For brokers, banks that partner with developers or contractors can present advantages

Jeff Burton, president, American Dream Development, and Randy C. Norton, managing partner, National Capital Partners

As published in Scotsman Guide's Commercial Edition, December 2008.

With much distressed real estate entering the market at various stages of completion, property-value estimations are important for all players in a real estate deal.

But most equity-buyers use cost-to-value estimates, while lenders use loan-to-value for underwriting. And in today's market, money managers calibrate acquisition strategies through acquisition-to-value calculations only.

Thus, gaps are showing up between various property-value estimates. To receive the most-relevant data, mortgage lenders should employ third-party-feasibility and cost analyses, in addition to the appraisal. Already, government-based programs such as the U.S. Department of Housing and Urban Development (HUD) 221(d) loan, require this.

Fortunately, the housing meltdown has brought with it a ready pool of experts who can step in to meet the demand for third-party help. Many small- to medium-size developers and contractors have been sidelined by the credit crunch. They are looking for new sources of revenue to keep their companies afloat, and they often can help your lenders better size up a deal.

In many cases, brokers should seek lenders that employ these consultants.

How it works

If many financial institutions would have implemented cost-data verification before lending in the past few years, perhaps this real estate mess would be smaller today. Many contractors and developers also paid themselves first and did not finish their work. But a partnership between a lender and a developer-consultant may serve as a model for equity funds on the buy side of the table as well as for lenders dealing with distressed assets. Using appraisals is a starting point, but detailed analyses such as feasibility studies and construction-cost evaluations go a step further.

The developer-consultant's role is to look at the asset, examine what contracted work has been completed, and estimate what additional capital would be needed to finish and reposition the asset. This involves looking at construction documents and re-evaluating the project as would a bidder. The consultant also will ensure the fees related to the project are in line with industry standards.

Based on the consultant's analysis, the lender could assess whether the targeted project offers an exit strategy, allowing the purchaser to complete the work and sell the asset for a profit to meet its return-on-investor goal. The consultant's cost-to-value analysis also could help position the project's pricing to beat its competitors.

Savings potential

What kinds of savings could a developer-consultant uncover in a typical real-world scenario? Consider the example of investors who asked a consultant to evaluate the cost assumptions behind a commercial building they had purchased recently. Among the consultant's findings:

• The purchase plan failed to capitalize on $1.5 million of tax-increment financing. If caught, this would have saved the investors 35 percent of the project's overall cost.
• A structural "overdesign" boosted structural-component costs by 30 percent.
• Use of alternative building products could have cut costs by 10 percent.
• Cutting aesthetic features such as roll-up glass walls in office condominiums hurt the project's absorption rate.
• More consistent management of change orders would have saved $60,000.

In total, the consultant helped identify lost opportunities for savings and subsidies totaling $3 million. For lenders or purchasers looking at this property, the same type of analysis could make or break decisions about whether to invest or how to proceed to completion.

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Seeing this partnership model work with lenders and developers or contractors can help brokers understand its intricacies and its potential. The same principles can apply on larger projects or on entire portfolios spread across multiple markets.

Jeff Burton, a former regional manager for KB Homes in Denver, is the founder and president of American Dream Development, the 63rd-largest builder in the United States. Headquartered in Kansas, American Dream Development is a successful builder of affordable, planned communities. E-mail: jburton@adreamdev.com. Randy C. Norton is managing partner of National Capital Partners, SEC-registered investment advisers, a $300 million private equity fund focusing on distressed real estate and special opportunities nationwide. E-mail: randy@natcapfunds.com.