Between 2000 and 2007, a little-known part of the apartment business generated huge amounts of returns for developers, equity investors and lenders: the ”PRE-SALE or STANDBY” . On these pre-sale structures, lenders often provided close to 100% of construction dollars, instead of the typical 80%. The developer and equity investors contributed little or no capital on the asset, and only provided a guarantee to take out the construction loan. With little or no equity on the deals, this structure allowed developers to stretch their limited resources, build more properties, and generate considerably higher fees. It allowed equity investors, including Closed/Open Ended Funds and Life Insurance Companies, the ability to generate large profits without having to contribute much, if any, capital. This guarantee, or the exposure to potential liabilities, was usually mentioned in the footnotes. This structure also allowed lenders to put out more capital by making higher loan-to-cost (“LTC”) loans (usually at 95% to 100%of construction costs) on the asset due to the guarantor’s perceived strong balance sheet to support the loans.

There is no master database or list of pre-sales, but based upon our detailed research and knowledge of the apartment markets and players involved, Caldera estimates the gross construction costs of these apartment properties to be greater than $2.5 billion with possible imbedded loss to the investors of $500 million.

Pre-sales were a leveraged way to play the compressing cap rate and rising apartment market in an easy credit environment. The following example illustrates how a pre-sale typically functioned.

Conclusion

In each market, cap rates and development yields varied, however, the example shows the impact that a poor pre-sale deal has on an equity investor. More importantly, it saddles the equity investor with an asset he generally did not intend to own, and, going forward, one that will continue to have partnership and operational issues.

In a rising market, pre-sales were a great way to leverage all aspects of the development chain. They allowed all parties to work on more deals and earn higher fees than the historical normal equity structure would ever allow. Firms were able to generate outsized fund or profit-loss returns as they did not have to put up any real capital to achieve and book profits.

Many of the funds involved can absorb these losses due to their large balance sheets. However, irrespective of the size of the funds, many equity investors are still vulnerable since they are either already substantially levered up or don’t have the ability to draw on additional outside capital from existing investors. Caldera estimates that in the short term, guarantors, including Funds and Life Insurance Companies, will have to fund approximately $500 million to pay off the negative equity, or the imbedded loss, in the assets. However, if the assets are to be permanently financed at 70% loan-to-value ratios, then additional $600 to $800 million equity will be required, running the total equity cost between $1.1 billion to $1.3 billion.

This problem will snowball as the constructions which started between late 2006 and early 2008 will be completed in the 2009 to 2010 period, and their construction loans will mature. Investors may attempt to get existing construction lenders to extend. However, these extensions are usually only for a short term, and investors are still required to pay down the negative equity to rebalance lowered valuations. In a rising market, these issues would not be as severe. However, in most markets today, rent rolls and asset values are declining, creating further pressure on the refinancing process. This will potentially expose investors to further equity needs.