Zombie Condos, Part II: Day of the Charge-Off

by: Jeffrey Bernstein

So what's going to happen to all those partially built buildings around the city and the boroughs? I am afraid the prognosis is not good unless the developer has deep pockets....and who has deep pockets these days? Even those who do are up to their pockets in alligators right now. But let's go through an example of what happens to a real estate project when it fails to achieve its original highest and best use.....I'm warning those of you with weak stomachs that it ain't pretty. According to the International Herald tribune article cited below, there are over 100 of these sites around New York City.

But first, an explanation of highest and best use. Highest and best use is an appraisal concept, but it's a really good way to think about how land is utilized. Simply stated, the highest and best use of a piece of land is its maximally productive (most profitable), legally allowable, physically possible and financially feasible use. So, for example I may have a piece of ocean-front property and I may want to build a casino on it, but if it isn't zoned commercial, isn't in a place where gambling is legal and the flood and wind insurance is ridiculously expensive, I'm probably not going to be able to make much money trying to do it and therefore probably won't be able to, period.

In general, certain locations will best support certain kinds of development depending on zoning, traffic, supply/demand etc. In the last number of years the highest and best use of land in New York City in areas zoned for residential development (and even in some that aren't) was condominium development. Residential real estate prices were high and rising, supply was reasonably tight, financing was available on good terms and condominiums can be sold out quickly, allowing the sponsor to pay off their debt and extract their profit quickly.

At the tail end of the real estate boom, when condo prices started to stall and financing condominium projects got hard to justify, hotel development became the highest and best use in many areas (even those zoned for residential) because the hotel market was very tight. The near 90% occupancy (which is about as good as it gets because they have to change the sheets some time) and high and rising room rates, appeared to support new supply additions. Hotel development should naturally have a high return because unlike office or retail properties which may be rented for five or ten years with rents indexed to inflation, hotels have very volatile/unpredictable cash flows. They are an overnight leased fee business, so you never really know what your cash flow will be tomorrow (yes, reservation systems give you some visibility, but you get my point) and you have to really manage them; they are probably the most management intensive real estate asset, followed by multi-family.

Now, land sellers are not stupid. They know that their land is going to be bought by a developer building condos who thinks he's gonna sell out at $1,400 a square foot, or a hotel builder who is going to get $600 per key for his hotel in an acquisition; and they price their "PRIME HOTEL DEVELOPMENT SITE" accordingly. This is where the trouble starts. Developers, whose job is to develop stuff, buy this premium priced land, which already has a bunch of the developers' profit baked into the price because to develop stuff you need land. They then race to get the building built while the market is still good. That's unless they are the deep pocketed/experienced guys who buy up cheap land in a downturn, or when a neighborhood is bad, and sit on it until they can see that in two or three years when they finish building the market will be primed to take up the space. Read here about how even these very experienced, professional and deep pocketed types are being vexed by the current environment.

Okay, now you get the picture of the challenges that developers face, but usually can surmount when prices are going up, up, up. Now I will share with you an example of what happens when things go wrong going into a downturn. Names and other details have been changed to protect the subject.

I recently came across a project in an emerging market of New York City, where the developer built a very nice condominium building and ran out of construction funds when he was about 85% done. He had some delays and construction problems, resulting in cost overruns, and the bank refused to give him any more money. He had already used some mezzanine financing and could not access any more debt. Now this guy, unlike so many of the New York City developers who were buying land in the last couple of years, paid only a couple million bucks for his land 15 years ago and could have sold it for $10 - 12 million 2 years ago, but decided to develop it. Note for those who have not seen my previous comments about the New York City land bubble, here is a chart of data from the New York Fed, from about 9 months ago. The chart doesn't look like this anymore...

Unfortunately, he chose to build, and he actually had pretty good luck in pre-selling the units. He was able to pre-sell maybe 55% of the units for $900 per square foot (reasonable for the fictitious neighborhood), implying a value for the project of about $60 million. His construction loan was $25 million and he had $2 million of mezzanine debt. He needed an additional $6 million to finish the project. There is a school of thought that would say, despite all the financing challenges in the market and the decline in the value of these units since pre-sale, if you really put your back into it, you could blow these condos out in the next 6 mos. for $650 per square foot on average, leaving a project value of $46 million and a profit even after the additional construction cost of maybe $10 to $13 million.

The 'take in a partner - finish the building - and blow out the condos' option doesn't actually exist in this environment. No investor wants to take that kind of risk, regardless of how much of the $13 million profit you offer them. Here's where it gets ugly.

When banks used to underwrite a condo deal, they wanted to know what it would be worth if they ended up owning it (they have revived this practice in the last 12 months, but they aren't really financing anything anyway). To be conservative they would value the building based on its use as a rental property, which the bank would own and rent out, until it got its money back, just in case the sale of condos was somehow precluded. If you read some of the recent press out their about Zombie condos, you will see that many have been going rental. So that is how this fictionalized property is currently being viewed by potential investors.

Valuing the property as a rental, where the initial investment is recouped through years of rental income (which is very tax efficient, but slow) produces a current value of approximately $27 - $28 million. You see multi-family rental is not the highest and best use of a building of this type, even in today's environment where condo prices are down 15% plus. Even if it were, it's a way less valuable use than condos were a couple of years ago when the construction financing was put in place.

As a result, we have to take the $28 million rental value, back out the $25 million construction loan, $2 million mezzanine debt plus the additional $6 million the bank would have to spend to finish the building and oops, this thing has negative value. In truth, the developer's equity is totally wiped out, the mezzanine debt position is worthless and the bank will likely take a loss even if it finishes the building itself and keeps it for five years. Since the bank isn't in the business of throwing good money after bad and managing multi-family buildings, it will probably look to sell the loan for a haircut. An investor looks at this and says, well the building is worth $27 - $28 million, but I need to spend $6 million to finish it and then I will have the carrying costs of marketing it and getting it rented up and maybe some interest cost, plus I want a good return. So, I'm only willing to buy this thing for .......drum roll please! Maybe $17 million. That's right, the project, which originally was selling out at an implied value of $60 million, will be sold for $17 million, with the bank taking an $8 million hit.

Now take a look out your window at all those half built condos and hotels....OOOH that's gonna leave a mark. Understand as well that before the actual charge-off of the bad loan and sale to an investor at a price where something can be done with the site, the bank will have to foreclose on the borrower, who may try to declare bankruptcy to forestall the process/allow for some kind of debt restructuring, all of which can take a year or more. You can read about how messy these battles can get here. The one positive fallout is that land prices are going to continue to be crushed, which will eventually help make new development sensible again.....eventually.

Companies with exposure to New York City construction activity include VNO, FCE.A, GKK, NYB, SOV, COF, SFI.

Disclosure: The author has no positions in these securities.