With lenders going into bankruptcy and the sales market disappearing, developers all over New York are facing choices about how to ride out this down cycle.
“If you go past construction sites, there are buildings with cranes that aren’t moving,” said Shaun Osher, CEO and founder of Core Group Marketing. “There are half-built buildings where there’s no construction happening.”
However, the choice of whether to “mothball” a project isn’t always up to the developer — sometimes the decision is made for him by the current lack of loan availability.
“Some developers, because they were trying to get into the ground before the 421-a tax abatement expired [in July], even used their own money, and now they can’t get construction financing,” said Andrew Gerringer, executive vice president of the development marketing group at Prudential Douglas Elliman. “So they’re in a situation where they couldn’t even get a construction loan, so they’d be forced to mothball.”
How long a project can sit on the shelf depends, of course, on the developers’ costs.
“Often, in the deals I see, there is a provision in the developer’s pro forma that gives them time, but not two or three years,” said Steven Kratchman, president of Steven Kratchman Architect, which does development consulting.
“In their pro forma, they might have 12 months of padding, so if I were in their shoes, what I might be doing in this market is stalling these three or four months until things start to clear up, with the credit crisis [and] with the new president,” he said.
“I’d wait to find out what’s going on till more like January, or perhaps do a three-, six- or nine-month stall.”
Kratchman said he is consulting on three New York City projects that have chosen to halt development to reassess. They include a hotel, a commercial building and a condo, but he declined to cite them by name or address.
Sunk foundations, sunk costs
The decision to mothball is also driven by what stage of completion the project is in. Certainly, for those who own land free and clear, building in a weak sales market doesn’t make sense, said Alex Hurst, founder and managing partner of Palatine Capital Partners, a New York City-based firm that buys struggling real estate assets and redevelops them.
“If you didn’t finance the land, you’d sit there, and you’d hold it,” he said. “You own an [unleveraged] piece of real estate, and your carrying costs are largely the real estate taxes, which are pretty nominal on land.”
However, developers who have already financed their land could be in a difficult position. “You have to hope you can figure out a way to refinance it, because normally land loans are pretty short-term loans,” Hurst said.
With the credit markets largely frozen, a property developer might have to resort to working with the current lender. “You call up your existing lender and say, ‘The world has stopped. I need an extra two years. Can you extend the terms?'” Hurst said.
For developments that are in the middle of construction, some sales and marketing efforts have been put temporarily on hold, in the hopes that a finished product will induce more apartment hunters to purchase.
Kenneth Horn, president of Alchemy Properties, has decided to hold off on all marketing and advertising efforts for two properties — Hudson Hill Condominium at 462 West 58th Street and Isis Condominium at 303 East 77th Street — until construction has reached a point where there is one floor completed in each building, and thus a model apartment for each unit line. For Hudson Hill that will probably be next month, and for Isis it will be around February.
“Maybe a couple of years ago you could sell off of floorplans, but now people want to know that, one, the building will be finished, and two, you have financing to finish the building,” Horn said.
Meanwhile, as The Real Deal first reported, developer Kent Swig, head of Swig Equities, closed his sales and marketing office at 25 Broad Street after subcontractors on the job were not paid due to the bankruptcy of Lehman Brothers. Those subcontractors have filed liens on Swig’s project, and at least one firm, Nova Development Corp., has filed a lawsuit in Manhattan Supreme Court. Swig did not return calls for comment.
The 346-unit condo has seen its funding frozen, but he appears to be pinning his hopes on waiting things out.
“He’s closed his sales office, he’s reduced his costs, and he’s trying to sort through the financing mess right now,” said Steven Goldschmidt, a senior vice president and managing director of Warburg Marketing Group, who is not connected to the project. “And dollars to donuts, he’ll reopen at some point. He’s going to keep his offering plan alive.”
Some developers are going in search of more equity. “I think we’re going to be seeing quite a bit of this,” said Osher. “They’re either going to have to foot the bill themselves, which is highly unlikely, or try to find funds elsewhere — investors, private equity funds — which is happening a lot. Or they can try to sell their project.”
Without additional equity, the options are dim. A developer could sell the land and take a loss, or go into foreclosure and walk away from the project. If the sales market dissolves while the project is already under construction, it’s an even more perilous situation.
“Developers have a tendency to personally sign for some portion of the loan. And you’ve got deposits from people. It becomes a complex situation very quickly,” Hurst noted.
Warburg’s Goldschmidt said the smaller developers have already felt the pain of the market. “The market peaked about two years ago for those smaller developers, so there’s already been a shakeout.”
Mothballing an asset is usually a last-resort strategy. “The math is pretty simple, right?” Hurst said. “Whatever you borrow, you need to continue to pay interest on, and once your interest reserve is gone, you’re coming out of pocket, or else you’re in default.”
Lenders capitalize an interest reserve for the development period and the time it should take to sell out the project, which is typically two to three years, he said.
On a $50 million project, for example, where a developer borrowed 85 percent to build, that’s a $35 million loan at, perhaps, a 7 percent interest rate. “Every year you’re coming out of pocket for $2 million,” Hurst said. “If you continue to come out of pocket every year, at some point your profit margin disappears.”
He continued, “So for developments like, for example, Riverton in Harlem, the come-to-Jesus moments will be when those interest reserves disappear, because suddenly somebody has to come out of pocket to feed the lender, and the minute you stop paying interest, you’re in default, and once you’re in default, they can pursue remedies like foreclosure,” Hurst said.
The current climate of buyers looking for bargains doesn’t help. “Developers may be in a position where the offers they’re getting are lower than what the mortgage to the bank is, so they’re in a position where they can’t sell,” said Gerringer.
“The developer could go to the bank and say, ‘Help me in taking a bit of a hit, so I can sell it,’ but we’re not seeing it yet,” he added.
Staving off foreclosure
Kratchman said he’s being approached by financial institutions and potential investors to examine struggling projects in New York in an attempt to preempt foreclosure. He said he was involved in more than half a dozen such deals, priced at $30 million or less, in the first three weeks of November alone.
Kratchman said his role is to attach a value to the half-finished project for either the lender or the private investor. He said he recently assessed a stalled Manhattan condo for a potential investor and came up with a value of $3.5 million. The lender’s basis, meaning the principal plus accrued interest and penalties, was $5.7 million.
The developer, lender and potential investor could not come to an agreement on the price of the building, which Kratchman declined to identify, so the lender pursued foreclosure, and the property went to auction. Because no buyer was willing to pay what the lender wanted, the lender ended up buying the note and now owns the property.
“As a lender you do this because you want to protect your basis, but at the same time it’s potentially bad, because you’re sitting with a REO [real estate-owned] property on your book,” Hurst said.
Gerringer said the opportunities to purchase struggling developments at advantageous prices aren’t yet out there. “The deals aren’t out there at numbers people are willing to buy them at,” he said.