Homebuilders in a Hole

Homebuilders in a Hole

Battered by the bust, they're filing for Chapter 11 and begging hedge funds for help
by Dean Foust and Dawn Kopecki

When Kara Homes began building Horizons at Birch Hill, a community for active seniors, the plans were ambitious: 228 spacious residences that weren't typical cookie-cutter McMansions. But four years later, the project in Old Bridge, N.J., has been abandoned by Kara, which is now in Chapter 11. A dozen or so homes stand unfinished, the front doors swinging in the wind, and the half-built clubhouse bears a large "Unsafe for Human Occupancy" sign.

"It's not a great situation, but we're all hanging together," says Frank Ramson, one of the development's 70-odd homeowners. "What's killing us is the uncertainty of how long it might take another builder to step in."

Ramson isn't alone in his angst. The downturn in the housing market has caught the nation's homebuilders by surprise, leaving many overextended with costly land they can't develop and unfinished homes they can't sell. The financial strain is starting to show. From Arizona to Arkansas, dozens of small- and midsize builders have filed for bankruptcy over the past six months.

And in late April, credit analysts at Moody's Investors Service (MCO) warned that a number of large homebuilders could fall out of compliance with their debt agreements later this year, leaving them at risk of default unless lenders come to their rescue by agreeing to rework their loans. Some builders are so desperate, in fact, that they're even running into the arms of hedge funds to bail them out with fresh loans at high rates and onerous terms.

More Bankruptcies?
Wall Street certainly has its concerns about the industry. This year the price of credit default swaps—in effect, a tool for bondholders to hedge their risks—has risen sharply for several large builders, including Pulte Homes (PHM), Toll Brothers (TOL), and D.R. Horton (DHI). Toll Brothers Chief Financial Officer Joel Rassman says: "The people buying the swaps may think it's riskier, but the people actually buying our paper don't [because our spreads with Treasuries are shrinking]."

But for the industry as a whole, there may be even more problems waiting just below the surface since many builders entered into big land deals with partners, amassing billions in debt that doesn't show up on their balance sheets. "I think we're going to see a lot more [bankruptcy] filings in the next 6 to 12 months," says Tucson attorney Eric Slocum Sparks, who is representing one local builder, AmericaBuilt Construction, in Chapter 11. "I've got a couple of clients who want to see me next week, and I know these aren't social visits."

The extent of the industry's woes will depend on where housing heads from here. So far analysts and executives alike are unsure whether, or by how much, the slump will deepen. But the trends aren't pretty. The National Association of Realtors now predicts that new-home sales are likely to drop 18% this year, a bleaker scenario than the 9% decrease in the February forecast.

Daring Bets
Nonetheless, the current generation of builders entered this downturn with far better balance sheets than their brethren in the last housing bust during the late 1980s. And barring a total collapse in the market, lenders are also likely to offer a safety net, making concessions to keep the builders afloat in the near term. "I expect the lenders will be willing to work with them," says Fitch Ratings analyst Robert Rulla. "They'll want to maintain that relationship for when the turnaround comes."

Still, those lifelines can come at a big cost, namely higher interest rates, special loan modifications, and tough new stipulations that restrict everything from the builder's right to repurchase shares to its ability to take on new debt for future expansion.

For some, the white knights may be hedge funds. Consider the plight of Dominion Homes (DHOM), an Ohio-based builder that sold $257 million worth of homes last year. When Dominion fell close to default last August on $216 million in bank debt, hedge fund Silver Point Finance bought the loans and negotiated tough terms. Some $90 million of the refinancing came with an interest rate of 15%, vs. the 9.25% Dominion had been paying.

Silver Point also stipulated that it could receive a 15% stake in Dominion in the event of default. "The [fund was] willing to go where no other regulated institution would go," says Ronald F. Greenspan, an attorney and restructuring adviser for FTI Consulting (FCN). Dominion CFO William Cornely admits the new rates are high, but says it "affords us the opportunity to continue operations during the downturn and position us for the rebound."

Using Up Cash
If business doesn't stabilize, more builders could find themselves in the same hole in the ground as Dominion. Already, some analysts are concerned about the pace at which many builders have been burning through cash. Moody's credit analyst, Joseph A. Snider, notes that 11 of the 21 large builders whose debt his firm rates had negative cash flow in 2006 as many were stuck with higher-than-expected inventories of homes they couldn't sell.

Dallas-based Centex (CTX) took a $150 million charge after walking away from options for more than 37,000 lots nationwide and wrote down other land by roughly $300 million, triggering a 79% plunge in fiscal 2007 profits. "We still see uncertainty in many of our markets," Centex CEO Timothy Eller told analysts on Apr. 30, warning that the industry could be in the middle of a three-year correction.

More bloodletting may be ahead. Many large builders also took minority stakes in joint ventures, allowing them to stockpile land for future needs while keeping billions in debt off their balance sheets. Alisa Guyer Galperin, an analyst at the Center for Financial Research & Analysis, estimates that Lennar (LEN) is on the hook for up to $910 million of $5.6 billion in debt through partnerships not on its books.

Battles Ahead?
One fear is that if a partner runs into financial trouble, Lennar and other homebuilders could find themselves battling with lenders that demand they make good on the partnership's total outstanding debt. Florida builder Technical Olympic USA (TOA) is now embroiled in a lawsuit with one of its lenders, Deutsche Bank (DB), which claims the builder is in "multiple potential defaults" on $675 million in debt owed by joint venture partners that failed.

For its part, Lennar CFO Bruce Gross says the company has mitigated its risk by partnering with strong institutional investors like the pension fund CalPERS and has structured the deal to make sure it isn't liable for its partners. "Our joint ventures are very strategic and are designed to share the upside opportunity and downside risk with other investors," says Gross. For now, Wall Street is thinking only about the downside.

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real estate, mortgages, home builders, hedge fund returns, lending, real estate market downturn