The residential developer is in a no win situation. Having lent to this community for 20 years, I am familiar with the hardships, frustrations, politics, and time it takes to successfully entitle, develop, and deliver finished lots to the general public. It takes about 3 years to fully entitle a piece of raw land in the Baltimore Washington Region, sometimes more. The more regulation in an area, the more time (and money) it takes to gain all of the necessary approvals. Then, throw in another year for hard development (shovel in the ground.) Given this time frame, that means that the developer who brought finished lots to the market in 2007, probably contracted to purchase the land in 2003. 2003 was quite different than today or even 2007. The developer works backwards from a potential finished lot price. This is dictated by the future potential value of the house to be built on that lot. Even if the builder only estimated a 5% increase in price each year from 2003 to 2007, he would have grossly overvalued today’s market prices.

The Baltimore/Washington region typically has higher than the national average of home prices. Lets assume that a finished (fully developed and ready to build) lot values for $280,000 based on an $800,000 house price. The lot being 35% of the total value. This ratio was not uncommon from 2002 to 2007. The previous ratio was 25% of the total and has returned. Banks were commonly lending to the developer at stepped up values. If the land was engineered for recorded lots, but the lots were ‘paper lots’ (no streets or roads yet) then a developer could finance up to 75% of the value of the recorded lot. In our example, lets say a recorded lot was worth $110,000, based on $100,000 of hard development cost and another $10,000 per lot of interest carry. Cost all in is therefore $220,000 for a 21% profit. A reasonable margin for 4 years without revenue, but not off the charts.

This profit is only on a per lot basis. Assuming the developer is the builder, which is what the trend was during this decade, that means that the developer still does not yield a profit until he delivers a finished house – lets add another 9 months to our 4 year time frame. Now the developer finally reaps the benefit of 4 years and 9 months of labor, but guess what year it is? Late 2007, and the market is falling apart because suddenly, all of those people who were able to afford $760,000 mortgages (assuming 5% down), can’t afford them anymore.

What impact does this have on the bank loan overall? Lets assume that the subdivision in our example is made up of 50 lots. If the bank lent 75% of raw value, then typically the bank would provide the ‘hard development’ dollars needed to complete the project up to 75% of the potential finished lot value. 75% of the value of the finshed lot is $210,000 per lot, multiplied by 50 lots equals $10,500,000. The developer likely signed a Note and personal Guaranty for this loan amount and the bank took a first Deed of Trust on the property. The terms of repayment are usually accelerated beyond the par loan amount per lot. In order to transfer a completed house to a buyer, the developer is required to pay that accelerated amount to the bank at the time the house transfers to the home buyer. Both Bank and Developer thought that a 25% cushion was sufficient to make sure the debt could be repaid.

I’m sure you can see what has happened. Since the mortgage industry is now only providing loans to people who can really afford them (based on documented underwriting), the once $800,000 neighborhood
is now a $480,000 neighborhood (40% decrease in value). The developer now has a loan that is grossly under collateralized. This means the lot is only worth $120,000 (25% of total value). If the loan is $210,000 per lot then the most that the developer can repay is $120,000 (not including selling expense). This means that there is a $4,500,000 shortfall.

This is the dilemma at many of our community banks and most large banks. It’s a difficult situation and one that means ‘pain’ for all involved. The community banks in this situation are uncertain what to do about this situation. Causing much confusion for borrowers as there is no consistency in handling the loans. Each bank is dealing with borrowers differently. Foreclosing is costly and as yet, has done little but cause bank’s to own real estate. Taking the huge losses that are required to sell the asset is not the preferred avenue for most.

Working with the developer and sharing the burden of the loss appears to be the best solution if you believe that people still want to own a new home. If the developer is willing to stay in the project and complete it, market it, build it and sell it, for little more than to cover his overhead, then at least the Bank doesn’t have to put the whole operation together.

I started MB Advisors, a financial consulting firm, in part, to assist the developer and builder who has an ‘upsidedown’ project, but has cash or income from other sources to fall back on while he ‘retools’ product and modifies his financing. Most of the banks in this situation find themselves without enough ‘loan structuring’ experts to handle the volume of loans given the amount of time and complexity of the modifications. I streamline the approach for the bank by presenting solutions that reduce loss and bridge the gap between bank and borrower. Everyone will feel some pain, but it will be far less the quicker that both sides accept some of the loss.