For several years, the real estate development and construction industries have been reeling from an economic slowdown with reductions in property demand, significant standing inventory levels, and bank-initiated project foreclosures. As a result, both the residential and commercial real estate roller coasters are racing toward the bottom of this economic cycle in declining property values and sales/leasing activity. Lenders' balance sheets have ballooned with distressed and nonperforming assets.
Contractors and developers with patient capital and a long term investment mindset have an opportunity to take over some assets at bargain prices, but these transactions present some unique risks that must be addressed. The following article will explore these risks, and the solutions for evaluating these opportunities.
The Problem
During the extended construction boom that spanned 1997 - 2007, homebuilders, commercial property developers and large public builders all relied on debt instruments (land secured, development and construction loans) to finance their operations. The easy access to project financing was, in fact, the life-blood of the construction industry and the driver of its enormous growth. For large public builders, project financing is arranged at the enterprise level through large, money center banks and facilitated by corporate lines of credit. For smaller builders, regional community banks have provided the primary source of debt capital through specific project loans (assets on the banks' balance sheets). In both arenas, lender balance sheets have swollen with thse assets, many of which are now distressed and non-performing. As property values plummeted and credit markets dried up, many residential development projects were abandoned due to lack of funds. Project sponsors without access to equity injections from outsiders (e.g., friends, family, institutional investors and off-shore soverign capital) were often unable to keep the project afloat. The typical path of such ill-fated projects usually involves the bankruptcy of the project sponsor, lender foreclosure, and transfer of the property into the bank's "real estate owned" (REO) portfolio.