Chapter 11 Bankruptcy

As one continuation of my blog about the Great Recession, I’d like to share with you what I know and learned about Chapter 11 bankruptcy.  It was the best of times; it was the worst of times.  No, it was really just the worst of times.

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In 2007, the owner and equity partner for our development business sold their entire real estate portfolio to Morgan Stanley.  The core business was nice office buildings throughout Texas and cities in the Southwest.  The timing was perfect for the seller, and the creator of that business is a legitimate billionaire as a result.  Morgan Stanley was buying up real estate as fast as they could to have a place to put all the money that was flowing in from clients that wanted to be in real estate.

They couldn’t buy fast enough.  Even the smartest guys in the industry were caught up the frenzy, same as  our retail buyers who showed up at the lotteries.  They were making the purchases with huge short-term loans from global banks so they could lock up the assets before the equity was even in.  Late in 2007 things started getting a little shaky, but not full on disaster, yet.  The in 2008 we watched everything fall apart.

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I was laying a lot of people off.  We were making sales for the lowest price per foot we’d ever done on a new condo building.  We were desperately trying to pay back construction debt with sales wherever we could.  Buyers were suing to get out of their contracts to close on units.  California law makes it easy to walk from a deal if you can prove the developer did something wrong and that’s the path people were taking.

Sometime in 2009, it became obvious that Morgan Stanley would not be funding our business any longer.  We were on our own to cut costs and generate revenue however possible, and they were going to default on the $4 billion loan they used to acquire the business that owned ours.  The mighty Morgan Stanley was on the ropes themselves.  It was just unimaginable to watch these institutions that once seemed only second to the Federal Government in terms of wealth and power just dry up and crumble away.

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Remember seeing this guy on the news every day? Treasury Secretary Paulson

I was the Corporate Controller of the business at the time and not involved in every decision at the top.  Some time in the fall of 2019 I started to hear that a bankruptcy was being considered.  I knew nothing about it at the time but was going to learn quickly.

As I’ve mentioned before we were in the first third of a long-term development project that had taken many thousands of hours and endless expertise and hundreds of millions to dollars to lay the groundwork for so we couldn’t just walk away.

There was much cross-collateralization of debt at the time (this topic is worthy of another blog) and we had a plan to protect the “good” long-term assets in exchange for giving up some of the heavily-indebted ready for sale inventory, including a 5-star luxury hotel that had been 10 years in the making.

The plan was to file a Chapter 11 bankruptcy.  Chapter 11 is a plan to stay in business.  It means all the parties with current or future money owed must vote for a deal that affirms they would rather take something less and agree there is benefit to your business surviving.  Chapter 7 means liquidation, the business is over, and the creditors divvy up the proceeds of the sale of assets.

I will blog again about being in the middle of Chapter 11 and how it ended up.  If you like my blog, please follow in the sidebar to the right. Also, please connect with me on Twitter or LinkedIn.

The Great Recession

The Great Recession happened right in the middle of my career.  I worked for a real estate development company on a large-scale project that was about 7 or 8 years into a 25-year master plan.  And it was high-end, second home resort development in California.  It really could not have been worse.

We started on several golf and ski resort communities in 2000.  We were taking a model that had worked in the high-end mountain resorts of Colorado especially well during the convergence of the late 90s tech bubble and empty nest baby boomers arriving at the peak of their vacation home purchasing potential.

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We adopted the model to California resorts with high hopes that the market was ripe for some new development.  The plan included two brand new golf course communities, a high-end luxury hotel with a residential component, and an 1,800-unit master planned community at the base of and on the ski resort, and a club to bring it all together.  Entitlements and planning took a couple of years but when the first real estate was offered it was obvious the plan was right.  In 2002 we began delivering finished lots and townhomes, and by 2005 we were delivering a multi-story mixed-use base ski village that was the nicest in the state. 

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At both the golf course communities and the ski village we had oversold lotteries to allow potential buyers the opportunity to select lots or units based on architectural renderings and site plans.  We had people threatening to sue because they showed up at a fancy hosted party and were unable to get their chance to plunk down a hefty deposit for a lot that hadn’t even been built.  That was the peak and we all now know that money was just too easy to come by and that was the real source of the hyper-competitive market for any and all real estate. 

We were writing the term sheets for construction loans and delivering to the banks, knowing if they didn’t take our proposed terms another bank would.  We created three different Community Facilities Districts with local utility and community services providers based on appraisals showing sales in the billions of dollars over the next 20 years.  Based on the way real estate was selling at the time, the assumptions were correct.  We had taken out every loan available, including the biggest loan the company had ever closed on to build the 5-star luxury hotel.  The loan was so big it took a consortium of four major international banks to deliver the funding.

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None of this was easy.  There was so much effort put in by smart and hard-working people.  We had folks that had relocated from around the country, experts in construction, sales and marketing, land planning, architecture and design, and finance.  The machine was humming, and the future was bright.

It was all too good to be true.

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Homeowner’s Associations are such a mixed-bag when it comes to real estate development.  When a buyer hears HOA it can sometimes communicate a superior product, with lush maintained lawns, sparkling pools surrounded by towel draped chaise lounges, and shiny new fitness equipment always empty and available to help you change your life for the better. 

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HOA may also communicate lengthy Board meetings full of contentious issues, know-it-all Board presidents who like to impose their will on unsuspecting neighbors, and lawn police.

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One of the first questions I hear out of many real estate shoppers when informed the property they’re looking at is part of an HOA is, “How much are the dues?”

Many of the real estate projects I’ve worked on through the years have included HOAs.  The appeal to developers is they can put in that fancy entrance gate and signage, they can include a park with bocce courts and firepits, and they can add the pool/fitness room/men’s and women’s locker/spas and not have to pay for them forever.  The facilities are very attractive in the sales process and many buyers are truly attracted to an amenitized community that will have certain standards enforced on new construction within the community.

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Developers build the amenities, hope to recover the costs with increased sales revenue, and know they can turn the facilities over to HOAs to maintain and manage in the future.  In theory, it’s wonderful.  In reality it can be, too.

But when things go south with the HOA it can tear a community apart and be hunting grounds for construction defect attorneys.

One risk a developer takes with constructing and operating HOA amenities is that sales pace could slow dramatically and leave the developer paying tens or hundreds of thousands in dollars in annual dues for units that have yet to sell.  In California, developers are required to provide financial instruments that guarantee the viability of the HOA until the point when enough units have sold to buyers that the expense of the HOA is not concentrated with the developer.

Another problem HOAs create for developers is they provide a gathering place for buyers to complain about problems with their units.  Developers and builders generally offer warranties on their products and successful developers stand by their product and take pride in what they do because they want to continue doing it.  It’s relatively easy to deal with one buyer and their complaint(s).  When a group of buyers convene in the HOA and share complaints they tend to feed off each other.  Suddenly, an innocent design or construction mistake can transform into the belief that the builder and seller conspired to construct a low-quality product and commit fraud upon their customers.

Next add a construction defect attorney to the mix, who gets paid a percentage of whatever he or she can recover from the developer and their insurance company.  There exists an entire industry based on hijacking HOAs and convincing them to enter lawsuits that cost millions and take years and tear apart many relationships.  There may be ultimately be siding repaired or windows replaced but when the motivation becomes the largest possible legal victory instead of fixing simple construction problems, much is lost along the way.    

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Opposition to Development

There is much opposition to new development in this world, some of it warranted, much of it not.  This is one of the most difficult parts of the development process.  Developers like to work on a level playing field but so much of what happens when plans materialize for previously undisturbed land is highly emotional and can become a political issue.

Two of the major opposition groups to developers are environmental groups and the classic NIMBYs.  I’ve worked on development projects in the mountain resorts of Colorado and California.  It’s amazing how much local sentiment can affect the ability to create new communities in certain locations.  As far as I can tell, there is not an acre of land in the US that is not spoken for by someone or by some entity.  And as mentioned in a previous blog, every parcel of land in this country falls under some jurisdiction, whether it be a county or the federal government.

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Most developers study and understand the rights vested in land when they purchase it with an eye for future development.   Land must make sense physically.  You don’t want to have to move a mountain or fill in a lake if you don’t have to (though projects like that start to make sense in certain cities).  But after you determine the land makes sense you need to make sure the governmental entity in charge allows for the land use you would like to build.

In today’s world, most cities and towns want to grow and have a plan for that growth.  Commercial in certain locations, dense housing (apartments) in others, parks, schools, single family residences, and roads, trails, and public transportation corridors that connect it all together.   You can tell when you’re in place that’s been planned versus a place that grew up in fits and starts and doesn’t make sense.

Most developers would like to create a place that functions well for their customers and that starts with fitting into the bigger plan for the community.  But when someone sees the empty field behind their house that their kids rode dirt bikes on, or that they walked their dog in, sometimes something snaps when they find the current usage might change.

Mountain towns are infamous for the “pull up the drawbridge, we’re full” mentality.  I’ve seen it so many times.  There are many folks who have their house on the lake, near the creek, or in the dense forest, who object to anything like their very own property ever being built again.  It’s remarkable how emotional folks get in their effort to deny additional opportunities for people to live the lifestyle they so love.

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We cannot poison our waters and cut down all our trees and I’ve never met a developer who wants to do that.  Most understand the reason people want to live in a specific place and the goal is not to ruin that.  A major part of development expense (which ends up in the home price) is when a developer buys land with certain rights, but the plans to develop are objected to by members of the community, and local politicians and government officials don’t play by their own rules or even change them midstream.

There exists a perception of the big bad developer who would poison the environment to make a buck, but I haven’t seen it.  There is however now a whole industry motivated towards fighting development and the professionals who engage in it are no less motivated by financial gain than the developer.

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In real estate development there are many reasons and ways to determine what a parcel of land is worth.  It’s easy to figure out what a house in a neighborhood that has an abundance of sales activity is worth.  We all start with the average sales price per square foot on recently sold homes in the same neighborhood.  Adjust the per sq ft number up or down based on the level of finish (floors, counters, fixtures, etc.), amenities (pool, outdoor kitchen, 3 car garage) and precise location (backs up to permanent open space, views, away from heavy vehicular traffic).

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It’s far more imprecise when considering the value of that neighborhood’s vacant land in the state when no development improvements had begun, and houses had yet to be constructed or sold.  Appraisers are independent certified professionals who can offer an opinion of value on the land, your building, your house, or whatever else you need.  They’re most often called in when you’re securing debt on property, from a construction loan to mortgage, or even the public financing options that I discussed in the previous blog post.  Appraisers are hired by the group or institution that is doing the lending to provide some comfort that there is value in excess of the debt to be provided.

Appraisers are doing the same work as the county assessor and the underwriter for the developer who is trying to figure out what a piece of land is worth.  There are two key ways to determine value on an undeveloped land parcel.  Appraisers use discounted cash flow models or look for market comparables.  In a perfect world they have both.

A discounted cash flow is a business model that shows the cash flows, in and out, over the life of the project.  In real estate development the first big outflow will be for acquisition.  Second, you’ll see outflows to design the project and obtain county or city approvals.  Next, you’ll see outflows for construction of infrastructure and for the team to manage the process.  Finally, you’ll see marketing outflows that ideally soon generate sales, and cash inflows. 

The discounted cash flow (DCF) will take those periodic cash flows and discount them by a factor that incorporates the relative risk of the project, inflation, and bakes in the cost of the invested capital that is used to fund the costs.  DCFs are strange in that the discount rate is negotiable but should be relatively similar to projects with similar profiles and life spans.  Regardless, take all the cash flows in and out over time, apply the discount rate, and you have a present value of the project.  The appraiser is generally going to start with the developer’s model since it’s presumed the developer has a reasonable handle on the costs and the market for sales.

In almost every instance the developer wants the appraisal or valuation to come in as high as possible.  Except when you’re dealing with the county assessor, in which case you want their DCF to generate as low a present value as possible.  Adjusting costs higher or lower, adjusting sales volume and pace, and tinkering with the discount rate will all drastically change a project’s value.  Excel is the tool most everyone uses.

This just begins to touch on the art and science of valuation.  There is a lot of gray area, but it can be critically important in determining if a project will get off the ground.

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Public Land Finance

There are many ways to finance real estate development.   Owner or investor equity and bank debt are the traditional ways to fund development.  But there is another way, unknown to the general public, rather mysterious and complex, and dominated by experts in this niche industry.  Developers can unlock serious funding for public infrastructure if they can develop relationships with governmental entities that are willing to sponsor their plans and can assemble the team of attorneys, engineers, consultants, and financiers that it takes to get it done.

Public finance is a local industry.  As far as I can tell it differs from state to state and some states utilize the tool more than others.  In Colorado they have Metro Districts, in Nevada they have Special Assessment Districts, and in California they have Community Facilities Districts.  I’ve worked on several Community Facilities Districts (CFDs) but assume the mechanisms are similar in every state and also assume all 50 states have a similar tool on their books.

CFDs in California are commonly called Mello-Roos districts, named famously (or infamously) after the California legislators who sponsored the bill that created the structure.  All these districts are a way to promote development of public infrastructure while funding it with a tax assessed on the land that is developed and assumed to have a much-increased value once the roads, sewers, electric lines, stoplights, fire stations, and water tanks are completed that will benefit the land.

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A developer/landowner must partner with a municipal agency that has the legal authority to levy a tax.  Municipal agencies (cities, towns, utility districts, services districts) will engage if there is some benefit to them such as a new fire truck or a new well.    It also allows them to build their empire by increasing the size of the public infrastructure they manage and the residents/customers for their services.

When the developer owns all the land, they can vote to allow a special tax to be levied on the land.  The municipality can then sell tax-exempt bonds based on the special tax they are going to collect over the next 15, 20 or 30 years.  The municipality will engage an investment bank to do their magic to figure out how much total dollar volume can be sold based on the projected tax collection.  They’ll figure out what interest rates need to be offered (lower rates mean more debt can be serviced) and how to sell the bonds to institutions and retail clients.  Of course, the bigger the issuance the bigger the commissions collected by the bank so they’re properly motivated.

The bonds are sold with many disclosures to ensure that bond buyers know the revenue sources that will pay them, what the bonds paid for or will pay for (the facilities), and how the bonds fit into the overall tax load on the properties that will pay them back.  The tax load cannot be too high relative to the value of the property.

The bonds are generally regulated by the SEC and can achieve a rating from the bond rating agencies.  However, if the bonds are being sold ahead of the development happening that will create the value that will support the bonds then you have “story bonds”, with no rating.  The buyer has to believe the seller’s story and believe they can execute on what they promise.  As a bond owner, you look forward to the day in the future when your cash flows are supported by the 1500 new families that own new houses in the brand-new subdivision rather than paid by the one developer/landowner who is in the early stages of taking a large risk in developing the land.

The public financing can significantly reduce the upfront capital investment in the project required by the owner when the bond proceeds are used to acquire the completed public infrastructure from the developer, but the tax obligations and servicing of the debt, and ultimately repaying the bond debt, remain attached to the land until they’re paid off.

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Due Diligence

Due diligence is a term common to many lines of business and industry. It simply means to do your research before making a purchase. According to the Investopedia site it became a common practice and common term with the Securities Act 0f 1933. The law was meant to ensure that investors had access to truthful and relevant financial information and disclosures when considering the purchase of publicly traded stocks and other financial instruments.

In real estate due diligence is a similar concept but can be a very lengthy and complex process, with lots of room for interpretation and errors. You’re looking for a piece of land to develop. You think you have a good idea for how to use the land that will be in demand. You’ve got some money committed for purchase and improvements based on your plan generating a return. Now the fun starts.

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The nice thing about buying land is that you can see it, feel it, walk on it, observe the activity that happens on and around it. But in 21st Century America it can often be what you cannot see that matters. There is no land that someone doesn’t own. And there are a lot of individuals and groups that have rights to land they don’t own.

In Nevada the federal government owns approximately 85% of all land. Even when land is not publicly owned it usually has some designated use in the municipality in which it exists.

The first step in your due diligence will be to figure out what you’re allowed to do with the land. Can you build residential units? Homes or apartments? Can you build commercial? Can you farm it? Does a certain percentage have to remain undisturbed? How tall can you build? Etc.

You’ll find most of the critical information about the property in a title report. The title report will list all the ownership claims to the land. It will list all the easements. The easements determine who is allowed access to the land for various uses. Is there a major utility that runs underneath your property that can’t be disturbed and occasionally needs maintenance? Does someone have the right to drive cattle across your property every spring and fall ? (I’ve seen it). Does a mining company have rights to access some valuable mineral found deep underneath your foundation? Better know now.

When you enter into contract on land the contract will usually define a due diligence period which allows some time for you to perform this research before closing on the property. The contract will usually allow for refund of the deposit if you find anything that’s detrimental to the value of the property. The seller will usually provide any relevant information they have about the land that will help facilitate a sale, but not always. It can be a nice head start but you’ll want to rely on your own team of experts. Lawyers, land planners, engineers, architects, hydrologists, geologists, biologists, and lobbyists may all be critical in determining the allowed use.

There’s plenty more to consider when purchasing land and I’ll revisit this topic in the future. Just remember to leave no stone unturned. It’s often what you don’t know that can be dangerous.

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