The worst bet in real estate today: Construction loans - USATODAY.com

By Paul Wiseman, USA TODAY

The biggest bank killer around isn't some exotic derivative investment concocted byWall Street's financial alchemists. It's the plain old construction loan, Main Street banks' bread and butter for decades.

Deutsche Bank has called them "without doubt, the riskiest commercial real estate loan product." The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

And the worst may be yet to come. Banks, adopting a desperation strategy known as "extend and pretend" or "delay and pray," have been reluctant to admit defeat, repossess half-completed housing developments and strip malls — and dump them on a depressed market at a big loss. "There probably are many loans out there that are in worse shape than reflected on lenders' books," says Chicago construction lawyer Joshua Glazov.

Even so, the numbers are already grim:

•Across the banking system, nearly 17% of construction loans were non-current — at least 90 days past due or otherwise in trouble — at the end of March, a record level and a stark contrast to less than 5.5% for all loans, according to the latest numbers available from the Federal Deposit Insurance Corp. For construction loans on one- to four-family residences, the percentage of bad loans is even worse: nearly 23%.

"Construction loans are experiencing the biggest problems with vacancy or cash-flow issues, have the highest likelihood of default, and have higher loss severity rates than other commercial real estate loans," the Congressional Oversight Panel, tasked with overseeing the federal bailout fund, reported earlier this year.

•The 10% of banks that had the highest concentration of construction loans at the end of 2007 account for more than half of the 274 banks that have failed between then and Aug. 6, according to an analysis for USA TODAY by SNL Financial in Charlottesville, Va.

•Even the banks that have survived despite holding high concentrations of construction loans remain vulnerable. Their average "Texas ratio" — which measures their bad loans as a percentage of their capital and reserves against loan losses — stood at 101% on June 30, up from 90% three months earlier, SNL found. Anything over 100% signals that a bank is in danger of failing. For construction-loan-heavy banks, the median Texas ratio — which weeds out the worst cases — was still high, at 62%.

"It's been a bloodbath out here," says bank consultant Tod Little of BNK Advisors in Las Vegas.

Developers typically take out short-term, adjustable-rate loans to buy and develop property. The bank releases money in increments — as the developer needs it — and puts some of the proceeds in a reserve from which the builder makes interest payments before the project starts generating revenue. After the project is completed — and tenants have moved in and started paying rent — the developer takes out a longer-term mortgage to pay off the construction loan.

'Cocaine' for banks

Many small and midsize banks, eager for growth, grew addicted to construction loans during the housing boom. "Construction lending is really the cocaine of the banking industry," says veteran banker Rollo Ingram. "They're easy to do. They're big-dollar loans that can bulk up a balance sheet. And there are always developers who want loans."

Construction loans — officially labeled "acquisition, development and construction" loans — surged more than 150% between the first quarters of 2003 and 2008, when they peaked at $631.8 billion. (Overall loans rose just 55% during the same period.) If a bank said no to a construction loan, "The developer could just go down the street," says Brandon, Fla., bank consultant Jon Campbell.

And some of the people getting loans during the real estate frenzy of the mid-2000s were amateurs, says Boston bank consultant David Brown: "They were contractors who got the bug and felt they could make a living at being a developer."

It did not end well. Construction loans started blowing up when the real estate market collapsed and the economy tumbled into recession. The 10 biggest banks, facing problems of their own with subprime mortgages, were largely immune to the deterioration in construction loans, which accounted for just 2% of their assets in 2007, according to the Federal Reserve. By contrast, construction loans accounted for more than 10% of assets at banks that didn't rank in the top 1,000. "What's causing the problem is Main Street America, the construction loan made by the bank down the street," says Bill Bartmann, who owns a debt advisory firm. "They built, and nobody came."

Making matters worse: Community banks never sold the construction loans to investors the way banks unload auto loans and residential mortgages. "Most construction loans are so unique, so different, so non-homogenous, that you can't securitize them," Bartmann says. "They were kept on the books of the banks that originated them." And there, many of them started to turn rotten.

A failure's postmortem

Rollo Ingram witnessed one spectacular flameout up close. He was chief financial officer at Atlanta's RockBridge Commercial Bank, which opened in 2006, backed by other members of the city's business elite.

RockBridge told banking regulators it planned to specialize in business lending. It didn't, plunging instead into real estate and construction loans. The bank told regulators in 2006 that construction loans would account for 5% of its portfolio. By the end of 2007, they accounted for 42%. Business loans, which were supposed to make up 50% of RockBridge's lending, came to just 28%, according to an after-the-fact autopsy by Federal Deposit Insurance Corp.'s inspector general.

Nor did RockBridge recruit veteran loan officers with enough experience to safely assemble its risky portfolio, the inspector general concluded. "They hired younger, less-experienced ones, and didn't hire enough of them," Ingram says. He says he was forced out in 2008 when he complained about the risky direction the bank was taking.

By the time RockBridge failed last December, more than 60% of its construction loans had gone sour.

Other banks on SNL Financial's list of failed construction-focused banks fared even worse: At Chicago's Ravenswood Bank, more than 69% of construction loans went bad before regulators pulled the plug Aug. 6. By the time Wheatland Bank in Naperville, Ill., failed in April, more than 80% of its construction loans had gone belly-up. Security Bank of Gwinnett County, Ga., failed a year ago with three-quarters of its construction loans underwater. Georgia saw more construction-focused bank failures (34) than any other state between the end of 2007 and August, according to SNL.

Brown of RMPI Consulting in Boston blames the banks themselves. He says many banks, trying to cut costs and boost profits, dropped training programs that would have taught loan officers how to assess risks on construction projects and other loans: "I could see it coming for five years," he says. "Banks got sloppy; banks got greedy; banks got lazy."

But Little says many construction loans were prudent when banks made them. Some banks demanded that developers make 50% down payments only to see the value of the projects drop 80%: "That's really killing the community banks."

He says regulators are unreasonably forcing banks to take losses on real estate loans and pushing them out of business when they would rebound if given enough time to work with borrowers and await a recovery in real estate. "They're bayoneting the wounded," he says.

Then again, a council of federal bank regulators issued a statement last October encouraging banks to work with commercial real estate borrowers struggling with empty office space and storefronts, evaporating rental income and collapsing property prices. "Prudent loan workouts are often in the best interest of both financial institutions and borrowers, particularly during difficult economic conditions," the council said, adding that regulators wouldn't force banks to write down otherwise good loans "solely because the value of the underlying collateral declined."

"The regulators have probably held back in places," lawyer Glazov says.

Troubled construction projects are a nightmare for banks. "If a bank forecloses on a house, it's a house. Everybody knows what to do with it," Bartmann says. "But if you're dealing with a half-constructed hotel or a half-constructed strip mall, not only does no one want it, you now have to maintain it" — trim the hedges, pay the property taxes, write checks to the power company. So, many bankers have chosen to wait it out, extending the terms of loans to troubled developers to keep from having to foreclose and take possession of a half-built headache. Which leaves bad loans and troubled property in limbo.

"The loans aren't coming to market," says Sam Chandan, president of Real Estate Econometrics in New York. "The distress is sitting on bank balance sheets."

Concludes Wayne Heicklen, co-chair of the real estate practice at the New York law firm Pryor Cashman: "They're hoping the existing borrowers or someone else will come along and put more money in the project and make it right."

How to make money buying and selling foreclosed homes

One man's loss is another man's gain. Or so the saying goes.

The latest loser in this equation is not the person that was forced into selling off their timeshare, or their garaged '65 Corvette Coupe, it’s your neighborhood bank. After years of progressive gains, home prices have plunged in a nationwide trend that still is not over, opening up opportunities for even the most average entrepreneur to turn a tidy profit.

Home foreclosure rates have jumped close to 30% over the past few years, and banks are eager to trim these dead weight loans off their books. Buying and selling foreclosed homes is an attractive option, but what do you need to know?

You have seen the commercial spots for so-called private and government foreclosure listings that are suddenly made public and you are goosed up after watching yet another home makeover show, but you need to do a little homework before heading off to the auctioneer.

Gather Your Info

Buying a foreclosed home has some twists, but you should familiarize yourself with the nuts and bolts that govern any home purchase or sale. The Real Estate Settlement Procedures Act (RESPA) is a set of laws that regulate such transactions. Take time to review your rights as a buyer or as a seller.

RESPA requires that certain disclosures be made at various points during the transaction. Some of these disclosures specify various up-front costs. Others discuss options available from a lender and go over your escrow details. Since you will possibly be moving through this process absent a realtor, you need to be aware of the basics.

You also have the right to request a barrelful of information regarding any property you are interested in purchasing. Such things as the property's water supply, its building materials like the roofing and insulation, lead-based paint or other potential hazards, waste disposal, property taxes and average utility bills, can and should all be provided upon request.

It is your choice as to the inspector that you want to hire, and in most cases, it is the seller's job (or the banks) to pay for an outgoing inspection. Try to gather as much information on the property before going all in; there is no "lemon-law" in the housing market as there is with buying a vehicle.

Make sure you do some in-house legwork on the internet too. Various websites can help you to locate homes in foreclosure. Foreclosures.com is one such site. For a fee,Realtytrac.com will provide you with up to date properties that have gone into foreclosure as well.

Realtytrac also maintains a database of distressed properties, HUD homes and REOs (real estate owned homes - those for which the bank holds the deed). The site also monitors monthly and quarterly foreclosure rates, breaks foreclosures down by state, and is a helpful resource for those who may be close to foreclosure themselves, or for the potential foreclosure buyer.

According to recent tends reported by Realtytrac, the national average when buying a foreclosed home is about 25 percent below the full market value. That is some sweet action.

Get the skinny on Liens

Another possible hurdle that should be investigated is whether a lien has been filed against any potential property you are looking to purchase. A lien is a legal claim against real property. Since you are looking into buying property that someone else did not or could not fully pay off, there is a good chance that a lien was filed as collateral to secure the lender's interest in the loan.

Other liens may be filed by the state or county, perhaps for unpaid property or state taxes, or even by the IRS. If an individual owes more than five thousand to the IRS, a Notice of Federal Tax Lien may be filed on real property. If this is the case, the IRS may be willing to subordinate the lien, or discharge the parcel (the house and land) from the lien. See IRSPublications 783 and 784 for more information.

Contractors can also file Mechanic's Liens for unpaid work that they did on that property. If more than one lien is filed, they are called "competing" liens, and are subject to what is called "date priority." Simply stated, whatever agency or individual got their hand in the pot first by filing their lien will be paid first by any proceeds.

A Title Search would uncover any such liens, and you should be aware that liens on properties bought through foreclosure typically transfer with the sale and remain on the property. That means you may have to pay them off before the property is free and clear. If you do not get a title search done, that home you think you just paid off may suddenly resurface with another large debt that must now be satisfied before you can assume ownership.

Go for Broker?

Buying a home through the foreclosure process is oftentimes a less formal transaction, and a quicker one, than looking to purchase property through a real estate agent or agency. Real estate agents receive their commissions through the seller. For this reason, some agents steer clear from the foreclosure market, although most are willing to provide you with a listing of foreclosed homes in your area.

For the first time foreclosure buyer, you can probably forget about trying to buy the property directly from the bank. Sitting down at the table with a bank requires a certain understanding of legalese. Although buying from the bank affords a fair amount of surety, (you get to fully inspect the property, demand a clear title, etc.) it is probably the least financially rewarding option and requires quite a bit of know-how.

The same can be said for the auction format. Besides having certain credentials required by the state to buy and sell at auctions, this marketplace is fast moving and a little tricky if you do not know your stuff. Hiccup, and that shanty with the corrugated steel roof is suddenly yours.

If you do choose to go with the auction format, keep in mind that a full inspection likely will not be possible, and that you usually have to pay in full with cash or a cashier's check, or at least a present a pre-qualified loan letter from a bank or lender that specifies the funds they plan to lend you.

You are not left in the cold without any assistance however. Try using a broker. For a fee, typically less than what may be charged through a real estate agency, a broker acts on your behalf, negotiating contracts, purchases and or sales. Banks use brokers to sell most of their foreclosed properties, and once you have eyed a few properties that a bank holds outright title to, there is a good chance you can work with the broker to get the home for less than full market value.

Many banks will let foreclosed property go for less than what is owed. If a bank cannot recoup full payment on the loan, they will “short-sale” the property, and accept less than Fair Market Value. A good broker may be able to ‘sniff’ out these deals.

Know the Neighborhood

Of course, you are not buying a foreclosed home in the middle of nowhere. Be sure to check out the neighborhood to see if it is suitable to you and your (or any) family.

If you are going to be "flipping" the property after you have put some work into it, then consider what type of family may be interested in moving in. What is the crime rate? How are the local school systems?

Remember, foreclosed homes in some areas have the potential to appreciate more than others. That largely depends on such factors as what was already mentioned, as well as comparable sales (the price that other homes in the immediate neighborhood have sold for), the neighbors, the home's proximity to a nearby city or any attractions, ease of access, how the home is situated on the lot, street noise, etc.

Get to know everything about an area you are targeting, consider the above, and then look for foreclosed properties in those areas in order to maximize your earnings at sale.

Another suggestion is to verify with local lease agreement provisions whether foreclosures in their area require tenants to vacate the homes. Since many foreclosures may be set up as multiple family rental properties, you probably do not want to take on the role of Joe Pesci in the movie The Super. It is better if the lease requires tenants to leave; most do, but still a good thing to be sure of.

Pre-Foreclosure

A great way to get your hands on foreclosed properties before they are mired in legal muck is to look for homes that may be in pre-foreclosure.

Just as it sounds, pre-foreclosures are homes that are going, but have not yet fallen, into permanent default loan status. In this case, you may be able to buy the home directly from the homeowner. Pre-foreclosures require the least amount of capital going in. You also have the opportunity to thoroughly inspect the home and conduct a timely title search.

In a pre-foreclosure transaction, the homeowner agrees to sign the deed of the property over to you, and you then assume the existing mortgage and make the payments to the lender. This option is attractive to the owner as well, because it allows them to avoid foreclosure and the horrid credit impact it carries, as well as salvage some of the equity in the property. Once the loan has been satisfied, and if the owner has equity over and above any liens on the property, you and the owner will have to negotiate how that equity is to be split, if at all.

I know what you are thinking though. How do I find properties that are in pre-foreclosure?

For sure, there is a short window of opportunity to get your hands on these properties, so you will need to work diligently. Once a property hits pre-foreclosure, owners have about 2 to 3 months to bring themselves current. If the homeowner does not rectify the default condition, the lender may post a notice of sale, sometimes right at the local county courthouse. This is done at least 21 days prior to any auction. If homeowners find they cannot bring themselves current, or know that they will not be able to, that is your chance.

Again, go online. Many agencies and even web sites that FSBOs (For Sale by Owner's) advertise on may show homes in pre-foreclosure. Local newspapers also list notice of public default debts that have been secured by liens.

In various stages of the foreclosure, notices are recorded at your County Recorder's Office. This public information is available to anyone, and is free. Visit your county's office and do a search for a Notice of Default (NOD), Lis Pendens (a fancy term that means a lawsuit has been filed on assets), or for a Notice of Sale.

In pre-foreclosure, you, your broker or your real estate agent should contact the owner directly to inquire about the property. Make sure you are in a position to make immediate payments if need be. You may be referred by the homeowner to a trustee or to an attorney, especially if that property is subject to the terms of a bankruptcy. The trustee or attorney cannot release specific information to you regarding a bankruptcy filing, but they can confirm if the property is in full foreclosure or not.

Remember your manners when trying out this option. Making contact with a homeowner who is in a financial dilemma is inherently thorny. Know that the owner in default retains his or her ownership rights, and may very well be attempting to avoid foreclosure. Selling their home or turning it over to you may not be something they want to consider, at least not as of yet. If it is clear they are trying to keep hold of their home, then move on. Telephone contact with these individuals may be tricky. For this reason, it might be best to try a mass mailing of a professional looking postcard to properties of interest.

Closing the Deal

Buying a foreclosed or pre-foreclosed home probably means that there is some fixing up to take care of. Unfortunately, once a homeowner knows that the bank is going to take control of their property, maintenance and repair work drops to the bottom of their to-do list.

Be prepared for structural or electrical problems, roofs that leak, etc. Vandalism may also be something you have the regrettable responsibility to deal with. Not from the kid with the spray can, but from the irate householder who is about to lose everything. Repairs that were not immediately evident may suddenly eat away the amount you may have shaved off the top of the market value.

Whenever you buy a foreclosed home, your contract should always have some type of contingency clause that may allow you to back out of the sale. That way, you exercise control on the property, and can also exercise your option not to buy it based on the home's physical or financial condition, or if you find it is sitting on a hotbed of buried nuclear contaminates.

Since many owners do not have the money or do not feel the need to make extensive repairs, you will probably see the term "as-is" on some of the purchase agreement paperwork. These two little words carry a lot of influence. This means you have agreed to purchase the property in its current condition, and you waive any realistic ability to later make qualms over the fact that there is a rodent population that rivals a small city living in the floorboards. Again, make sure that your contingency clause is clearly stated in your contract.

Keep a track of all your estimated repair costs and capital investments, both for tax purposes and for estimating your asking price when the property goes on to the market. Your chances of realizing a nice profit and keeping you in the "black" will increase if you keep track of such expenditures.

If you and the owner agree to proceed with the sale or transfer of the property into your name, then you will have to negotiate the terms of the purchase, taking into consideration the factors already mentioned. The foreclosing lender, trustee, attorney, real estate agent or broker may need to be present or included in these talks.

Certain intangibles may come across the bargaining table. It is surprising how many little factors may come up. The owner may want to stay in a pre-foreclosed home until they find a place to live, for example. As far as purchasing agreements, if you are not familiar with how to draw one up, consult with a local real estate agent. They will help you with one for a small fee.

If you can assume the loan outright, as in the case of a pre-foreclosure deal, you may be able to easily take on the current terms of the loan. If not, the bank may allow you toreamortize, or change the terms of the loan, such as the payment amounts, length of the loan, interest rates, etc. Other lenders may require the full amount of the loan up front.

Tips and Hints

A few other tips to be mindful of – It may be a good idea to focus on homes that have only been lived in for perhaps 10 years or less. The longer someone has lived in his or her home, the greater the equity that has been built up. Dealing with the homeowner regarding this equity, especially in the case of a pre-foreclosure sale, may be problematic.

Too, remember that your target goal should be saving at least one fourth off the full market value. At the same time, this will be subject to the recent home recession trends. This means you may have to settle for making a little less than that, especially considering the way property values in some markets have nose-dived.

Many new foreclosures stem from problems in the sub-prime market, and people are losing their homes after being hit with huge jumps in their monthly payments, particularly in the case of adjustable rate mortgages. Because of this, the lender may likely be pursuing an amount that is close to the full market value of the property, or at a slight discount only.

To sum it all up, buying and selling a home in foreclosure is no doubt a gamble. As with any risky venture, you do not always win. Nevertheless, by doing your groundwork in advance, familiarizing yourself with your local state's foreclosure laws and sticking to a couple of necessary principles, buying a home that has been foreclosed on and then marketing it can be a profitable and rewarding endeavor.

Making Money With Wells Fargo Foreclosures

Because of some mitigating circumstances, many homeowners were forced to renege on their obligation to pay their mortgages. This resulted to thousands of Wells Fargo foreclosures offered for sale on the market daily. 

This opened a floodgate of smart investors and first-time homebuyers who want to buy bank foreclosure properties either to live in, rent out or re-sell. Wells Fargo foreclosures are very cheap, selling as low as half their current market value. The explanation for the low prices is very simpleWells Fargo does not want to be saddled with unprofitable properties so it would prefer to sell them at low costs. 

Where to Find Cheap Bank Owned Properties:

Any smart investor can tell you that you can profit from a real estate if you buy a property at a very low price and sell it for a substantial profit. So start by looking for bank foreclosures that are cheap yet in good condition. To save you time and effort, subscribe to foreclosure listings. A foreclosure list is the secret weapon of many smart investors. This is the tool that enables them to get ahead of their competitors.

Subscribing to foreclosure listings gives you a chance to know about new foreclosures as soon as they are placed on the market for sale. And you will know every new foreclosure home in all major cities and towns in the country even without leaving the comfort of your home or office just by subscribing to foreclosure listings.

Buying Bank Foreclosures:

You can buy bank foreclosed homes at auctions. Buying at auctions gives you an assurance that the properties are really at their lowest market price. However, because buying means bidding on the property, there is a great possibility that you will get carried away by the excitement of the process and end up overbidding on the property. You can avoid this mistake by setting the amount that you can afford to pay the property.

Learn everything you can about the foreclosure investing market and give yourself an edge over other buyers who are hunting for cheap Wells Fargo foreclosures.