Real Estate Projects Gone Bad Leave Banks on Hook

In the 1990s, Robert Abercrombie had some difficulty securing construction loans to build homes in Northwest Arkansas.

But by 2001 and in 2002, banks were becoming more and more eager to lend him – and several other homebuilders – money.  “Anybody that had a pickup truck and was breathing was a builder,” Abercrombie said in July.

Soon new homes and subdivisions were popping up in Northwest Arkansas as people flocked to the area. “Everybody had been told for about five years that this was never going to end,” Abercrombie said.

But the end came last year as new properties began to sit unsold.

The homebuilders have been feeling the pinch. So far in 2007, 13 homebuilders in Benton and Washington counties have filed for bankruptcy protection, listing more than $1 million in debt each.

And it looks like more bankruptcies are coming, and there is some fear that the market illness could spread into the commercial sector as well.

“I’m seeing it, and every other bankruptcy lawyer I know of is telling me they’ve got builders and people connected with building [projects] just flooding into their office,” said U.S. Bankruptcy Trustee John T. Lee in Siloam Springs.

If the bankruptcy trustee can’t get equity out of the home by selling the property, the asset is going back to the bank.

“I’m guessing hundreds and hundreds of houses in this part of the world are now owned by banks or will be owned by banks,” Lee said. “What the heck they do with it, I’m just not sure.”

The banks in Northwest Arkansas are now dealing with a wave of troubled loans.

“It’s the worst possible situation when a bank forecloses and takes back assets that it wishes its customers were managing,” said Kathy Deck, director of the Center for Business and Economic Research at the Walton College of Business at the University of Arkansas. “It puts stress directly onto the banks.”

It’s expected the banks will sit on the recovered properties for a while and then sell them at a discount just to get rid of them, Lee said.

More problem loans will continue to surface over the next two or three quarters, said John Dominick, a professor of banking at the University of Arkansas at Fayetteville.

Banks that relied heavily on the construction loans will have more loan losses and will have to increase their loan loss allowances to cover the losses.

Some banks will take a hit on their earnings as a result, he said.

“When you get too much overbuilding, this is what happens,” he said. “And it’s happened in many, many locations. But it will pass.”

But not all banks in Northwest Arkansas are feeling the stress.

Arvest Bank noted that in 2005 it started sponsoring the Skyline Report, which is prepared by the Walton College of Business. The report details the real estate trends in Benton and Washington counties.

“We commissioned the study so we could be more familiar with the market,” said Jason Kincy, a spokesman for Arvest.

Still, Arvest had $3.7 million worth of loans that were 90 days or more past due at the end of 2006, which was up 236.4 percent from the $1.1 million it had in 2005.

“The first guard against losses is going to be sound underwriting,” said Payne Brewer, Arvest’s executive vice president and loan manager for its Fayetteville market. “And part of sound underwriting is evaluating the market.”

Arvest’s loan officers relied on the Skyline Report to watch for trends in the construction market, including the commercial real estate market, he said.

Arvest reported $22.2 million net income for the quarter that ended March 31, up from $20.5 million in the same quarter of 2006.

Not all banks are so lucky.

While Signature Bank of Arkansas reported earning $1.1 million in 2004, it lost $2.8 million in 2005 and $1.9 million in 2006. The Fayetteville bank also reported losing $377,000 for the first quarter in 2007.

At the end of 2006, Signature Bank had $478,000 worth of loans that were more than 90 days past due, a number that had been wiped out by March 31.

Parkway Bank in Rogers reported losses of $956,000 for 2006 and $92,000 for the first quarter this year. The Rogers bank’s loan loss allowance went from $869,000 in 2005 to $1.1 million at the end of 2006.

One of the biggest increases in loan loss allowance can be seen at ANB Financial in Bentonville. Its allowance went from $8.9 million at the end of 2005 to $19.4 million at the end of 2006. It hit $29.5 million at the end of the first quarter this year.

ANB’s net income also is off its pace from last year. It reported $908,000 for the first quarter 2007, more than 85 percent off the $6.3 million it earned in the first quarter of 2006.

While most of the bankruptcies are tied to home construction projects, the next domino to fall could be the overbuilding of commercial property in Northwest Arkansas.

“There’s starting to be an oversupply there in certain segments,” Brewer said. “The new projects that are coming on aren’t being absorbed as fast as maybe they have in the past.”

In the first quarter of 2007, 1.5 million SF of commercial property was added to the Northwest Arkansas market, and vacancy rates in some of the submarkets are beginning to rise.

For the office/retail sector, the vacancy rate jumped from 11.3 percent in the first quarter of 2006 to 20.3 percent in the first quarter of 2007.

Vacant warehouse space also jumped from 11.7 percent to 20.2 percent during the same period.

“A lot of the commercial builders, just because there was money to be made … had to expand,” said Stanley Bond, a bankruptcy attorney in Fayetteville.

“Some of the commercial builders may be slowly [seeing] that their bottom line is starting to erode because of the drag brought on by nonperforming residential real estate issues.”

No More Leeway

Seven of the 13 bankruptcies were filed between June 5 and July 15. Homebuilders who once worked with their banks through the rough times aren’t finding that same leniency anymore.

On July 5, Tower Enterprises Ltd. of Siloam Springs filed for Chapter 11 bankruptcy after an interest note came due from the Bank of Rogers on a 69-acre subdivision being built in Gentry.

“[The bank] immediately sought to enforce it,” said Don Brady of Springdale, the attorney for Tower. “The banks made a lot of mistakes in their lending, and they’re paying for it now. And so I think they’re tightening the reins across the board even on projects that they may have considered viable a year or two ago.”

In Tower’s case, Brady said the project is worth $6.2 million but the bank’s claim is $3.7 million.

Brady said there isn’t that much work left to be done on the project and then it can be sold.

“We didn’t feel like [the bank] wanted to work with us at all, so we had to take the extraordinary steps of bankruptcy so we could complete the project,” he said.

Brady said he’s optimistic that the bank will be paid off once the project is completed. 

Slowing Growth

The jobs being created in Northwest Arkansas started the housing construction boom.

Between 2003 and 2005, employment in Benton County shot up 14.3 percent, from 84,925 to 97,075.

Employment in Washington County also saw a 12 percent increase, from 87,175 to 97,600, during the same period.

But between 2005 and 2006, the expansion slowed dramatically.

The two counties’ employment increased barely 2 percent.

With the increase in jobs in the area, homebuilders revved up production. And they never stopped.

“There was a rush to build homes because the area is growing so quickly,” Deck said. “When you see an economy that is thriving the way that the Northwest Arkansas economy has thrived, everybody wants a piece of it.”

Banks also were flocking to the area.  “When banks are here to serve the area, the way they serve it is by getting their assets out and working,” Deck said.

Loan officers were stumbling over each other to woo homebuilders for business, Lee said.  “Everybody was making a fortune,” he said.

Banks were aggressively going after the construction loans because loans are the only way a bank could generate profits, said Dominick, the UA banking professor. 

“You can’t put it in bonds and make that much money,” Dominick said.

Most people thought real estate was a can’t-lose investment. And builders never entertained the thought that they could fall into a financial crunch if they couldn’t sell the homes they were building.

It also didn’t help that banks didn’t perform careful risk assessments before leaping forward with new construction projects, Bond said.

“Lending standards everywhere were a little more relaxed than they have been in the past,” Deck said.

“And I think that was a direct result of the kind of competitive nature of the market.”

The Beginning of the End

About a year or 18 months ago, homebuilders began to realize the gold rush was coming to an end. They couldn’t sell the spec homes they had built.

“They kept trying to make ends meet, paying interest on construction loans as long as they could, to the point they couldn’t,” Lee said.

The money dried up to pay the subcontractors and suppliers. Soon creditors rushed to the courthouse to file lawsuits.

The homebuilders, who had personally guaranteed the banks’ loans in most cases, then ended up in bankruptcy court to protect their remaining assets.

“Most of these folks depleted their assets trying to keep above water,” Lee said.

After a bankruptcy is filed, a trustee swoops in and tries to sort out the mess. One option is to sell off the homes if there’s enough equity in them to pay off the mortgages and have some left for other creditors.

“But the value has plummeted so that there’s little or no equity in most anything,” Lee said. “[Homebuilders] haven’t paid interest on it in a long time.”

Abercrombie, who had been in the homebuilding business for 20 years, said the property involved in his bankruptcy is probably worth 40 percent less today than it was a year ago.

Still, he said he’s been able to slowly sell off his property and reduce his debt, which was $8.2 million when he filed Chapter 7 bankruptcy on May 21, by around $5 million.

Others weren’t so lucky and got into the homebuilding craze just as the industry was starting to decline, Bond said.

“People whose natural impulses toward conservatism with their money decided that it was just too good and they needed to jump in and try and get some money out of it,” Bond said.

And some of those people are now in bankruptcy.