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Condo Development: Time to Live to Fight Another Day
Published: February 27, 2008
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By Jonathan Lee
Assistant Vice President
George Smith Partners
As we continue to engage in dialogue with our clients regarding the financial landscape, it is the condominium developer that seems to have the most difficult task in this deteriorating environment. This article explores the background of the condominium problem and suggests some solutions available in this difficult financing market.
“Lenders recognize these facts and have shown a voracious demand for [infill condo-to-rental conversion] as it provides the safest return in a difficult real estate environment.”
“Construction lenders will lend again to borrowers who read the terrain and pro-actively make decisions to protect against greater losses.”
With little or no absorption of new units, our condominium clientele are reaching out to us to evaluate available solutions. This cycle will likely filter out inexperienced borrowers and leave only well-established real estate professionals in the marketplace. But those that withstand this downturn will do so if they follow this axiom: it’s time to live to fight another day.
Before delving into the issues condo developers face, it is worth noting that one of the most surprising elements of the downturn for this segment is the sheer speed with which it occurred. As of June 2007 a substantial number of construction lenders were still actively quoting condominium loans. Coinciding with the meltdown of the CMBS markets in August, lenders shifted gears and would only lend to experienced borrowers with compelling transactions. By late September these lenders were broadly advised to cease lending on condo developments until their current portfolios matured successfully. As a result, the seemingly endless supply of construction liquidity that existed for six years was turned off in less than four months.
The environment for condo developers on the sales side has not improved as buyers have largely remained on the sideline as the fallout continues. While those in the industry know the news is never as bad as advertised, the public seems to ignore this fact at developers’ peril. The expectation among several clients I have spoken with is that significant price reductions will be the only off-set that will lure buyers back into a risky real estate environment.
As a result, condominium developers and construction lenders are collectively wringing their hands as contractors march projects toward their certificates of occupancy. The question is: what do they do when the buildings are finished? Depending on the business plan, there are several solutions for developers that push aside short-term “fix-its” and focus with long-term vision. For purposes of categorizing these solutions, let’s separate them into two segments: “for sale” and “for rent.”
For Sale
The most obvious solution is to accept the current reality and sell units at a discount. This is admittedly difficult to do as developers have put years of substantial work into pro-forma returns they see evaporating with any price reduction. The question for developers of “how much to cut prices to attract buyers?” is akin to trying to catch a falling knife. This is especially true for developers who have multiple projects in close proximity and don’t want to hurt their own comparables. However, loan officers and banks have long memories when it comes to moves like this. Construction lenders will lend again to borrowers who read the terrain and pro-actively make decisions to protect against greater losses.
Another solution is to sell the entire building in a bulk sale to a stronger long-term player. This again gives construction lenders comfort in the long-term relationship of the condo developer. The difficulty is that the buyers that have materialized for this asset play are submitting offers as apartment buildings with above-market cap rates. Their argument is that a three-year apartment hold rolling to for-sale units in the future is a risk, and therefore demands concessions on even brand new buildings. Furthermore, the active equity players that are writing legitimate offers are doing so with a tempered drive to close. The perception among clients who have gone this route is that the bulk buyers prefer to wait for further market deterioration and bigger discounts before becoming more aggressive.
For Rent
The good news for condo developers is that there is still money in the marketplace for a well-conceived business plan coupled with a well structured financial plan. Specifically, condominium developers who begin to look at their deals as rentals have several options available to them.
It is important to note that the “For Rent” scenario should be addressed as the Developer nears Certificate of Occupancy to avoid problems that arise when lenders try to finance partially sold buildings, or “broken condos”. In a broken condo there are issues relating to the control of the homeowner’s association, which typically resides with the developer until a significant number of units are conveyed to buyers. Renters and owners do not necessarily make good bedfellows and their objectives are usually not aligned. As a result, renting the entire building out makes both practical and economic sense.
Most condominiums built today were in urban in-fill locations that are highly desirable because of their location and proximity to transportation arterials and employment centers. Rental projections look very good as leery home buyers look to continue renting. In some parts of Los Angeles County rental rates have increased 15-20 percent over a three-year period while vacancy has remained as low as 3 percent. Lenders recognize these facts and have shown a voracious demand for the product as it provides the safest return in a difficult real estate environment.
Long Term Financing: Proceeds Driven
Developers who adjust their business plan to a long-term apartment hold have several structured options available to them. These five, seven and 10-year loans are aggressively priced and garner maximum proceeds to retire construction loans. In strong rental markets like Southern California, these lenders have the ability to fund loans at certificate of occupancy. This affords developers the ability to retire construction debt immediately and begin lease-up with a patient lender.
Short Term Financing: Cycle Survivors
Developers who believe they are building into a down cycle that represents a short-term dip are likely not best served by a long-term loan program. These developers believe that they will still meet their sales projections if they can sustain their projects through the next two to five years. They will best be served by “Cycle Surviving” loans that are noteworthy for their aggressive 1.15 debt coverage ratios and, in some cases, zero pre-pay clauses.
Structured Bridge Financing
The third solution is to approach bridge lenders for 24- to 36-month loans. A bridge loan would retire the construction loan and give developers time to sell the units in the near future at their pro-forma price points. Bridge lenders will lend on stabilized apartment buildings all the way to a 0.80 – 1.0 DCR. This allows developers to sustain the project with rental cash flow before selling units in the future. Perhaps most importantly, the bridge loan will include release clauses that will allow developers to sell units without pre-payment penalties.
These three lending programs come from a variety of sources and are viable options for borrowers that have solid business plans backed with the correct economic structure. We have closed transactions with these firms and have relationships that understand what can and cannot be done in the marketplace. As condo developers face the difficulties in the market, we are actively consulting with our borrowers to ensure their gains survive the current downturn and are realized in the future.
Founded in 1992, George Smith Partners specializes in arranging financing for commercial and residential properties, including acquisition, construction, bridge and permanent loans as well as mezzanine loans, highly leveraged participating loans and joint venture equity. http://www.gspartners.com/
