COVER STORY, MARCH/APRIL 2010

DISTRESSED PROPERTIES: IT ISN’T JUST THE ECONOMY
The construction industry may have contributed to the financial predicament that some new buildings face.
By Jaime Lackey

When you buy a new car with little money down, you can purchase “GAP insurance” or guaranteed auto protection. This insurance kicks in if your car is totaled or stolen and you’re upside down in the loan. It is too bad there isn’t a type of insurance to bridge the “gap” on commercial real estate loans when the economy is totaled.

There are a number of new or under-construction properties in the Northeast that are considered “distressed.” To find out more about how these properties are faring, Northeast Real Estate Business recently talked with Barry LePatner, a construction attorney and a specialist in construction industry efficiency and cost containment. LePatner is also the author of Broken Buildings, Busted Budgets: How to Fix America’s Trillion-Dollar Construction Industry.

NREB: From a legal perspective, what is a working definition of “distressed properties”?

LePatner

LePatner: Distressed properties include those that have been foreclosed by lenders, those that are in default by borrower/owners, and those that are in some form of bankruptcy proceeding. This has come about largely because real estate prices have cratered and the underlying debt assumed by owners on both commercial and real estate properties is out of balance with the current equity of these properties.

From a technical perspective, “distressed properties” are defined as properties with greater than 15 percent lien-to-value ratio and either $1,000 or more in outstanding Emergency Repair liens or more hazardous or immediately hazardous Housing Maintenance Code violations per dwelling unit. (Residential Landlord Tenant Law in New York § 6:146).

NREB: What are some examples of distressed properties under construction/newly completed?

LePatner: Through November 2009, the value of new properties in Manhattan falling into distress skyrocketed to over $12 billion. (In July 2009, it reached over $15 billion.)

In Manhattan alone, there are approximately 186 distressed properties, ranging from offices to hotels. Manhattan ranks 29th among U.S. markets in distress as a percentage of total property investment volume. Approximately 43 offices, valued at $4.5 billion, and 100 apartment buildings worth $5.7 billion make up the bulk of distressed properties in Manhattan.

The largest such project involves the $3 billion commercial-mortgage-backed securities loans for Stuyvesant Town/Peter Cooper Village. Purchased for $5.4 billion, its estimated value today is $1.8 billion.

NREB: Intuitively, we think of “distressed” properties as outdated, rundown buildings that are largely vacant. How does a brand new, sometimes unfinished, building become “distressed’?

LePatner: Many of these projects were planned and developed at the end of the latest business cycle (post-2006). Prices for land were at their highest and the cost of construction had grown by more than 30 percent since 2003 and 2004.

According to an article written by Robert Knakal of Massey Knakal Realty Service, in the period between 2005 and 2007, there were $109 billion in investment sales in New York City real estate. Mr. Massey estimates that values in these investments have declined by an average of 32 percent year to date. Approximately $80 billion of the $109 billion spent on investment properties are not in a negative equity position. Lenders are engrossed in bad deals and bad debt.

On the construction end during this period, so-called "guaranteed maximum price" (GMP) contracts and "fast-track" project delivery became the norm for most large-scale, complex projects. Construction managers, who serve as the aggregators of the various subcontractors and materials suppliers for a project, persuaded owners to commence construction to proceed on an accelerated basis under the guise of potentially saving millions of dollars in financing costs and ostensibly allowing owners to capture “early” revenue from the completed project.

However, GMP contracts and the "fast-track" process were based on incomplete design documents, which invariably led to significant cost overruns of 20 to 50 percent above contract prices and incurred delay costs totaling millions more. These costs had to be funded by mezzanine lenders, adding considerably to the debt incurred by developers for their acquisition and construction costs.

Change orders, claims, and delays to project completion, stemming largely from incomplete design documents, became the norm, driving up actual project costs by 20 percent or more — even 100 percent at times — over the owner’s anticipated project budget. To the nation as a whole, construction cost overruns damage the economy by more than $120 billion each year. For many commercial and institutional owners and developers, paying for unexpected overruns and carrying costs out of pocket are often catastrophic.

As a result, the prices paid for the land — plus the cost of construction at the height of the market, coupled with unwarranted cost overruns and delays in getting to projected closings and profits — led to most of these properties never having a chance as the market turned down.

In the recent past, unexpected cost overruns were paid to the builders by owners accessing additional lines of credit or by reducing the developer’s anticipated profits. In the current economic climate however, unlimited project financing is no longer available. Such costs will now have to be paid by the owner.

As a consequence, public and private owners who anticipated relying upon additional monies to finalize a project are left without the ability to fund completion of a project. The result is a property that is overrun with debt and unable to produce the anticipated revenue.

NREB: What do you typically see happen with these distressed properties?

LePatner: At much lower prices, they will be slowly absorbed by the market, completed at recession-era costs, and sold as prices once again begin to rise over the next few years.

NREB: How does a developer/owner ensure an investment in a new project will result in a viable, profitable project?

LePatner: There are new economic realities for those seeking to move forward with new projects. First and foremost is facing the reality that lenders will require a developer to put up 40 to 50 percent of the equity in a new project before funding a construction loan. Second, there are no mezzanine lenders to provide funding for cost overruns and delays, all of which will now have to be paid directly by the developer or corporation. Public and private owners will increasingly demand certainty for their capital project costs in order to protect their equity stake. Unanticipated project cost overruns can no longer remain an afterthought or be assumed to be covered by additional financing.

The necessary reforms hinge on two fundamental principles: (a) the use of true fixed-price construction contracts based upon fully complete and coordinated construction documents; and (b) a transparent construction process brought about by the introduction of a reliable owner’s intermediary to the process, who is able to restore balance to the currently dysfunctional owner-contractor relationship.

NREB: Many “distressed properties” are the result of the down economy intersecting with the problems in the construction industry. What are your predictions on both fronts for the next few years? How will new properties in the Northeast fare?

LePatner: Owners will need to take a more long-term outlook on any new real estate investments. The underlying base of value will still need to be there, whether one is investing in an existing property, considering completion of a current distressed property, or coming out of the ground for a new project.

Yet it will be years before we see a healthy kick-up in prices. Moreover, it is unlikely that there will any near-term jumps in valuations akin to what we saw in the years from 2004-2007.

As a new economic cycle begins, lenders will have every reason to question whether the capital projects they finance will be subject to the same kinds of project-crippling delays and cost overruns that today afflict such projects nationwide.

In the past, contractors had the upper hand on construction projects — even though they have much less risk than lenders and owners — because they know the most about the building process. Owners and lenders were in a position where they were forced to sit by idly and simply abide by what the contractor tells them, or risk halting the building process, throwing their projects off schedule and over budget.

In the new economy, there will be an onus by lenders on owners to take control of the process. This will require upfront project planning and design preparation, an equitable accounting and allocation of project risks between owners and contractors, and a transparent process for owners and builders to exchange information on project pricing and market conditions. All of these factors provide lenders with certainty that their construction loans will cover all completion and contingency costs — and provide owners and investors with assurance that their investment is protected.

NREB: Anything else you’d like to say about distressed projects in the Northeast?

LePatner: The American construction industry has the lowest productivity of any sector in our economy. Its widely documented inefficiencies cost owners an estimated $120 billion per year. The hard truth is that, even in a soft construction environment, the construction industry is ruled by change orders, claims, and delays. It is a system that has always created substantial problems for owners, but now it is directly affecting the financial institutions that lend to them.

In 2010, credit availability is likely to enable some well-planned capital projects to move forward. In this renewed environment, construction cost overruns are no longer affordable, nor should they be tolerated by lenders and investors. Lenders should realize that unwarranted and unwelcome cost overruns must become a vestige of the past.

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