The stories and video of new houses being demolished in Victorville are continuing to pop up in blogs and other news sources (see Calculated Risk, the LA Times, and the Wall Street Journal, for example). It’s a compelling story, but the way it’s being presented almost everywhere is misleading.
First, here’s the video if you haven’t already seen it:
The video, and every story I’ve seen referencing it except one, gives the clear impression the bank thinks it makes economic sense to demolish completed and virtually completed but unsold houses because the market is so bad. However, the original source of the story (see this post) interviewed an officer at the bank, who makes clear the real issue is the homes were built before the roads and other site improvements were completed. Completed homes could have been sold at some price, but if there’s no road to the home you can’t sell it.
This is obviously bad construction lending practice; you should complete site improvements first (or make sure you’ve held back enough money to do so). Hence the headline, roads before roofs. This seems obvious, but it happens more often than you might think. When I was at Capmark a few years ago one of our workout deals was a project where we funded the equity portion of a purchase of a multifamily land parcel, and then discovered the access road we needed couldn’t be built because it would cross a stream which was the home of an endangered fish species. That investment was a total loss.
It’s also obvious it takes more than a few mistakes to bring down a lender, but when you have a major due diligence breakdown like this, you have to wonder if it’s not the tip of an iceberg of bad decisions. From the WSJ story linked above:
Guaranty Bank has significant exposure to construction loans to home builders. Last month, its parent company, Guaranty Financial Group, was issued a "cease and desist" order by the federal Office of Thrift Supervision, citing the firm's "unsafe and unsound banking practices."
I’ve previously posted about Capmark’s problems here. Since then, they reported a $1B loss in the first quarter.
The second part of the headline is roofs before retail. Before you develop a retail project, you want to make sure there are enough people living in the market area to support it. Because subdivisions were being developed at such a rapid rate, this rule was frequently violated, and when the music stopped on the residential side many retail projects were left without a customer base. Between the two retail sites indicated below, which do you think is doing better?
The lesson is, it’s important to develop in the right order; infrastructure, then residential, then retail.
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