FEATURE: Home is where the hurt is

The US residential real estate sector has taken a battering over the past 18 months. As the unwitting cause of the global economic crisis, valuations have gone into freefall while foreclosures have risen at rates not seen for decades. On an almost daily basis come stories of homeowners struggling with negative equity, banks trying to modify housing loan terms in an effort to stave off foreclosure and prospective homeowners unwilling to bid amid such volatility.

The US residential sector has, according to many real estate veterans PERE has spoken with, never felt such pain. And it's not expected to get better anytime soon. A report by Moody's Economy.com last month warned house prices in the US will fall another 11 percent in 2009 – on top of recent average annual declines of 25 percent. In total, Moody's said house prices in the majority of metropolitan areas will have fallen by more than a third from their peaks of 2005 and 2006.

It is a meltdown that has thrown the US homebuilding industry into chaos.

Read the latest earnings reports from a handful of the nation's development companies and the outlook for the industry appears bleak. DR Horton, the largest homebuilder in the US, said in February it had just 4,006 homes under contract at the end of 2008 compared to 8,138 in 2007. Rising foreclosures, high inventory levels of new and existing homes, increasing unemployment, tight credit and eroding consumer confidence were all to blame, according to chairman Donald R. Horton.

Indeed, the state of the market has even prompted the creation of a website, http://builder-implode.com, dedicated to monitoring the latest casualties of the residential housing market crisis. Since late 2006, the website says, 66 US homebuilders have imploded or experienced some permanent adverse change, with another 68 on the site's watch list, including DR Horton.

Haven't seen it this bad

“I haven't seen it this bad. We expect the residential homebuilding sector to get worse,” says Mike Moser, East region president of Starwood Land Ventures, who previously worked for UK developer Taylor Woodrow in Florida for more than a decade.

It is such an incredible confluence of bad events, though, that is attracting the eye of private equity real estate players in the US.

Starwood Land, an affiliate of Barry Sternlicht's Starwood Capital, is just one of several players targeting the distressed homebuilding. Other interested buyers include Land-Cap, the joint venture between Goldman Sachs' Whitehall Street funds and NorthStar Realty, Kennedy Wilson and Oaktree Capital Management among others. (See p. 56 for an extensive list).

Formed in September 2007, Starwood Land expects to invest several hundred million dollars in residential land deals, whether raw land, developed or partially developed, over the next three years. However, like all real estate sectors in the US (and globally), the gap in buyer-seller price expectations has meant the firm closed just $50 million of transactions in its first year.

“It's been very slow so far but we anticipate many more opportunities in the next year or two,” Moser explains. “The 2004/2005 housing bubble has come home to roost and there is now a perfect storm of events. True demand for housing is low, although not absent, homebuilders are struggling from falling demand as well as a lack of traditional debt and foreclosure rates are strong. While those factors continue, you will see market prices decline.”

Private equity investors facing the challenge of this “storm” are therefore concentrating on three main strategies: acquiring the inventory of distressed homebuilders, taking equity stakes in development companies and buying the loans relating to real estate developments. Fund managers are employing a mixture of all three strategies, but among the early opportunities to emerge has been the need for developers to liquidate their inventories.

Banking on the land

During the housing boom, many developers banked land for future developments, partly to fuel their own construction needs,
but also in an effort to lock in prices amid the perception of ever-increasing property values.

By taking profits from home sales and ploughing them into land banks, developers left themselves little room for manoeuvre. “A
lot of developers got caught up with the heat of the market,” says Phillip Wiggins, chief executive officer of Dallas-based real estate investment firm, The Stratford Company, which is targeting land acquisitions through its $350 million Stratford Fund
III. “Unfortunately, when the market stopped, developers’ revenues quickly depleted leaving them little choice but to cut their inventories. Developers need income, and their inventory isn’t providing that,” he adds.

According to Starwood Land’s Moser, in some locations, such as Arizona and the over-supplied cities of Florida, developers
are “actively” trying to offload their inventory following “meteoric” falls in property prices. In September, Starwood Land closed on a portfolio of 2,500 residential lots in Palm City, Florida; Phoenix, Arizona; Los Angeles County and the nearby Inland Empire. The land was acquired from DR Horton, as the development company sought to shed its inventory and raise additional capital before its fiscal year-end.  

Moser declined to comment on financial details of the deal, but many private equity real estate firms note that funds can achieve “significant” discounts, so much so that in some cases land can end up free. All you end up paying for is the   improvement costs to the land.

“In many prime areas of the US, you will find that you are paying for the infrastructure costs of the land [the cost involved in developing raw land into a finished lot ready to build on] but that the land comes free,” says ING Clarion managing director
Doug Bowen. “In many parts of the country there are negative land values.”

However, for all those homebuilders willing to sell, there are just as many developers who are keeping hold of their best assets
in the hope of surviving the recession. Some private equity firms warn there is little that is meeting expectations, or which they are “comfortably” able to underwrite. “A-quality assets”, the firms tell PERE, just aren’t out there in any quantity.

Private equity real estate is searching for the good assets caught up in a bad situation. However, when an asset is selling for 10 cents on the dollar it’s not unreasonable to ask why its trading at such a discount. Sometimes junk is just junk, no matter what the price.

Rebuilding the homebuilder

An attempt on the parts of homebuilders to survive the downturn with their best assets intact could help fuel another opportunity for private equity real estate firms: the recapitalisation of homebuilding companies.

Although some investment firms see this as a longer-term strategy with more opportunities occurring in possibly a year to 18 months time, the current state of the housing market combined with severe credit constraints is forcing residential developers to look at all options. All developers are feeling the pinch, with most realising the recession is going to be deeper and longer than first anticipated. As one US developer told PERE: “You can't just wait three to six months to come out the other side.”

Residential developers unable to tap conventional construction financing will need to turn to other funding sources, according to Walton Street Capital managing principal Jeff Quicksilver. Walton Street is preparing to allocate up to 10 percent of its latest opportunistic fund, Walton Street Real Estate Fund VI, to the US residential/homebuilding sector, although Quicksilver says few opportunities that fit Walton Street's criteria have emerged to date. “Gap financing or rescue financing”, however, will be one area of growing importance in 2009 – particularly in the commercial sector, but also in the residential field.

Timing is eveything

Timing is, of course, everything when it comes to investing in any company, not least one focused on an already volatile industry. At the end of January, Texas developer Wall Homes filed for Chapter 11 bankruptcy protection after falling property prices and declining sales left it unable to operate. The firm was founded in 2005 by local homebuilder Steve Wall, with a $50 million investment from private equity firm Warburg Pincus. According to bankruptcy court documents, Wall Homes' assets were valued at approximately $43 million. The company owes $41.8 million to Warburg Pincus, $7.2 million to an investment vehicle called “Jen 1”, as well as more than $62.4 million to lenders including JPMorgan Chase, RBC Centura Bank, Frost National Bank, Comerica Bank and Guaranty Bank.

In May this year, private equity firm MatlinPatterson Global Advisors agreed a $530 million rescue financing package for Standard Pacific Homes, a 42-year-old US homebuilder that had been hit by the Southern California housing bust. The deal saw the firm, which specialises in distressed investing, exchange and buy additional stocks in the company for between $3 and $4 a share. As of press time, shares in Standard Pacific Homes were trading at $1.65.

With all the volatility of today's markets, many fund managers will be waiting for greater clarity as to the fallout in the residential sector – and the development companies that operate in it – before deciding on entity-level investments. “Recapitalising developers is a strategy you would look at only for the good quality homebuilders, those that have the experience of these types of markets and haven't left themselves overly-exposed. Even then, it's a strategy you might consider for later in the cycle,” says Wiggins, cautioning: “The vast majority of homebuilders might not last another year or two.”

From boom to bust

It is debt tied to homebuilders, though, that is expected to yield some of the best buying opportunities for private equity real estate firms.

Debt, of course, is the mother’s milk of real estate and at the height of the housing boom, at the end of 2006, banks in the US
provided roughly $560 billion in construction loans – around $330 billion focused on the single-family (or detached house) residential industry. Another $47 billion was targeting condo constructions while another $46 billion was aimed at rentalapartment developments, according to real estate research firm Foresight Analytics.

Today, delinquency rates for those construction loans are soaring. In the three months to the end of 2008, Foresight estimates
that single-family construction loans, which were more than 30 days or more past due, had reached 18 percent, with condo construction loans topping 25 percent. Rental apartment loan defaults were expected to hit 4.7 percent. In the quarter to the end
of 2006, delinquency rates were just 2.1 percent, 2.6 percent and 0.7 percent for the single-family, condo and apartment residential sectors respectively.

Overall, default rates on all construction loans, including commercial, were estimated to have reached 11.2 percent by the end of 2008 – a level not seen since 1993. “This is the worst residential real estate market I’ve ever seen,” Stratford’s Wiggins
continues. “It’s very painful and the strain on the development community is terrible. It’s not just local or regional markets; it’s on a national level, affecting almost all developers.”

In terms of the scale of opportunity though, Wiggins says, bank debt tied to real estate construction projects will be huge. “The
most sophisticated capital is waiting on the sidelines for just this opportunity.”

Facing reality

Banks, like some homebuilders, have generally been slow to respond to the realities of the residential market, and the declining
value of the construction loans sat on their books. Some banks, according to several private equity professionals PERE spoke with, are perceived to be “nursing” struggling developers through the turmoil in the hope that anticipated write-downs might be
avoided. For many, there is a real fear that writing down the value of some assets will create a precedent for the rest of their loan portfolio, a move that could severely impact capital ratios, and ultimately a bank’s solvency.

As ING’s Bowen says: “It’s just a matter of facing reality, sooner or later sellers and buyers have got to come together – there is
a recognition that the good times are definitely over and the bad times are upon us. The banks have just got to act accordingly.”
ING, which closed its $202 million Clarion Development Ventures III (CDV III) in September last year, is actively looking at
residential opportunities in the US, including in the debt space.

Bowen expects deals in the first six months of 2009 to continue to remain “difficult” with much of the deal flow taking place in
the latter half of the year. Bank debt, though, will become an increasingly larger p art of the residential story throughout 2009.
“As more attention is turned onto the banks by regulators, so the banks will start moving those assets,” says Bowen.

It is perhaps surprising then that there isn’t as much capital chasing residential opportunities today as there was just a year ago. Residential distress may have been “distress de jour” a year ago, but according to some residential-focused private equity specialists, that’s not necessarily the case today.

From residential to commercial

Many residential professionals are finding that some of the capital focused on the residential sector has instead shifted to
the commercial real estate world, where increasing amounts of distress are emerging daily.

According to Foresight Analytics, commercial construction loan defaults hit 6.6 percent in the final quarter of 2008 – up from just 5.2 percent in the three months to September 2008 and 4.1 percent at the end of the second quarter of last year. Of the $597.1 billion of outstanding construction loans at the end of the year, $321.8 billion was focused solely on the commercial real estate sector.

“Construction lending is much more sensitive to economic conditions than mortgage lending so it provides a very good indicator
as to the state of the market. All construction projects start with no income in place, so when their sales go, so do they.

And what we have already seen in residential is no doubt materialising in the commercial space,” says Foresight founder Matt
Anderson. “We are not yet at the levels of the early 1990s, but we believe there are more increases coming during 2009 and probably into 2010.”

Given the choice between owning a partially completed housing development, or an existing income-producing office block, fund managers without residential expertise could be forgiven for moving away from the sector.

For those GPs left in the residential game, the declining competition is a welcome development.


Land ho!

Below are some of the investment firms on a growing list targeting the largely land assets of distressed residential homebuilders – and their lenders – as reported on sister news site PrivateEquityRealEstate.com.

Starwood Land Ventures

The affiliate of Starwood Capital has been actively searching for deals in the US residential sector, closing on 2,500 resident lots from homebuilder DR Horton in September, as well as forming joint ventures with builders, developers, lenders and land holders in Houston, Northern and Southern California, Atlanta and Northern Virginia.

LandCap/Kennedy Wilson

Separately the two firms have been targeting residential opportunities across the US, with LandCap – a joint venture between Goldman Sachs' Whitehall Street funds and NorthStar Realty – closing on a $40 million loan portfolio backed by 2,900 lots from Wachovia Bank in August, and Beverly Hills, California-based Kennedy Wilson targeting the multifamily sector. However in October, the duo joined forces to form a $100 million joint venture targeting “unwanted” inventory held by homebuilders and financial institutions. The assets will be sold through auction to the public.

Oaktree Capital Management

Oaktree has been active in the Japanese residential market, completing a tender offer for the J-REIT Re-Plus Residential Investment. However last month the Los Angeles-based firm turned its attention to the US forming a joint venture with developer The Ryland Group. The partnership is targeting distressed residential land for development, with the intention of selling the assets as finished lots ready for the construction of property. Ryland has the right to “option” all lots sold by the partnership.


Florida's residential property prices have plummeted since the peaks of 2005/06. As a result, Lubert-Adler has launched a $1 billion investment fund with national developer The Related Group to acquire property and mortgages from developers, lenders and property owners in the state. Assets will range from finished condominium units to raw land.

Brookwood Value Partners

Florida was a key destination for Brookwood, as the Massachusetts-based firm made its foray into residential land acquisitions, buying lots in the Southwest Florida planned community of The Grove. Like Starwood, Brookwood bought the land from homebuilder DR Horton. As part of the deal, Brookwood acquired 214 finished lots and has agreed to purchase another 140 lots upon completion.

Pacifica Equity Partners

San Diego-based Pacifica Equity Partners has also been targeting failed projects in the markets which overheated the most – Florida, California and Nevada. In December, the firm bought four pools of notes backed by single family housing, condos and finished lots from regional banks for “deep discounts”. Pacifica said the notes had a face value of $70 million but declined to disclose further financial details. However some GPs say discounts can be as low 20 cents to 30 cents on the dollar.

Dunmore Capital

Discounts on land debt have been so great in parts of California, land has been trading for almost nothing. Sacramento, California-based firm Dunmore Capital closed on five debt packages involving 400 lots related to distressed property developments where the underlying assets – finished and improved residential lots in California and Nevada – traded for less than the cost of making improvements to the land. As a result, founder Sid Dunmore is expanding the firm's strategy from specializing in opportunistic land entitlement investments in Northern and Central California to buying distressed developer debt saying: “This is a pretty amazing opportunity.”

Stratford Realty Capital

The Dallas, Texas-based private equity firm closed its third fund, Stratford Fund III, on $350 million at the end of 2008, targeting land in high growth areas that is two to three years away from development. Traditionally, the firm has invested 70 percent in residential and 30 percent in commercial opportunities, although an increasing number of commercial investments are emerging in the latest fund. Stratford Fund III has around $200 million in dry powder.


Five-year retreat

The price of single-family homes across the US remained in freefall in 2008, with many metropolitan areas seeing five years of growth wiped out, as of November 2008. The S&P/Case Shiller Home Price Indices tracks the price of thousands of individual homes in arms length transactions across the US. The indices have a base value of 100 in January 2000, thus an index value of 150 means a 50% appreciation since January 2000 for a typical home in that state.

Phoenix Los Angeles Denver Miami Las Vegas New York Top 10 metropolitan cities
Nov-08 130.54 175.85 127.65 169.62 138.04 186.81 166.05
Nov-07 194.45    240.43 133.36 237.99 201.95 204.36 205.25
Nov-06 194.45 240.43 133.36 237.99 201.95 204.36 205.25
Nov-05 219.12 262.56 137.53 262 228.77 210.3 220.81
Nov-04 148.59 216.58 132.16 197.64 207.48 183.69 190.08
Nov-03 125.53 171.11 127.08 161.11 139.16 160.59 159.55
Jan-00 100 100 100 100 100 100 100
Nov-98 91.59 91.38 86.96 93.49 95.46 89.41 89.76
Nov-94 74.46 76.59 67.16 86.69 86.77 78.5 77.23
Nov-90 65.41 97.36 48.78 79.95 81.85 76.14 80.09
Nov-88 N/A 84.69 47.86 76.09 68.64 84.84 77.28