Capital

Higher Money Costs Spread AD&C Pain: A Case Study Solution

A multi-billion dollar 385-acre, 2,216-home master planned community already through successful phases of development – One Lake, in the Bay Area's Solano County, CA – had a brush with a liquidity event. Here's what happened next.

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Capital

Higher Money Costs Spread AD&C Pain: A Case Study Solution

A multi-billion dollar 385-acre, 2,216-home master planned community already through successful phases of development – One Lake, in the Bay Area's Solano County, CA – had a brush with a liquidity event. Here's what happened next.

Together with
December 12th, 2023
Higher Money Costs Spread AD&C Pain: A Case Study Solution
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Things go off the rails in the world of residential community development and construction all the time, and it's harrowing. But it's often just a starting point. For all the rules of engagement that drive deals, set the stakes, and lay out the terms of project resources, commitments, investments, and returns, improvisation on all of those rules stays on the table.

A theme and variations of such improvisations are playing out across U.S. residential real estate as financial turbulence works its way into both newly penciled and ongoing projects, some of them with billions of dollars hanging in the balance. A domino effect of financial stress got set in motion when a quantum leap in the cost of capital occurred as the Federal Reserve launched its fiscal and monetary policy war against inflation in early 2022. This cascaded down among lenders and finance partners and spread strain and duress into some of the nation's residential community projects that had been thriving up until the Fed pivot.

One such deal, a multi-billion dollar thriving 385-acre, 2,216-home master planned community already through several successful phases of development – One Lake, in the Bay Area's Solano County, CA – came face-to-face with a liquidity event as higher interest rates threw normal channels of acquisition and development capital into a state of upheaval during the past two years.

Last week, Builder Advisor Group announced its affiliate – One Lake's lead developer Walnut Creek, CA-based McKinley Partners – closed a $70 million first-lien loan as the lead lender for One Lake. The loan is being utilized to replace Trez Capital as the previous lender and finance the development of more than 1,400 entitled and partially developed lots.

We had a $32 million facility with Trez," Steve Riter, a Founding Principal at McKinley Partners, operating in land investment and development for more than two decades on the West Coast and Mountain States. "I think the year we did that was in 2021 and that was the facility that we had. We were moving along in June of 2022. The project was in very good shape. We had returned capital to our primary and initial investors and getting profit participation from our builders. We had the next $18 million of land sales of about 106 lots scheduled to close in the fall and winter of 2022. And so we were feeling very good. We still had headroom in our existing loan facility to borrow against all the needs that we had. And so we moved into preparing to open up our next planning area – planning area five – which required a massive infrastructure lift for the next 1,104 homes in that planning area. We were preparing for that when interest rates started shooting up."

What followed was a white-knuckle brush with financial disaster. Long and short of it, Trez – getting squeezed under the weight of its own exposure to changing interest rates – put pressure on McKinley to deliver up or suffer existential consequences.

The borrower faced challenges with the previous senior lender's mandated paydowns, resulting in impairments and restrictions on further land development," says Tony Avila, CEO of Builder Advisor Group. "Our loan replaced the senior loan, paid off a second lien, satisfied accounts payable, provided capital to finish lot improvements for the remaining neighborhoods, and funded a 9-month interest reserve. Our affiliated debt fund demonstrated its ability to move quickly and close within 60 days."

At the time Riter and one of the other McKinley Partners founding principals Dan Aguilar started working with Encore, they were not entirely sure they'd be able to get the $70 million loan closed. Still, they were able to tap into a deep well of trusted-relationship capital with a number of their wet and dry utilities, grading, and infrastructure contractors to carry through on horizontal development activities during a financially treacherous stretch.

Everybody was getting skittish, Trez included," says McKinley's Riter. "So, during a very difficult stretch financially, we leaned heavily on our sub base, and we had a fantastic and very cooperative group of subs that carried us through this whole summer and into the fall to let us continue to make progress on Planning Area 5, so that we could deliver the next few neighborhoods in early 2024 and mid-2024, to put us in a position where we could have that in August."

Here's how Riter describes what had to feel like a frantic attempt to line up capital that would spare the project from a vicious circle of land impairments, devaluation, and diminishing returns.

We had some unresolved issues with our seller that had to be taken care of, and we were at the 11th hour on those," says Riter. "The Encore team became very flexible in allowing us to facilitate a transaction, with some covenants that we have in terms of LTVs and things like that. So we were able to successfully negotiate with the seller, and get it resolved and closed just at the 11th hour. In the meantime, we were successful in getting Lennar to acquire 131 lots with the prior lender. Encore was creative enabling us to tricky transaction. And then they and then they were also astute in understanding the entire cost to deliver the balance of the project."

The One Lake project is not alone in its moment of truth as a higher-rate environment continues to press hard on lenders and borrowers alike.

We're seeing less and less capital available for acquisition and development financing," says Avila. "We're seeing banks either pulling their lines or stopping lending on land acquisition and project land acquisition and development financing. And as the banks have pulled back, private credit lenders have also pulled back. We're focused on that and here to help."

Today, Wall Street investors are sharply divided over whether to fight the Fed, time the Fed's next move, or take the Fed on its word.

Meanwhile, access to the real-world upfront acquisition and development capital it takes to keep the power on for the near future of new residential real estate activity is tough and getting tougher.

National Association of Homebuilders chief economist Robert Dietz noted recently that construction lending among FDIC-insured institutions has trended down the past two successive quarters, and is now down 2.9%, year-over-year.

On the other hand, Dietz observes, the fact that lenders have tightened up on credit and are charging borrowers more for their business hasn't stunted the appetite among land investors and developers to keep building lot supplies at least on a par with where they've been rather than to lose ground. Dietz writes:

The current amount of existing residential AD&C loans now stands 51% lower than the peak level of residential construction lending of $204 billion reached during the first quarter of 2008. Alternative sources of financing, including equity partners, have supplemented this capital market in recent years."

ABOUT THE AUTHOR

John McManus

John McManus

President and Founder

John McManus, founder and president of The Builder’s Daily, is an award-winning editorial, programming, and digital content strategist. TBD's purpose is a community capable of constant improvement.

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