More on Fractured Condos

Fractured condos are condo projects where only a portion of the project is sold to individual owners, and the remaining units are rented to tenants. A couple of recent examples:

The Millworks at Novato (from the Marin Independent Journal):

Millworks, a 420,882-square-foot residential/commercial project at De Long and Reichert avenues, had a grand opening in May but has only sold two of 124 condominiums situated above a Whole Foods grocery store slated to open next spring.

"Because of the mortgage market, it's really hard to get condo loans right now," said Mike Ghielmetti, president of Pleasanton developer Signature Properties. "A lot of the folks who are interested in buying there have homes to sell, and it's just a slow market. This is what we have to do for an interim period to make this viable."

Unit financing is a huge issue – Fannie and Freddie won’t buy unit mortgages until the project is at least 50% sold out, so these days the only available financing for unit purchases tends to be the construction lender on the project. It seems likely the construction lender on this deal refused to do that (construction lenders are not keen on holding long term fixed rate mortgages in portfolio). I suspect the other problem with this project is it’s pretty big for the size and niche it fills – how many people are there who want to live in downtown Novato?

Siena in Corona Hills (from GlobeSt.com):

 

A buyer from Fontana has acquired 189 units of a broken 296-unit condominium conversion project from its lenders for $14.25 million in a deal that says much about the state of the multifamily market in the Inland Empire today, according to Paul Runkle of the Inland Empire office of Hendricks & Partners in Temecula, who brokered the sale. The property is the Siena in Corona Hills at 2125 Highpointe Dr., formerly an apartment complex known as the Crossing…"This comp says that a quality, broken condo deal that was leased up with rentals, that was not readily financable, and was widely exposed, eventually sold at at 8.93% cap on an all-cash basis," Runkle says.

There are enough numbers in the story to piece together the before and after on this deal:

The moral to the story on this one is, don’t buy an apartment project on a 3.55% cap rate.

See previous post “Are Fractured Condos a Good Investment Opportunity” for a discussion of some of the hazards of doing these deals.

Why Haven’t There Been More Construction Loan Defaults?

Delinquency rates for CRE construction loans are “only” 12%; why is that?

Distressed Volatility quotes testimony from Richard Parkus - Head of CMBS and ABS Synthetics Research, Deutsche Bank (italics mine):

90+ day delinquency rates are currently in the 12% range for construction loans in bank portfolios, but are somewhat higher for construction loans in regional bank portfolios. In fact, I am perplexed by the fact that construction loan delinquency rates are only 12% at this point. However, I believe that this can be explained by the fact that they are typically structured with interest reserves which are sufficient to cover interest payments until the expected completion of the project. Thus, construction loan delinquency rates are currently artificially low due to interest reserves, but will likely rise dramatically within the coming 6-12 months. In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which would imply losses of at least $140 billion. This, of course, would be disproportionately borne by regional and local banks."

I agree with Parkus that interest reserves are responsible for keeping these loans afloat. Most construction loans are indexed to LIBOR, or less commonly, Prime. This chart from FedPrimeRate.com shows what has happened to these rates:

Construction loans started in 2005 or earlier were mostly refinanced before CRE permanent lenders pulled back, and CRE construction lending declined dramatically during 2008. As a result, the construction loans still out there were originated most during 2006 through the first half of 2008 (the period inside the ellipse on the chart above). The interest reserves on these deals were sized assuming prime would remain around 8%, and LIBOR would be at around 5%. Since then, prime has dropped to 3.25% and 1 month LIBOR is 0.29%. As a result, an interest reserve sized to carry a loan for two years can now cover interest costs for four years or more. So, even though projects are not hitting the occupancy and rent levels projected, many lenders are willing to extend these loans because the interest can be kept current from the original interest reserve without increasing the loan commitment. The hope is markets will recover before the reserve runs out or interest rates go up.

Construction Lending Blues

Although most of what you read about CRE loan problems refers to CMBS loans, the reality is construction loan defaults are a much, much bigger problem. The reason you hear so much about CMBS is availability bias; CMBS loan performance is closely monitored and loan level data is readily available, while construction loan performance data is extremely fragmented.

John Reeder at Real Property Alpha notes:

When you go home at night and turn on the lights, you don’t have to think about what it took for that light switch to turn on.  Somebody had to develop a power plant.  Somebody had to develop the utility infrastructure to deliver the power.  The neighborhood you live in is likely part of a development that somebody had to get approved.  The store where you buy your groceries is part of a retail center that had to be built.  It wasn’t always there.  But these are things we take for granted.  The difficulty of development does not weigh on us.

And yet development is hard.  Even experienced developers fail… all of the time.  In order to bring projects online you have to make it through a gauntlet of challenges that includes buying the land right, proposing a marketable project, obtaining environmental clearances, getting discretionary zoning actions approved, getting through construction within budget, and enduring market cycles.

If a construction project makes the headlines, it’s usually a big deal that’s blown up in a conspicuous way. For example, construction at the Las Vegas Fontainebleau hotel, pictured at left, is currently shut down as a result of the construction lenders’ unwillingness to advance funds. The borrower is in bankruptcy and and all parties are litigating (more on the story at the Zero Hedge post  Fontainebleu Fiasco Soon To Get Epic). However, big projects are just the tip of the iceberg; for every big project there are ten smaller ones in trouble.

Here’s a list of the way construction loans can go wrong. Some of these are “normal” risks in getting a development done, while others are cyclical. I’ve put the cyclical issues which are currently in play in italics.

Jurisdiction Approval Issues. This category of issues creates delays or cost overruns which put the property in jeopardy.

• Failure to obtain necessary jurisdiction approvals. These could be big, obvious approvals (e.g. a building permit) or an obscure approval which wasn’t obvious at closing (for example, an approval for an off-site bridge over a stream for an access road to get to the project).
• Change in infrastructure requirements or fees post closing with no grandfathering
• Change in code requirements post closing with no grandfathering

Construction Issues

• Costs underestimated in the initial project budget
• Unanticipated site conditions (for example, soils problems) leading to delays and/or cost overruns
• Exceptionally bad weather leading to delays and/or cost overruns
• Labor or material cost increases post closing (e.g., the price of plywood goes up after the budget is set)
• Labor strikes or unavailability leading to delays
• Material unavailability leading to delays
• Failure of the contractor or major subcontractor(s) due to financial problems unrelated to the project (this often creates delays or cost overruns which puts a property in jeopardy)
• Construction or design defects (for example, water infiltration) which must be cured, leading to delays and/or cost overruns

Leasing Issues

• Decline in rents from the original pro forma
• Slower than anticipated lease up
• Higher than anticipated tenant improvement costs (in a soft leasing market, developers have to offer more tenant improvements to get tenants to sign up)
• Deteriorating financials or bankruptcy of a major tenant

Construction Loan Issues

• Increase in interest rates resulting in early depletion of the interest reserve
• Insolvency of or regulatory restrictions on the construction lender

Permanent Financing Issues (these issues may prevent the construction loan from being refinanced before it matures)

• Increase in interest rates
• Increase in operating expenses compare to the original pro forma (for example, real estate taxes assessed at a higher rate than anticipated)
• Increase in cap rates (resulting in a value decrease such that a permanent loan can’t be obtained)
• Tightening of underwriting standards
• Deteriorating financial condition or credit of the sponsor unrelated to the project (for example, foreclosures on other projects)

This list is not complete, but it gives you a sense of how unpleasant it is to be a construction lender (or borrower) these days.

Abandoned Projects Everywhere

Calculated Risk has a post featuring a video of an abandoned condo project in Irvine, CA:

Yesterday, the Wall Street Journal had a story on abandoned construction projects. An excerpt:

No one tracks precisely how many construction projects nationally have been stopped by developers midstream. But an indication of the scale comes from New York-based Real Capital Analytics Inc., which estimates that there were 3,929 distressed commercial properties across the U.S. as of March 31 -- a 55% jump since Dec. 31, 2008. Roughly a quarter of the properties involve developments, unfinished, Real Capital said.

The story mentions a website, UnfinishedConstrution.com, which specializes in liquidating such sites. Here are some photos of featured properties:

The site also features an alligator farm for sale:

That seems entirely appropriate given the difficulties of jump starting a project which has been shut down.

Related Posts: Roads Before Roofs, Roofs Before Retail, When Real Estate is a Liability: The Movie, and Workouts 101: Complete the Project!