“This Financing Doesn’t Fit”
Warren Buffet once famously quipped, “I wear expensive suits. They just look cheap on me.”
Traditional developer debt financing is a long-standing, robust banking product that has helped fuel the building of America. However, if debt financing is not carefully customized to fit individual projects, it can quickly be rendered inadequate and contribute to project failure. One size does not fit all. An expensive suit can look cheap if not carefully tailored to fit the individual.
Developers are optimists who envision grand projects, utilize equity to purchase the necessary land, flesh out a design, and submit the complete package to the bank for lending.
Bankers are actuaries who review the plan details, the developer’s reputation, and after adding interest and fees to reduce their exposure, agree to lend the amount necessary to complete the project. Commitments are signed by both parties and the project is off and running. Sound banking practice requires that the total amount be secured by the land and building.
The Developer’s Dilemma
But the building has yet to be built. This becomes the banker’s dilemma. The banker’s solution is that funds can only be drawn down as the project progresses. Progress payments are then considered fully collateralized against the amount of work put in place.
The fallacy is that the collateral is primarily the value of uncompleted work. However a partially completed building has questionable worth and may actually be a liability because:
- Value cannot be realized or converted to cash without additional investment and considerable effort to complete the project which requires a unique set of skills.
- Therefore, partially completed work has little or no real value.
- There is no available return until a project is completed.
- And no cash flow until it is sold.
With multiple projects the degree of risk is cumulative and constant, decreasing only when each project approaches completion.
Because developers are optimists and bankers are actuaries they rarely speak the same language.
- Bankers seek to limit their liability by withholding funds until something is built.
- Developers seek to succeed by investing further funds.
- Bankers seek to preserve
- Developers seek to use
- Bankers rely on discounted present value for safety.
- Developers rely on future value for success.
Somehow both bankers and developers seem to agree that partially completed construction is a viable asset for collateral that can be borrowed against in spite of the fact that it has extremely limited value until completed. For example: If a project is delayed or stopped for any reason, the incomplete portions of the work become more a burden than an asset. It may even be considered a liability in that more funds and effort are required to realize any portion of the anticipated value. Skills the typical bank lacks; and funds the typical developer doesn’t have. Recovery depends on cooperation.
Did Value Exist or Evaporate?
The response to a project stopping for any reason is where bankers and developers part company. In doing so they unintentionally validate that the collateral of a partially completed project has far less value than relied upon.
- Bankers tend to “blame” the developer for bad management and instinctively protect their position by shutting off future funds.
- While the developer sees no other response than to continue the project to completion even at an inflated cost hoping to harvest future value.
Dilemma: Only by working together can lending be recouped or losses minimized.
Let’s Talk Business
Reconciling these two points-of-view is the hope of this blog. We will be posting more research on this topic and outlining the solution. We invite our readers to weigh in.