capital-restructuring plan. “Are you going to reinstate your bank debt or bring in new equity? These questions need answers,” he explains, because most builders require an equity injection in order to come out of 11. At the end of Kimball Hill Homes’ Chapter 11 search for equity, its managers finally decided to discontinue the company’s operations after one last ­potential investor suddenly pulled out.

Builders can generate revenue while in Chapter 11 by agreeing to equity carve outs that extend ownership to creditors, or by building out and managing lenders’ foreclosed real estate assets. But these usually won’t cover operating expenses. And very few bankrupt builders have been able to negotiate debtor-in-possession (DIP) financing from banks.

Ken Neumann, who closed Warrenville, Ill.–based Neumann Homes early last year, concedes the “fundamental mistake” he made was filing Chapter 11 “too light. We didn’t have enough money to survive,” he says. Neumann Homes, which in late ­December was still selling assets and working with one bank to complete a project, was also hamstrung, says Neumann, by its inability to sever its Detroit subsidiary—whose loans the parent company guaranteed—from the rest of the corporation. “If I could do it over again, I would have altered the legal and financial structure of my company.”

Caruso lent his company DIP financing, out of necessity, when it filed. But builders should take a long, hard look at their ­businesses’ health before they pump more money into them, advises Troy Taylor, ­president of Atlanta-based financial consultant Algon Group. The determining ­factor, Taylor says, should be how such an infusion would impact the builder’s family and lifestyle if the business fails.

Banks Are Balking

Bankruptcy is a much different environment than most builders expect. It didn’t take Tony Marnella long after his company filed for Chapter 11 protection last April to realize it would be every man for himself. “I was told candidly [by Sterling Savings, one of Marnella Homes’ lenders] that it was not my partner. After eight profitable deals, I thought I had earned the right to have this discussion about the one project I stubbed my toe on. I guess not.”

Bankers insist they are doing what they can to keep viable companies in business, though some are more helpful than others. Bankrupt builders, by and large, say they are mystified by lenders’ inflexibility, especially when it comes to project-completion financing. “They puzzle me,” says Osborn of Village Homes, which in December had stated it had 52 homes under construction and another 11 under contract. Village estimates its cost to complete those homes at $5.9 million. “Their decisions are contrary to a common-sense business approach.” In response to lender objections, the court last month denied Village Homes’ request to close short sales of four houses that would have netted the builder $1.47 million, which it planned to use to fund construction.

More builders are convinced that banks, given their druthers, would wash their hands of AD&C loans. Lenders are “increasingly intransigent” in their discussions with builders about providing new debt, says Appel. Bordwin and Roof add that ­because many banks don’t have workout departments, bankrupt builders find themselves talking to bank personnel who focus mostly on foreclosures.

A coalition of 135 builders, spearheaded by Barratt American’s president Mick Pattinson—who took his company into Chapter 11 in late December, two days after Bank of America foreclosed on seven of its projects—is seeking investors to create pools of unleveraged funds so builders won’t need to rely on banks. And today’s lending climate requires builders to hire professionals who can communicate with banks that might not be disposed to listening. Marnella says he told his lenders a year before his company went under that buyer demand was softening. “What I got was a pat on the back from my bank, which told me to keep doing what I was doing.”

Will banks change their tune as more builders fail? Labovitz says some lenders already are taking “a realistic perspective” that accepts the need for “consensual restructuring” of builders’ debt. Roof says some builders have had success renegotiating letters of credit on projects already in progress. John Dischner, a director with

AlixPartners, notes that Bank of America, which was adamant about taking back land from bankrupt Levitt & Sons, has been willing to work with Caruso Homes. But Dischner also says lenders’ evaluations of real estate remain unrealistically high. “Yet they won’t fund builders to manage inventory and sell it down the road at retail.”

Timing The Recovery

Regardless of whether more builders formally declare bankruptcy, one thing seems certain in this recession’s wake: There will be fewer builders this time next year. Some industry watchers are already talking about the disappearance of half of the companies that build fewer than 25 homes annually.

Under such dire market conditions, Chapter 11 could serve as a good place to wait out the downturn. “What you want to do, if you can, is batten down the hatches, hibernate for a while,” says Algon’s Taylor. “Be like a submarine, with a skeleton crew on board to make sure everything works, but don’t fire any torpedoes.” However, Hede and Appel caution clients that Chapter 11 is an expensive hiding place.

A company representative says a “leaner” TOUSA will emerge from Chapter 11, possibly by this spring. (It is looking for a new investor, confirms Labovitz.) Caruso Homes has reduced its land assets to around 200 lots, from 2,500, and is turning to family, friends, and business associates to fund future projects, which will target active adult buyers. Caruso expects to build 30 homes in 2009, or about 90 percent fewer than before he filed for Chapter 11. Village Homes should come out less land heavy, too, predicts Osborn, who also expects his company to offer customers a narrower product assortment.

Having sold personal property, including his Maserati, under the terms of his reorganization plan, Marnella is self- financing the completion of his Volare neighborhood, 14 of whose homes were recently sold at auction. In the future, he vows to keep more inventory to rent—up to 25 percent of what he builds in his next project. Marnella’s company will build about 50 houses in its first year out of Chapter 11. Ever the optimist, he intends to double that number by 2011.

Brushed Off

The owner of Arizona’s Brown Family Communities blames lenders for his company’s demise.

STRANDED: Dave Brown, the owner of Brown Family Communities, says his lenders abandoned his company at the first sign of weakness. What irks him the most is that lenders preferred to let his company fail than to extend financing to complete sold houses.

Credit: Mark Peterman

What forced him to shut his doors, he says, was the lack of support from lenders GMAC Financial Services (which Brown says “stopped ­returning my phone calls in January”) and Chase, which cut off his company’s $50 million credit line after Brown Family Communities fell out of compliance with one of that loan’s covenants.

“They treated me like a bum who had missed a car payment,” says Brown, who had drawn about $25 million from that credit line. “To this day, they have never told us how much we owed.” Brown calls himself “naïve” for having signed a borrowing base agreement, which theoretically makes it easier for the debtor to repay a loan and re-borrow off of it. “The small print allows the bank to close out the loan anytime it wants to,” he says.

Mary Jane Rogers, a spokeswoman for Chase’s Western states ­region, tells Builder that company policy prohibits her from discussing Chase’s relationship with clients. She notes that Chase has been reducing its exposure in the residential construction sector for several years. Rogers says Chase is “working with” a number of distressed builders, which she couldn’t identify.

What confounds Brown is the unwillingness of banks to provide financing that would allow builders to complete homes they’ve sold. His company had 31 homes in various stages of construction and 80 pending sales. Brown said that Chase indicated it wanted to complete some of these, but how many he was never sure. Brown ended up refunding $580,000 in buyer deposits out of his own pocket. “This was a well-thought-out effort to put me out of business,” he believes.

Despite the bad taste in his mouth, Brown wants to build homes again. Local banks have approached him about restarting as a builder or developer. “I’m 76, so I’m too old to get a paper route,” Brown quips. But he must wait for market conditions to allow his re-entry. If the recovery takes several years, “I’ll be out of gas."

EXIT STRATEGY

Credit: Jon Krause

• Self-finance. The first reaction of many builders has been to dip into their own pockets to keep their businesses alive. The wisdom of that depends on how big a hit the owner can afford if his business ultimately fails. This option, of course, is limited by the owner’s resources and assets.
• Find new financing partners. Builders and developers keep insisting there are private equity funds out there itching to buy land and companies. However, their financing doesn’t come cheap and is likely to require the owner to relinquish at least some management control of his company.
• Shut down and liquidate. Many builders have taken this option, which (theoretically, at least) is less expensive and quicker than filing Chapter 11 or 7. However, this option seems less feasible as companies get larger, with multiple lines of collateralized credit, and subs and suppliers who think they’ll get a better shake through a court-sanctioned process.
• File Chapter 11. Protection from creditors will give builders breathing room to figure out a plan to reorganize and re-emerge as a new company or conduct an orderly asset liquidation. Chapter 11 also provides a platform for companies to renegotiate debt with lenders. The irony of Chapter 11 is that debtors short of cash to pay for a bankruptcy’s considerable upfront and sustained costs—lawyers, restructuring experts, accountants, and the like—can find this option futile. And so far, few builders have emerged from Chapter 11 as operating entities.
• File Chapter 7. The most common form of bankruptcy, it differs from other types of liquidation because it doesn’t involve filing a plan for repayment. A court-appointed trustee gathers the debtor’s nonexempt assets and uses the proceeds from their sale to pay creditors. This process can include an owner’s personal property, although several states exempt certain assets, such as an owner’s house, from being liquidated.