Workouts for private builders could take another 2-3 years
We recently hosted a conference featuring David McCain of MPKA, which is a consulting firm that provides financing and debt restructuring advice to homebuilders. Private builders may still require another 2-3 years to fully work through legacy real estate transactions that usually carried full recourse for the borrower. This recourse element has complicated restructurings as most private builders have personal asset holdings that are real estate centric and therefore do not carry the liquidity necessary to quickly address non-performing loans. Many small banks are still not aggressively pursuing loan restructurings given limited capital reserves that could be further strained by recognizing a writedown on a failed loan. Home prices have declined 31% since the peak, which implies that land prices are down more than that given relative stability in the value of construction materials. At this stage of the cycle, modifying existing loan terms is less common while foreclosure and liquidation are becoming more prevalent, which implies continued opportunities for public builders to acquire attractively priced land for at least the next two years. We estimate that ~40% of deliveries for the industry this year will come from newly purchased land (since the beginning of 2009), which carries a gross margin benefit of at least 200bp over legacy lots.
Restructurings are now making their way inland
Loan restructurings for private builders on the East and West coast were the first to be addressed when the downturn began, which may reflect the quick demand recovery in those markets and the ability to execute trustee sales versus the judicial foreclosures that are required elsewhere in the country. Credit issues in the Midwest are now coming up with increasing frequency, which includes Indiana, Michigan and Ohio. Addressing these loans could present attractive lot deals for public builders that have a large presence in those markets, which include BZH and MHO in Indiana (>10% of their national community base) and MHO and NVR in Ohio (>20% of their national community base). BZH could be a particular beneficiary as we estimate that only 25% of its deliveries in F2011 will come from newly purchased land, which creates an operating leverage drag relative to peers.
Capital available for construction but not lot acquisitions
Credit availability generally remains non-existent for acquiring and developing entitled land given the still ample availability of finished lots, although some lending has returned for home construction in attractive markets (e.g. cities on the coasts). A lack of credit from smaller banks may persist even after housing starts rebound as commercial loan issues are starting to arise with increasing frequency, which reflects the fact that these loans typically carry longer maturities than residential loans and therefore are only now starting to mature. This reality could erode capital for smaller banks that otherwise would be available for residential real estate development. Terms for residential construction loans to private builders carry maximum loan-to-value ratios of 50-60% versus more than 70% at the peak and require at least six months of cash collateral to cover interest payments. The alternative to bank credit for private builders are private equity or other investment funds that are extending loans at interest rates in excess of 10% or making equity investments with a targeted return on capital of at least 18%, which severely limits the scope of projects that private builders can pursue.
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