Builders and developers face harsh choices about their real estate holdings, especially because the scarcity and hesitancy of home buyers makes the value of basic assets almost impossible to pinpoint. Every day, we read about large builders, such as Lennar Corp., liquidating land at discounts as high as 60 percent of the price they paid a mere two or three years ago. The subprime mortgage crisis and widening liquidity crunch have also put pressure on banks to shore up their own capital bases. How do these changes in the market affect home builders and developers?
Unfortunately, interest rates as high as 20 percent in a falling market have eroded a great deal–if not all–of many builders’ equity. Under such circumstances, a home builder faces the unpleasant dilemma of advancing fresh cash, abandoning a project to a lender, or restructuring the deal’s terms in light of a rapidly changing–and, in this case, deteriorating–market.
To make this decision, a builder needs to understand the value of the project today and try to anticipate what the value of the project will be in the future. Without current, valid information, a builder faces difficult decisions in a vacuum. This situation may prompt a company to choose a course that, with additional insight, would clearly not be in its best interest.
Builders who bought land with little or no debt are in a substantially better position than those who used excessive leverage with a blended interest rate of 20 to 30 percent. During the recent rapid increase in home prices, builders accepted higher costs of capital because the main objective was to take advantage of risk-free cheap money and increased profits.
Regardless of the situation, it is imperative that a builder update sales projections in accordance with the current market–including allowances to facilitate sales, such as a price reduction or additional upgrades. However, unless a builder also updates cost information, this tactic may create a trap. For example, say the builder allows $4 million for a recreational facility when the initial budget is established, but management later decides it wants a spectacular facility that costs $12 million. Unfortunately, the finance department is usually the last to be informed of this change–if it is informed at all–and the budget is now $8 million short.
Once a builder has prepared updated revenue and costs estimates, the next step is to evaluate the project cash flows. Two cash flows should be prepared: one that represents reality and another that anticipates a worst case scenario in which prices fall and sales slow. In general, the latter is more critical as it allows builders to understand their exposure in an uncertain marketplace. It also puts the builder in an informed position to decide whether to hold, sell, or renegotiate with its sources of capital.
Preparing two cash flow models also strengthens the builder’s credibility. In an uncertain market, lenders want reassurance that builders are prepared for the worst. If lenders suspect a builder is sugarcoating the situation, they may be reluctant to continue a long-term relationship. It is often better to stick with the original lender than to seek a new partner that may demand a larger share of the profits or add covenants to the financial and management structure.
Builders and developers need to understand the financial reality of their projects and consider multiple alternatives if they want to maintain the support of their investors and lenders, which is essential to complete a successful community.
–Barry Gross is founder and president of Developers Research. Executive vice president Scot Oldham has been with the company since its inception in 1997. For more information, visit www.dev-res.com.
