As construction financing all over the city sputters, many developers — from giants like Extell to builders of simple four-unit condos in the boroughs — are finding themselves on the hook for more cash.
Since lenders are unwilling to fund cost overruns as the market spirals downward, many developers are being forced to pour unanticipated millions (often out of their own pockets) into partially completed projects — or face not finishing the job.
“As developers, we have a choice,” explained David Kislin, co-developer of Five Franklin Place, who is funding the Tribeca condo entirely out-of-pocket along with Leo Tsimmer, his partner at the firm Sleepy Hudson. “We could stop and hope the world gets better, or we could build with our own dollars.”
That’s not an option for every developer, and the coming months may spell disaster for builders without capital at their disposal.
“In a lot of cases, they don’t have the cash,” said Jarret Tarnol, director of commercial real estate finance at the Manhattan-based GFI Capital Resources Group. “This is a market that’s cleansing itself of people who don’t have the resources to cover these contingencies.”
During the recent construction boom, lenders willingly funded the cost overruns, delays and design changes that nearly always occur on construction sites, confident in the projects’ earning potential in a rapidly escalating market.
“It became absolutely standard for banks to fund overages as part of the construction loans because projects were doing so well,” explained Gary Rosenberg, founding partner at the law firm Rosenberg and Estis. “They were happy to loan you more money.”
But the crisis on Wall Street quickly reversed that trend. “There’s a great deal of concern surrounding the slowing pace of sales in new developments and what the future holds for the units that will be coming online,” said David Schechtman, senior director of the turnaround and distressed group at Eastern Consolidated. “For projects that have run into cost overruns, or any of the other myriad pitfalls particular to development projects which would require additional equity, those pitfalls are causing trepidation on a level they wouldn’t have had a few years ago.”
In many cases, the banks are simply unable to fund all or part of the loans. “These banks are underwater,” Tarnol said. “They’re on the hook for their losses. They don’t have the capital to fund the loans they’ve committed to.”
As a result, they’re scrutinizing each project much more carefully. “A lot of clauses in loan documents are being reexamined,” he said. “Banks are finding ways not to fund these deals.”
And when developers attempt to refinance their loans or get an extension in order to fund cost overruns, lenders refuse — or demand that a developer or the project’s investors also put equity into the deal in either cash or forbearance in the form of interest accrual until a later date.
In other words, Schechtman said, “The bank is telling you, ‘The well is dry. You’ll have to go out of your pocket.'”
The problem is widespread, afflicting projects of all sizes.
According to Marc Shapiro, a partner in the real estate group at Orrick, Herrington & Sutcliffe, virtually every project that has financing that’s either matured or will mature in 2008 has had to deal with finding replacement capital. “The lenders will naturally look to the developer to invest those additional dollars,” Shapiro said.
Developer Gino Vitale of Vitale Builders in Red Hook, Brooklyn, recently sank $3 million of his own money into a partially completed 15-unit residential building in Carroll Gardens after requests to his lenders for additional funding failed.
“When I went back to the bank for more, they said, ‘We can’t give you another penny,'” he noted. “The only reason it’s working is because I put $3 million of my own money in.”
He added that the requisitions process is taking much longer than normal. “I needed $380,000 and they sent me a check for $80,000,” said Vitale, who owns some 40 properties. “The rest I have to pay out of my own pocket.” If he doesn’t pay it himself, he won’t be able to pay subcontractors, risking that they could walk off the job or put a lien on the project (see More subcontractor woes expected).
“If we’re not getting funded, we can’t pay our subcontractors,” he said. “It’s a snowball effect. There’s a lot of stress on the developer if the banks aren’t giving us any funds.”
As a result of similar cash-flow problems, subcontractors and suppliers are also short of money. “My subs, they’re getting tormented by suppliers,” Vitale said. “Normally, they wouldn’t ask me for a penny. Now, they’re begging me.”
Some developers, finding themselves unable to get construction loans to begin with, are building projects almost entirely on their own dime. For example, Extell’s 900,000-square-foot Diamond Tower on West 46th Street is reportedly proceeding with foundation work, though Extell CEO Gary Barnett hasn’t yet announced a construction loan.
“Developers are not just putting in a lot more capital, they’re self-financing their projects,” said Sleepy Hudson’s Kislin, who likened the situation to driving a car cross-country without using credit cards to pay for anything along the way.
“We’re filling up the gas tank with our own money,” he said.
For its part, Sleepy Hudson is banking on the fact that few new construction projects will come out of the pipeline once the economy recovers.
However, many of the small-time developers who entered the business during the building frenzy of the last decade don’t have deep enough pockets, or enough industry connections, to tap into new capital streams.
“The late ’90s and early 2000s was the great age of new developers,” said Jeff Bern-stein, a partner at the boutique real estate investment firm Guild Partners. “There was tons of money to be made, and lenders would back people that weren’t experienced.” While many were successful, he said, “they didn’t amass the wealth to be able to come up with a check for $20 million.”
As a result, some projects will never come to fruition. “There are a lot of projects that are just shelved for now,” said Eric Zipkowitz, a real estate partner at the law firm of Wachtel & Masyr. “There are a lot of holes in the ground that are going to stay as
holes in the ground until … the credit markets start flowing again and the basic economic assumptions that drove the project are back in place.”
As for the developers, “some of them unfortunately will lose control of their projects,” Schechtman said. “Some will see the worst-case scenario, which is their equity wiped out of foreclosure.”
A bevy of new funds has sprung up in anticipation of the troubled properties expected to flood the market. For example, Douglas Durst, CEO of the Durst Organization, has announced plans to invest $300 million in distressed properties through a fund he’s creating with the development firm Sidney Fetner Associates.
Other developers will end up taking on partners, even if that means sharply cutting into their profits. “We are working with developers and their financial partners to bring fresh capital and solutions to the problem,” Schechtman said.
But whether a project survives depends heavily on its fundamentals. “There are plenty of guys who are well-capitalized,” Bernstein said. “It’s all about staying power.”