With commercial banks unlikely to start making new acquisition, development and construction (AD&C) loans anytime soon, builders should be focusing on working out what remains on their books and looking for investors to help them finance new and existing housing projects, according to panelists participating in a Nov. 9 NAHB webinar.

Marty Mitchell, vice CEO and vice president of land and business development for Mitchell & Best Homes, which is based in the Washington, D.C. and Baltimore metropolitan area, said he has spent most of his time over the past three years on workouts and negotiations with lenders.

Since late 2006, credit has been tightened across the entire spectrum of AD&C lending, Mitchell said, and its availability “for private builders is at the lowest level ever seen.” Recently, the trend toward higher credit standards has started to slow, he added, but that only means that fewer banks are tightening, not that banks are actually starting to make AD&C loans.

Federal loan officers have been reporting significantly more loosening than builders have been reporting in NAHB surveys, and that may indicate a disconnect between banking regulators in Washington and examiners in the field, he said.

Commercial banks have been the most significant source of financing for home builders and developers, but today “most private builders are being shut out from bank credit,” Mitchell said, with the exception of the few remaining builders who have very strong balance sheets.

Builders who have existing loans are unlikely to be able to obtain new ones, he said, largely because federal bank regulatory guidelines on how much banks should be lending for real estate suggest they should only have active construction loans in an amount equal to their ca[pital and three times their capital in all kinds of real estate loans. The going can get tough for banks that exceed these limits, especially for the smaller community banks on which builders rely the most.

The bank regulators also aren’t looking at the housing market on a local and regional basis, Mitchell complained. What they aren’t seeing is that “there are many markets around the country where the inventories are coming down” and there are only small supplies of new homes. In his own market, he said, “when a spec is available, it is very competitive against the existing market.”

In addition, credit is exceedingly scarce because banks are failing to sell loans at appropriate discounts to free up capital for new loans. Making the problem even worse, inadequate appraisals that are coming up with ultra-conservative valuations because of a difficulty in getting appropriate comparables and the use of distressed sales as comps, is further undermining the willingness of banks to extend credit to builders.

(For NAHB resources on what builders should be doing to improve their appraisals, go to www.nahb.org/appraisalsprogram.)

Difficult Lending Conditions to Linger

Many in the industry who have survived past downturns believe the AD&C market will have to come back soon to appease their shareholders, he said. “Unfortunately, for the foreseeable future, banks don’t have to lend to make money.” Instead, they can borrow for almost nothing from depositors and the government and reinvest those funds to get a 3% to 4% return.

Mitchell predicted that conditions for AD&C borrowers will remain difficult for at least the next two years, may not ease for at least five years and may “not return to what was considered normal over the past 20 years.”

Consequently, “almost all builders will have no choice but to turn to investors of some kind to work through existing loans and get new ones,” he said. “The deal may need to be almost all equity to get things done.”

For the near term at least, reaching new sources of capital will entail “more sophisticated pro forma’s and analysis for the project” to show to investors projections on the internal rate of return, loan-to-value ratios throughout the project and the maximum loan amount that will be needed, and when, he said.

Any multi-lot projects will require a market study from a reliable outside source, he said, “and you will need to complete your own competitive market analysis to know what features you need to include in your house.”

Builders need to provide lenders with loan packages on the proposed project that are “as easy as possible to understand,” he said, and that can be separated into parts for easy distribution. “With a limited amount of financing, make it as easy as possible to move the request forward,” Mitchell advised.

Community Banks in Uncharted Waters

While times are tough for the nation’s community banks, Timothy K. Zimmerman, president and CEO for Standard Bank, said that they will be returning to a significant role in providing financing for home builders, who are “key” customers for them in the local community.

“Community banks are in uncharted waters,” he said, “with almost every AD&C loan in our portfolios under severe stress and intense regulatory scrutiny.”

Zimmerman was less than enthusiastic about current conditions in the housing market, noting that builders have been able to attract relatively few buyers even after slashing prices and that many markets are saturated with developed but unsold lots.

As AD&C borrowers who are having “long holding periods with essentially no cash flow,” he said, “builders are being pushed out of relationships with bigger banks.” Lines of credit are not being renewed, loans are being called and additional collateral is being requested.

“Community banks want to have a customer for life because they know the builder’s reputation and history,” he said. “But taking on a new project will generate almost immediate criticism from the regulators, so why take on that level of risk at this time?”

Zimmerman said that banks have been seeing some slowing in such negative trends as high inventories and declining prices, “but not a total reversal” on existing lots and models, which is what must occur before they will begin financing anything new.

“We are aware that we are in this together with our builder customers,” he said. “While waiting for conditions to improve, all parties must be open and honest with each other so that we can work with the facts no matter how bad they are.”

Zimmerman added that community banks do now want to foreclose because once they do, “the value falls to new lows and there is blood in the water.” Instead, banks want to keep the builders engaged, so they can rely upon their expertise to work through problems “and keep things going until the market starts to absorb the inventory.”

With regulators listing high AD&C lending as a top reason for bank failure, looking first to appraisals using foreclosures and fire sales for primary comparison and pushing values far below loan balances due, banks are looking for new marketing plans, more equity in the deal and alternative payment sources.

Live to Build Another Day

“Bank examinations will become more stringent over the next two years and it will be tougher to get credit,” predicted D. Rand Roan, principal and founding member of Apogee Partners, LLC.

With prospects not generally favorable for a return to normal anytime soon, builders should be concentrating on restructuring, he said, and focus on reducing their debt and removing personal guaranties as they move forward on workouts with their lenders.

Roan said that his company has been able to successfully work with home builder clients to structure a transaction so that they “live to build another day.”

“Many home builders face projects overburdened with debt” and on which they have made personal guaranties, he said. “Most don’t have the balance sheet or financial legs to pay the note deficiency nor the additional assets to satisfy the new loan-to-value requirements from the bank on existing credit.”

For these builders to stay in the business, third-party capital for restructuring may be required, he said. In return, the investors may want the entire project or a substantial equity position.

“Don’t get too enamored with your projects,” he advised, “and be open to investor and bank ideas.”

The loan workout environment varies by bank, he said, but “banks are starting to realize that they have to do something with nonperforming assets.” Every restructuring or loan workout needs to be looked at based on its own merits, he added.

Roan said that his company has used a number of investor groups to assist in debt restructures, and they have then migrated into other projects through joint ventures, land acquisition entities and private equity groups.

“Private equity may be the only alternative,” he said, and equity partners will want to be paid in the range of 20% to 35%.

Reporting requirements for these investors are stringent. “Projects are going to be scrutinized and only the best will survive,” he said.

Rand said that private investors who have not previously had experience in real estate are beginning to appear in the marketplace. “There is more and more interest on the investor side,” he said. “It’s just a matter of putting the reports and analysis together and getting them to the right people.”

Introduced at last year’s NAHB International Builder’s Show, returning to this year’s show in January and supported by resources on NAHB’s website, the Partnership Pavilion can help facilitate the process of lining up builders with equity partners.

Presented by NAHB’s Business Management and Information Technology Committee and Builder magazine for free to association members, the webinar was the second in a four-part series, “New Horizons Webinars: Setting a Course for Success in the New Market.”

NAHB members can find AD&C resources at www.nahb.org/adcresources.