Bruce Norris is joined this week by John Bohannon. He is one of the partners in Buildzig, and he has a lot of experience in the builder control industry. He is on the company called Builder Control Inc, a funds disbursement company that has evaluated and inspected thousands of construction projects from single-family to large subdivisions to commercial. John is a great person to talk to since we are in the phase where it looks like we will have more new construction.
John is almost on the forefront before it happens because the services the company provides are not just looking at existing and what is being built, but projects that are ready to be coming on the map. Bruce asked John what he sees for 2014 that might be different from 2012 and 2013. John said we are definitely seeing more ground-up construction, specifically in the higher-end single-family homes. This has been a slow churn from the fix-and-flips that rebooted the real estate cycle in California. Projects got bigger and more expansive in the fix-and-flip arena, then it got so saturated with competition people started looking for a different product, and it naturally has evolved into the higher-end single-family home construction. These are still spec, but they are higher-end spec that were already purchased.
Bruce asked John if people come to him for other services related to looking at a piece of land and deciding what to do with it. He asked what the general feeling is out there from the contractors he deals with on their level of optimism and activity. He said the general feeling is very positive. Everyone feels good about where we are going for this year. There are some constraints since the labor market is tightening up in construction. There is inflation in material supplies. On large construction projects we are seeing the inflation line item being put back in the budget. They are running at about 3.3% on a yearly basis. They just acknowledged the fact that whatever price we say today, by the end of this project we will spend about 3% more on material supplies and labor. It is a positive mood, but they are being conservative in trying to plan for higher costs and tighter labor markets.
Typically John’s company works for lenders who always like to find the safe haven. Capital always gets directed to where lenders feel it is most safe or comfortable. Just like the typical cycles they see, fix-and-flip is very popular then turns into single-family ground-up construction. After this it moves onto a larger tract development, then multi-family to condominiums before the market crashes and we start all over again. After this you turn your condo project into an apartment building. Bruce understands the cycles really well, and John is suggesting this is a cycle we see where money flows from one safe haven to the next. This is where lenders say they do not do ground-up construction. This is what they said last year, and now they are saying they are going to do it again. This is a different animal than taking a piece of land and turning it into building lots. Lenders are not so excited about this yet.
There are lots of great deals on raw land right now. Finding the capital to make it something is very difficult. If one is so inclined and has the resources, it would probably be the perfect propitious timing for that building product. Just finding the capital that is willing to go there with you is very difficult. We are seeing all of it in fix-and-flips still, but it is starting to switch over into the single-family ground-up construction. Most of this seemed to be higher-end than median price. Production builders take care of the average median-type price home. On the speculation basis people who would be going to hard money lenders or private money lenders would be looking at the higher-end.
Bruce asked if most of what is being constructed in Riverside County is being constructed on lots that existed prior to 2010. John said this does seem to be the case right now. One interesting thing is you are going to be at the forefront of having things change because of what his company does. When Bruce looks at a chart, he can say that the creation of sub-divisions is still down from what is normal by over 90% in Riverside. You have a builder who should be able to sell anything they can build, but they are not going out there to create a new building lot. Those seem to be on opposite ends of the spectrum where they are not creating the building lots, but they would be happy to build something and make a profit on it. You then create your own artificial demand for product, but it does not necessarily have to be there if capital is willing to invest in sub-division and mapping new lots. However, they are just not willing.
In the house-buying business, they make decisions to buy a house inside of minutes. Bruce asked if he used this timeframe when buying land projects, how would this work out for him. John said you really want to find out what is the demand for wherever this land is. You can look at any piece of land and say we could build a sub-division there. The question is if it will actually have any buyers. The first question is what the particular land mass in this specific area will need the most. The answer in this regard is supply and demand. However, you are then limited by the zoning and the master plan of the community. Just because you can look at a piece of dirt and say it would be great for homes, it does not mean you can build homes there. You can always make exceptions, but any time you fall outside of a pre-determined zoning plan that the city has already spent a lot of time and money to put together, it is going to take you a long time and lot more money and consulting dollars to bring it into a final sub-division map.
You have to understand what the area needs, then you have to find out why it is being zoned. These usually meet up exactly where they should where the city has already thought that it is an area they really want to see industrial parks. They do not want parks in one area, but rather way over in another where they will be out of the way and not bothered by high traffic flow. There is usually a lot of thought put into those zoning plans. You want to build homes where it is one zone and where there is market for those homes. These are things you have to map out many years in advance. For them to change a usage, there would have to be a surprise they did not think of ten years ago.
Cities do change and alter over time, but for the most part they thought this out and it is part of the master plan community. They want residents in a certain zone, whether office or industrial, and the idea of changing that and getting the rights to build anything on a piece of dirt is called the entitlement process. This used to be very simple and involved going into the city asking to pay a fee to build something in a certain area, get the plans reviewed and be off and running. Now it is a very complex process that involves multiple consultants from civil to geo-technical engineers. Sometimes they are forced into an environmental pack report EIR, and these have various nuances of phase 1, 2, and even 3. This takes a lot of time and money, and the capital does not and rarely feels safe there. You are talking traditional lenders, banks, investment firms. They do not like to take this market risk; and they are leaving it up to other people, usually production builders, to take on this risk. It will not be until they have a final map recorded and you are good to go that people will feel comfortable investing in the mainstream capital. Until then, you are just building homes.
Sometimes when Bruce is speaking, someone will come up to him at the end of his talk and tell him they heard about a piece of land and need to close it in three days. There is never more a time when Bruce tells them this is something for which they should write a check. There are so many things that get in the way of this being successful and really don’t come into play for the single-family house. They always follow this statement by saying it is only 25% loan-to-value and is the best piece of dirt. The question then is how you put value on land. Big production builders, for example, are very critical about the residual land value of any work they do. The question is what the land is worth after we spent all the time and money to get it mapped, build a house, and sell it. After we do all of that and take our expected 8%, the question then is what is left over. This is the residual land value. To come up with a value for a piece of dirt that has no vested rights, titles, or anything or even a real conception of what could be done there is pretty impossible.
What cracks him up is how people always talk about the 25% loan-to-value since they would not have a way of knowing about this. This may not be good enough. During the downturn there were plenty of production builders with sub-divisions on their books, and the residual land value was negative. Bruce said he knew a lot of hard money lenders who had loans on those things. It goes back to John’s point about them not being the easiest things for which to get money since it takes a real expertise and a market that is cooperating. One of the problems with developers is that you are still below the numbers of 2006/2007. When somebody has a piece of land for sale and you go through all the costs, if you are talking about 8% this could disappear into the woodwork pretty quickly.
Discussing the services John offers, Bruce asked about what would happen if he called him to tell him he had a parcel of land that is five acres that he wants to handle. John would have already checked on the usage that the city wants it to turn into, and Bruce wondered if there is a thought on the history of the parcel at this point. John said yes and that this is a fairly newer consideration. However, because of all the lawsuits and environmental impact reports, cost, and the time it takes to do this the prior use of the land becomes a very critical question to ask. Was there a gas station on the lot or an old industrial building that had a waste dump? Just because you cannot see it does not mean it is not there. You also have to ask if the land has water rights and if it will be a problem to bring in waters. The past use for the dirt is a more important question than ever now, and you have to ask it and know what is there.
In one story, there was a gentleman out in Riverside County in the Temecula area who owned a 10-20 acre lot. He had a bulldozer, so he bulldozed a nice big hole in the ground. He filled it up with water and called it the kid’s pond. This was there for 5-6 years, and the kids loved it. Somehow it got mapped on the geo maps, and it became a blue line stream that got recorded on the books. When he went to do something to his own property and filled the whole back up to build something there, they refused to allow him. They told him if he wanted to do it, he would have to do an environmental impact report to show what was there and what happened. You really have to be careful since what can look like a dry river bank is in fact mapped out as a blue line stream you cannot go near, around, or on. This will mess up your density count for single-family homes. These are financials that are hard to overcome.
Bruce wondered if he had told this story, would common sense kick in regarding what he had to do, or does it go back to regulation and to say he is really sorry he did it. John said it was the latter, and Bruce asked why this is where it lands. John said it is the environment and all the lawsuits they have to deal with in every industry, not just construction. Construction is very litigious and a little more common in this industry than in others. John said a lot of times this comes over the misappropriation of construction hold outlets. This means what it really comes back to is a landmark case in 1976 with the Standard Insurance Company versus Bank of America. The judge wrote a beautiful case law summary and said Bank of America was releasing progress payments to the contractors from time to time as work was done. A little background was the insurance company provided a completion bond for a sub-division while Bank of America was a construction lender.
It came to a point where the project was not completed, the money was out, and the city went after the insurance company for this completion bond and told them to finish the project. The insurance company said no. They are good at this; they always say no right away and finally perform after a long, drawn-out battle. However, in this case they said no and sued Bank of America. The case ruling that came out said that the burden was on the bank to make sure that the money being released was congruent with the amount of work being done. The judge went on further to say this burden is not substantial and can easily be done by doing sight inspections and verifying the work is in fact. They then had to make sure it was commiserate with the amount of money released.
Ever since then, there has been a system in place called funds control. This happens when the lender makes a construction loan and they have a holdback amount for construction. This could be any amount; but they closed the loan and there is money sitting off to the side somewhere. What happens is the contractor starts work, he completes it, fills out a request saying what he has done, then an inspector goes out to the site. If the framing and foundation was done, then the inspector would confirm this and say it is okay to authorize the release of funds to the contractor. However, if it was not then we have proof and can say no you are not there yet. They would give them as much as what was completed. This has become the funds control process that has dimmed out of the case law from 1976. This is the right way to do construction loans for the benefit and protection of, not just the investor, but the lender of record and contractor as well. We do not want to give them too much money since they will get ahead of themselves and they are hard to find.
Bruce said they also borrow from projects to finish other projects. The person inspecting has some expertise in what he is viewing. There is a new rule in California that started last year called SB 978. What came out of this rule was, in part, reaction to the downturn and what happened. There were a lot of lenders out there who made financial commitments for construction and did not have the money. The contractor will submit a draw request, and the lender will tell them they do not have it. You take a project that is already in deep trouble because of market conditions, and now it cannot even get completed since there is no additional dollars to complete it.
The SB 978 said if you are going to fund a loan and do a private money transaction, then the loan should be fully funded up front. If it is a million dollar loan and only $200,000 is for construction, then you have to fully fund the loan. You then have to take the $200,000, and they may end up telling the lender they don’t trust them since they hurt them in the downturn. They may have them put it with an independent third party. They may tell them they do not entrust them with the money and to raise it all up front, close escrow, send it somebody else and make sure they have a qualified individual perform inspections. They give a slight definition of what qualified is, and it says an engineer, architect, and licensed contractor are other qualified inspectors. It is a vague definition, but the idea is can you look at a set of plans, walk on the job site, and see what is in front of you to understand what it is. The question is whether you can make a determination if the framing is 50% done or 75% done. If you can do this, then you are qualified.
In most cases, the owner of the property, if he is a general contractor, probably understands what he is looking at and can protect himself. However, a lot of times this is not the case. The person who has the project is not the expert. They are hiring somebody, and when they say they need money, they would just be writing a check if they did not have fund control. John said we see a long tradition of individual consumers who get a bank loan to build their dream house. Things then get ahead of themselves, and all of a sudden they are going to a private money lender and begging them to give them enough money to finish the job. Chances are this happened because the contractor was advanced too much money. Regardless of what people think of private money, it has been a staple for contractors in California forever. They are the ones who help the individual construction buildings. They are there, have gotten pretty smart, and use funds control in some form or fashion.
Whether it is a company like Build Zig or some other company, they want to make sure the money that is being released is actually being put into the project. As the hold back amount decreases, the increased equity value of the project goes up. They are matched up very well. If you have a $100,000 hold back and spent $50,000 of it, then the property should be at least $50,000 more because of the work done onsite.
Bruce asked how many inspections a city would do to get to a final compared to how many inspections would be done by fund control. John said city inspectors are all good and have a set schedule of when to go out there. These are major milestones. For example, before you pour foundation they want to inspect to make sure the forms are right, the correct rebars are used, the spacing is right. They have all these questions down, and they look for this and allow you to pour. You would then come back when the flaming is done and they check to make sure it was done according to the plans and specs. You can see that the pattern uses every major milestone. This includes the foundation and framing. Bruce asked how many of these would be in the project, to which John said you are looking at about 8.
Check out John and his company on the website at buildzig.com for more information on the different services they offer. Tune in next week as Bruce continues his discussion with John Bohannon.
For more information about The Norris Group’s California hard money loans or our California Trust Deed investments, visit the website or call our office at 951-780-5856 for more information. For upcoming California real estate investor training and events, visit The Norris Group website and our California investor calendar. You’ll also find our award-winning real estate radio show on KTIE 590am at 6pm on Saturdays or you can listen to over 170 podcasts in our free investor radio archive.