There are about 24,000 condos in the pre-sale stage in South Florida, and pre-construction prices keep going up. Are we going to see a market correction and what could cause that?

The history of Florida real estate booms is that inevitably the boom ends. In the past, when construction loans were financed with a single source, institutional lender, the first sign of distress for a completed and sold project was the failure of sales of units to close at the pre-construction contract prices agreed to by buyers. This time around, projects are being financed by purchaser deposits as high as 70% or 80% of the purchase prices and the deposits are paid in stages as construction progresses. Purchaser-financed projects should show distress earlier. The first stage of a slowdown in the market will occur when purchasers begin to fail to make their required additional deposits when the additional deposit payments are due. When this occurs, a developer’s source of construction financing will dry up and the developer has two choices: stop or slow construction, or get the balance of its construction financing from a conventional or hard money lender. Alternative financing should not be difficult for the developer to get because the purchaser contracts provide that the buyer has agreed to subordinate any lien of the purchaser on the project for the amount of its deposits to a later mortgage lender. Thus, a developer may overcome a project’s initial distress resulting from a slowdown in customer deposit payments by getting the balance of its construction financing from more conventional lending sources.

This time around, condo projects have a lot of equity on them thanks to the big deposits from foreign buyers. At the same time, construction loans represent a small percentage of the construction cost. In case of a loan default, how could bank react knowing there is so much equity invested in a project?

If a project stalls after the developer has obtained construction loan financing through a mortgage loan, the mortgage lender will be in a better position than in previous downturns. The mortgage lender’s lien will be senior to any asserted liens of purchasers and, because of substantial initial construction financing by purchaser deposits, the project will have a market value greater than the amount of the mortgage debt. Non-institutional construction lenders such as Hedge Funds or hard money lenders will be motivated to foreclose quickly, hoping to force a sale of the project that will result in the lender taking title or recovering payment of all of its loan, including default interest and fees. Institutional lenders will be motivated to exercise patience with the developer, even making additional advances under its mortgage to complete construction so units are able to be closed and the mortgage debt paid.

In the last cycle, many of the troubled condo projects were underwater, meaning the developers owed more in construction loans than the projects were worth. How did that fact influence a lender’s decision to do workouts or foreclose on them?

In the last real estate downturn, most construction financing was through institutional lenders. During the downturn, the lenders were under regulatory pressure to foreclose their mortgages and obtain repayment of the debt quickly. Because project values were less than the amount of the mortgage debt, lenders were not receptive to requests of developers for additional time or additional advances to complete a project. In addition, in the last downturn, some institutional lenders sold their loans at a discount or failed banks had their loans sold by the government at a discount and the loan purchasers were even more aggressive in pursuing collection of the debt or obtaining title to the project. Also, loss-share agreements between the FDIC and the acquiring bank mitigated the expense of aggressive litigation by the bank to enforce a mortgage loan acquired from a failed bank. Only at the end of the last real estate downturn – when condominium project values had bottomed and began to increase – lenders became more patient, allowing the developer time to sell its units in the rising market.

If there is a market correction and lenders try to foreclose on partially sold projects, how would foreign buyers, since they are doing most of the buying, we affected by it? What would happen to their deposits invested in the construction?

If there is a market correction, purchasers who have not defaulted on their contracts would have a lien on the project for the amount of their deposits, albeit subordinated to a later construction lender’s mortgage. However, if a purchaser had defaulted on its contract, the situation changes. For example, if a purchaser failed to make any installment deposit payments as construction progressed or refused to close the sale because of a declining condominium market or tightening of credit to finance the balance of the purchaser’s purchase price, the developer could declare the purchaser in default. Sale contracts allow a seller to retain the purchaser’s deposits as liquidated damages after a default and a purchaser’s lien rights are eliminated accordingly. If a Chapter 11 is filed by a developer, the Bankruptcy Code provides for a buyer to retain a lien on a project for the amount of its deposits if the bankrupted developer decides to sell the purchaser’s unit to someone else and rejects the original purchaser’s contract. However, to retain lien rights in a Chapter 11, a buyer must not be in default and must be prepared to perform its purchase contract. If a buyer is in default and not prepared to close the sale, then the purchaser’s lien rights in bankruptcy are vulnerable to attack.

This time around, developers of a distressed project will have an incentive to file Chapter 11, instead of losing their projects to foreclosure. Thanks to the new deposit structure, they will have enough value built into their projects to be able to obtain financing under bankruptcy protection to finish and market their projects. Also, let’s keep in mind the fact that the balance on the defaulted construction loans will be lower in relation to the project values since developers are obtaining construction loans that represent between 20 to 30 percent of the construction cost. Also, the uncertainty of purchaser lien rights and the diffused nature of their claims, would make it easier for developers to obtain bankruptcy court approval for a debtor-in-possession loan secured by a first mortgage on the property. That would be a low risk and profitable proposition for the debtor-in-possession lender.