Hard Choices

Photo Credit: Brian Stauffer

Bill Taylor didn’t see any other way out of the mess.Looking down the barrel of interest payments on land that he bought in 2006, he sold off five parcels, discounted standing inventory, finished homes that he had started, and closed a company that had produced roughly 200 homes a year. Once complete, he changed the message on the answering machine: Taylor-Morley Homes was out of business.

Meanwhile, across town, executives at McBride & Son, St. Louis’ largest private builder, also faced with a large lot backlog, took the opposite tack. The employee-owned company did more to advertise, promote, and sell new homes than anyone in the market—at the expense of margins, of course. As a result, sales fell only 4 percent last year in a market that produced double-digit declines.

The situation in St. Louis illustrates the kind of no-win choices that builders face as the housing downturn goes into its fourth year. With cash flow dwindling to almost nothing, even among the industry’s A players, builders increasingly are caught between a rock and a hard place. They must often choose between the better of two evils, two outcomes that both harm their company’s financial standing. In the worst case scenario, the decisions may tarnish their reputation among banks, trade partners, and employees.

The toughest decision, of course, is whether to shut the company down. But other painful moves include decisions to close down divisions with significant long-term potential, sell off prime pieces of land, bring in equity partners, mothball half-finished subdivisions, go all in with personal equity, and let go of seasoned managers.

Management consultants contacted for this article agreed that builders did not respond quickly to the downturn to maximize cash flow by selling off land, reducing personnel, and cutting ­expenses. Says Chuck Shinn, a management consultant in Littleton, Colo., “If they haven’t done what they needed to do to weather the storm by now, their chances of survival are minimal.”

Tough Choices Ahead

Steve Alloy, president of Stanley Martin Homes in Reston, Va., expects builder shutdowns and foreclosures to escalate based on his private conversations with fellow builders. Alloy has raised $150 million in equity that he’s been trying unsuccessfully to ­deploy for land purchases in the D.C. market. “A lot of builders started this with a grain elevator full of seed and a barn full of livestock,” says Alloy, whose company is insulated by public debt it floated several years ago. “Now they are facing the decision whether to eat that last seed or butcher the last dairy cow.”

The downturn has pushed many private builders to “the edge of a cliff,” confirms Tom Eggleston, CEO of C.P. Morgan Communities, who spoke on a conference call with investors last month. Eggleston believes that too few builders recapitalized their companies “on a timely basis” earlier this year. Now they are faced with margin calls and further declines in equity that make loan workouts much harder, if not impossible.

John Burns, a management consultant from Southern California, believes the best companies can still work their way out of this mess. He urges builders to work closely with the banks, sell as many homes as possible, find fee work if they can get it, and remain as patient as possible. Burns, who believes that tomorrow’s fortunes may be made in today’s land deals, thinks that now is the time to take on new equity partners to make deals. “Keep your reputation intact so you can attract capital and good people when the market improves again,” says Burns.

That’s essentially what Washington Township, Mich.–based Lombardo Homes did last month when it bought unfinished land, model homes, and lots in 14 communities left behind by Centex in Detroit. The deal, which may make the company the largest private builder in Michigan, was funded with private equity from a local investor. “In the coming years, the Michigan market will provide a rich opportunity for growth and expansion among private companies like ours,” says president Anthony Lombardo.

Everything must go

Some builders, unfortunately, don’t have the luxury to wait patiently, especially the ones who took out land loans at the top of the market with personal guarantees. The best outcome would be to sell the land to generate cash. But outside of a few high-profile deals done by public builders—Lennar, Centex, Orleans—no one seems to be able to come to terms on a deal.

Alloy confirms that a ton of equity waits to pounce on land deals. But he says the numbers don’t work for sellers or builders. A seller who bought lots for $3 million that are now worth $2 million can’t bring $1 million in cash to the table. And publics can’t get a low enough price to justify their development costs. “All over the country, raw lots have zero value,” says ­Alloy. “If the value of a lot is $70,000 and that’s what it costs to develop a lot, then it’s worth nothing.”

Tom McCormick, president of Astoria Homes in Las Vegas, acknowledges that he may have to sell some land at “below-market” prices just to eliminate debt on land he built up during the good times. Public builders have come looking for lots. “I’ve learned a lot through the downturn,” he says. “If you keep your land unencumbered, you’ll probably be OK.”

McCormick, like most builder survivors, has made the obvious moves. In three separate events, he has cut his staff by more than 50 percent, leaving a barebones operation that won’t be able to seize many opportunities should the market turn, which he thinks may happen sooner rather than later in Las Vegas. He’s been trying to negotiate fee work with banks but hasn’t been able to find mutually agreeable terms.

Biting the Bullet

Of all the options available to builders, the toughest to swallow may be bankruptcy. Yet it’s a bullet that dozens of prominent builders have had to bite in recent months, in many cases as a last resort to protect their assets, retain short-term operating funds, and keep the company operating. In some cases, unsecured creditors—­suppliers, subcontractors, and consultants—may not get paid in full.

MW Johnson Construction filed for Chapter 11 on both its Minnesota and Florida divisions this summer because it was the only way to sustain working capital. The Lakeville, Minn., ­company closed 260 homes last year and generated $61 million in revenue. “The companies filed now because the lenders would only provide more working capital in a Chapter 11,” Michael L. Meyer, MW Johnson’s attorney, told Builder. “We had no choice as we were out of money.”

In its bankruptcy filing, MW Johnson stated an intention to operate in a normal fashion for four months “to effect an orderly liquidation of its assets, all for the benefit of creditors.” But its plan ran into a snag in bankruptcy proceedings. It now looks as though the company is headed toward an early liquidation.

Portland, Ore.–based Legend Homes filed for similar reasons this summer—to protect the company’s assets—but it hasn’t been able to work out an agreement among its six lenders to even use money from new-home sales to fund its operations. At press time, Legend Homes, the industry’s 131st-largest builder in closings last year, was stuck in court proceedings trying to hammer out an agreement. The company has been forced to let go of most of its employees for lack of working capital.

President Jim Chapman, interviewed by Builder shortly ­after Legend filed, says that KeyBank attempted to use a margin call to coerce cross-collateralization. Legend owes KeyBank $22.3 million. “They wanted to take 100 percent of the closings on homes they didn’t even have construction loans for,” says Chapman. “And their approach has been to reappraise the land, say ‘here’s the margin’ and then ‘please remit $9 million.’ They’ve been very difficult.”

Caruso Homes of suburban Maryland filed for Chapter 11 this summer with liabilities of more than $100 million. “We have so much debt right now that we need to clean up our balance sheet,” president Jeff Caruso explained to Builder in an interview upon filing. Caruso, who has put $10 million of his own equity into the company, hopes to emerge from bankruptcy later this year in fighting shape with a new operating plan. He wants to recreate his company as a smaller one, building 100 to 200 less-expensive homes a year.

Working, or Not Working, With Banks

Builders report that most banks, especially local banks with which they have long-term relationships, have been willing to do workouts on revolving lines of credit and land loans. Many builders having trouble making loan payments have been able to work out forbearance agreements, where the bank temporarily forgives interest or even principal. One prominent Las Vegas builder says that “virtually every” builder in the area has a forbearance agreement. Burns, who counts several Las Vegas builders among his clients, disagrees. “That is not true about every builder in LV,” he says. “Believe it or not, there are firms who come out of pocket to keep their reputation.”

Builders who didn’t sign personally on their loans may be able to give them back to the bank and walk from deals, though again that may tarnish the builder’s standing in the market. It’s not uncommon to see these same builders come back with new equity partners and buy the same property back from the bank at a lower basis. “A lot of guys are doing that now,” said a prominent California architect, looking across a room of builders and developers at the PCBC conference.

The problem today is that builders have lost much of their negotiating power with banks. Their cash reserves are down to nothing. They’ve already pumped their own equity into the ­operation. And many of the banks aren’t in a much better position. The window to renegotiate debt seems to be closing quickly. Houston’s Royce Homes, the 44th largest builder in America last year, announced last month that it would liquidate after its credit lines were cut. The company might have been able to build its way out of trouble. But without credit for operations, it couldn’t pay its debt.

Photo Credit: Brian Stauffer

Enough builders are so angry about what’s happened between them and their banks that they’ve joined something called the Homebuilders Coalition for Responsible Bank Behavior. By late August, the association had 43 builder members, including Mick Pattinson, president of Barratt American, which was one of the 200 largest builders in this country before Bank of America cut off its $125 million credit facility. Pattinson, who has had to let go of 100 of his 130 employees, says that builders are “mad as hell, but they’ve been reluctant to put out their dirty linen about how they’ve been screwed over.” The Coalition plans to develop a Web site and hire a lobbyist and public relations person.

Publics Pulling Up Stakes

Though their moves have received less attention, public builders have been making difficult decisions of late to exit markets that they may have spent millions of dollars to enter. In many cases, CEOs for these companies spent years and a ton of dough on market studies, land, and infrastructure before making their move. They may have even sunk big money into buying a company to enter a market they coveted. Now, they are pulling up stakes because the operations are hemorrhaging money; they think they are better off with eggs in fewer baskets.

The Ryland Group recently announced that it had left Northern California after 20 years. Centex and Beazer exited Denver within months of each other. KB Home has pulled out of Washington, Chicago, and Albuquerque, N.M. With less fanfare, many publics have consolidated local divisions into regional offices. “Overall, in this type of market, I think it makes sense to cut your losses in non-strategic markets where you don’t have the volume to justify a presence and you aren’t optimistic about a turn in the next one to two years,” says J.P. Morgan’s Michael Rehaut.

Public builder analysts contacted for this story couldn’t provide numbers for what it has cost public builders to cut their losses in big-city markets. Beazer announced earlier this year that it was getting out of Charlotte, N.C., Cincinnati/Dayton, Columbia, S.C., Columbus, Ohio, and Lexington, Ky. It had entered some of those markets or expanded its presence in them when it purchased Crossman Communities for $600 million in 2002, including $191 million in cash that was financed with $350 million in private debt due in 2012.

“Yes, they definitely lose money when they exit,” says Ivy Zelman, president of Zelman & Associates. “How much, I’m not sure—usually it’s because they don’t have the scale to justify being there or they are bearish on the long-term outlook, i.e., Detroit. My guess is that they take the loss and never look back. A lot of mistakes were made and now are trying to be reversed at a big cost to shareholders.”

Meanwhile, people are watching to see whether the publics leave markets in an orderly fashion, finishing out subdivisions and making good on all their promises. The first ones to find out last month that Centex was leaving Denver were customers with ­contracts; they received letters. Even though Centex planned to build the customer’s home, the company offered the buyer a refund because Centex didn’t intend to complete the community, according to a letter obtained by the Genesis Group, a local market research firm. Centex announced the decision to the press days later, saying it will complete work on homes both in progress and sold, and that it will maintain a team in Denver to complete warranty work and support its buyers.

The same scrutiny is being given throughout the country to half-finished subdivisions. When builders or developers go bankrupt and can’t maintain the community, the public relations impact can be calamitous for every builder in the market. People who have already bought homes in a community speak out ­publicly about how the builder reneged on promises to build ­amenities, how unfinished homes are beacons for vandals, and how unmowed lawns and parks are hurting property values in their community.

A recent Tampa, Fla., newspaper story profiled a partially ­finished subdivision. It referred “to row after row of streetlights,” “white plumbing pipes sticking up out of the ground,” and ­common areas that weren’t maintained. It quoted people who already lived in the community who were very concerned about falling property values. A similar story in a Phoenix newspaper referred to a subdivision that resembled a “ghost town” with dried-out tumbleweeds that posed a fire hazard. The developer was bankrupt and the cash-strapped HOA couldn’t afford the clean-up.

That’s why, when Stanley Martin decided more than a year ago to cease operations in many of its suburban locations and instead focus on infill construction, the company budgeted to maintain its unfinished subdivisions. “We’re going back and cutting the grass in our undeveloped lots,” says Alloy. “In some of the neighborhoods, they are being used to play baseball ... . When the market is right, we’ll come back and build on them.”

Alison Rice, John Caulfield, and Ethan Butterfield contributed reporting to this story.