Construction Loans Increasingly Go Bad

• Joe Gose
• On 5:46 pm EST, Thursday November 5, 2009

A five-floor downtown Chicago shopping center, 280,000 square feet in all, is almost fully built -- and fighting foreclosure.

Its case heralds one commercial real estate crisis at the tipping point: souring construction loans. Rising construction loan delinquencies threaten to weigh on bank balance sheets and rein in lending even more. That would stymie property sales, further pushing values down.

In Chicago a group of lenders, led by Bank of America (NYSE:BAC - News), claim developer Joseph Freed and Associates has been in default since last spring and owes them $128 million on a $205 million construction loan. They also claim the project is $34 million over budget and want the court to put the shopping center into receivership.

The shopping center, part of the Block 37 redevelopment in Chicago, is weeks from opening. Though some new tenants have been signed, a few key ones have abandoned occupancy agreements. The project at 108 N. State Street is one of the last pieces remaining to complete the big redo, an ambitious city-led revitalization effort that has endured two decades of failed starts.

Dominoes Lined Up

Similar foreclosure scenarios will play out around the U.S. in months to come, said Samuel Delisi, a senior managing director in the Chicago office of commercial real estate brokerage CB Richard Ellis.

"We're going to start to see more banks move on construction loans as it becomes clearer that developers are in bigger and bigger trouble," said Delisi, who heads up the restructuring department of CB Richard Ellis' asset services group. "The banks will work with people for a while, but at some point 20hey have to say, 'Enough is enough.'"

Just as in other areas of real estate, commercial construction lenders got carried away with the exuberance of the high-flying market and loose underwriting that marked the middle of this decade.

Many ill-conceived projects were financed, analysts say. Developers are going bankrupt midway through construction as they face falling property values, cost overruns and inability to get more financing.

In Q2, 16.3% of all construction loans held by U.S. banks and thrifts were delinquent, according to Oakland, Calif.-based Foresight Analytics. The analysis firm predicts when Q3 is tallied, delinquencies -- loans 30 days past due -- will rise to 18.2%.

Most banks face writing down broken construction loans by 50% to 80%, says Robert Freedman, executive chairman at New York brokerage FirstService Williams. How much depends on the property type, location and state of the local market.

Some haircuts will top 80%, in Freedman's view.

"New construction is where the highest yields are, but it also is clearly where the biggest risks are," he said. "So when there's a correction in the market, this asset class will take the biggest pounding."

Lenders Lose Out

A Real Capital Analytics analysis of 20 defaulted construction loans shows lenders this year have recovered an average of only 43% of $537 million in outstanding balances.

The number of loans studied was too small to base concrete judgments on, says Dan Fasulo, managing director of research for New York-based Real Capital. But he says recovery rates could drop more as a wave of failing loans wind through courts or other resolution routes.

"I think that some of the rates we're seeing are a little high," Fasulo said. "The really bad stuff hasn't washed through the system yet."

Foreclosing on occupied properties at least brings in rent. But banks don't get that when they take back collateral underlying construction loans. They face the prospect of acquiring an empty shell of a property needing more work, and soft leasing and sales markets when it's done.

Banks can try to sell a troubled construction loan to a third party. They often avoid it because of paltry prices offered. Other options are: Sell a project as-is; complete construction, then try to lease and sell it; or mothball it until the market turns more favorable. Receivers help banks assess scenarios and strategize.

All the choices take more capital. Mothballing a project, for example, requires securing a building against vagrants and vandals, who can rip out copper or other materials from the structure for quick cash. And buildings open to the elements can deteriorate rapidly.

San Diego-based Douglas Wilson Cos., a 20-year veteran in resolving distressed assets, will oversee completion of 1015 Half Street in Washington, D.C. The 442,000 square-foot office building is about 40% complete. Developer Opus East, which filed Chapter 7 in July, started the project in a redevelopment district in Washington, D.C., near the new baseball park.

Why finish the project? Douglas Wilson, CEO and chairman of the firm bearing his name, says three things influenced the decision: the building's progress, the city's relatively healthy leasing environment, and that the lender had about half its $180 million construction loan facility still available for disbursement.

Completion decisions happen on a case-by-case basis. He says with a building "only 10% complete in a deplorable market," it may be better "to mothball the project" awhile.

Wilson and others expect to stay busy for a good spell. Freedman, for example, is just now seeing construction loans defaulting in New York, New Jersey and Connecticut.

"This is going to be a growth sector for asset recovery businesses," he said. "We don't think these construction loans will be trading anywhere close to par until 2015."

Buzz up!