Mike Fitzgerald

NOTE: I am not an attorney and this article merely relates different strategies I have seen friends and customers try when faced with land that is worth less than the amount borrowed against it. Please visit our Professional Resources page to find an attorney that knows far more about these issues than I do. The goal of this article is to give landowners some frame of reference to engage in dialogue with their lender before the situation becomes desperate.

I hear the same story all too often about land developers and builders who hold on until the very end trying to make payments on raw land or developed subdivisions until all their money is gone. Land speculation and development is very different from other forms of real estate investment because there is no possibility of income until the very end of the investment cycle when the property is sold. Unlike houses, apartments, office buildings, warehouses, or retail stores, it is next to impossible to derive lease income from land and lots. When the market for land evaporates as it has done in the last 12-18 months in Metro Atlanta, the land owners have no way to generate cash from their holdings. Many have tried to find work, but there aren't many vacancies in the two industries hit hardest by the Great Recession in Atlanta: Construction and Real Estate. To complicate matters, the loan payments must still be paid on a regular schedule.

So what is a land owner to do in this current environment? One option is to continue making loan payments until all resources are depleted and then turn over the property by a process known as deed-in-lieu foreclosure and file bankruptcy. Another option is to stop making loan payments, lose the property by foreclosure and then defend a lawsuit filed by the bank for their loss on the deal. Neither of these options seems very attractive to the land owner. Relocating to Belize might be somewhat more attractive.

A third option is a short sale - yes these work for land too. A short sale is when the bank agrees to release the lien on the real estate for a payment that is "short" of the amount due on the loan. There are two types of short sales - recourse and non-recourse. In a recourse short sale the bank does not forgive the remaining debt and may pursue the borrower to collect that debt just as if the bank foreclosed on the property. There are two benefits to a recourse short sale: 1) the borrower won't have a foreclosure on his record and 2) the borrower has some control over the selling price of the land. In a foreclosure situation, the bank takes the property back in at their most current appraised amount and that's the number they use as a basis for the deficiency lawsuit.

The non-recourse short sale is the best option for the land owner - in this arrangement, the lender and land owner work together to market and sell the property at a price they can both live with. The borrower then agrees to pay some portion (or in some cases none) of the deficiency between the selling price and the loan balance. The bank in turn agrees to forgive the unpaid balance and will not pursue the borrower for this amount in the future. There are two disadvantages to the borrower however: 1) The bank will send the borrower a 1099 for the forgiven debt and the borrower may have to pay income tax and 2) the borrower may have a notation on his credit report that says that the loan was satisfied for less than the amount owed.

I get calls all the time from private equity investment funds looking to purchase notes on residential subdivisions. I also list my fair share of FDIC and bank-owned developed lots and raw land. As I go about the business of trying to sell this "dirt," I've noticed some troubling trends. The first sign of trouble began in 2008 when the deal activity started to fall noticeably and we attributed it to the bid-ask gap meaning that there was too large a difference between what buyers would pay and what sellers would take. Then we saw sellers slowly reduce their asking prices and the conventional wisdom was that seller's would eventually reduce their price to the buyer's bid and the market would hit a bottom and deal activity would resume. The incredibily frustrating thing is that so far the bid-ask spread has remained pretty much the same percentage wise even though sellers continue to drop their asking prices. Most offers come in at between 30 and 50 cents on the asking price for raw land and lots.

Now this means there aren't too many deals being done in the land business right now. The main exception has been with several notable funds who have picked up a number of developed lots over the past 2 years from some of the larger Georgia and national banks willing and capable of selling their foreclosed land and lots at whatever price the market will bring.

The rest of the market activity in vacant land and lots amounts to a lot of talk. That brings me back to the conversation I had with an equity fund out of Michigan last week. They were considering buying a loan on a 150 lot subdivision in Fairburn. All improvements are complete including the top coat of asphalt. The note is non-performing and would need to be foreclosed upon and any back taxes brought current. The cost to foreclose and clear any tax liens together with what the investors pay the bank would be their total initial investment.

Since developed lots don't produce a revenue stream, the key to determining the investor's ROI is to accurately predict two things: holding time and exit price. That's what the fund analysts want to know when they call me. I usually throw out some recent transactions to show worst case exit pricing and then give them a "your guess is as good as mine" on the time required to hold the property. Most are budgeting 4-6 years right now.

The problem I've had recently is that I cannot even give a good exit pricing estimate because deal activity is almost non-existent and listings that I have at under $10,000 a developed lot are not getting any offers in less desirable markets. In the better markets along the northern suburban corridors, deals are still happening albeit at a snail's pace - but on the south, east and west sides of Atlanta, activity is at a dead stop.

So the $64,000 question is, "What are these lots worth in less desirable markets." I heard one pundit on cable news say that a good portion of the developed lots in the current inventory never should have been developed and will never be built on. I wouldn't go that far - I expect almost all of the developed lots to be built on at some point. For some lots, the hold may be much longer than most investors are willing to wait.

Let's assume a market will exist for lots in less desirable markets in 5-6 years. Let's assume the taxes are $400 per lot annually and the cost to mow the grass and maintain the detention pond is another $200 per lot annually. Without factoring in the cost of money, inflation, etc. - the lots would cost $3,600 to hold. Add to that the cost to foreclose and pay off back taxes and we can reasonably assume our investment in each lot would be around $5,000. Most of the investors I speak with are looking for pro forma returns of 25% annually.

A six year simple return would require the lots to sell voer $12,500 each in 6 years. In my opinion that's a best case scenario - what if the market doesn't return for 12 years - at that time the lots would need to sell for $20,000 to accomplish the same 25% annual simple return on investment. When demand returns for lots in these less desirable markets, I strongly believe the lots could go for $15,000 - $20,000 each.

There's one major flaw with my analysis. I'm assuming today's investors pick up the lots for free. Is that the only price that will get these lots moving?

The Lincoln Institute of Land Policy publishes Land Prices for 46 Metro Areas in the US with quarterly data from the 4th quarter of 1984 to the 1st quarter of 2009. The graph below shows quarterly lot values for the Atlanta metropolitan area. Residential Lot Values in Metro Atlanta
The Lincoln Land Policy data takes a different approach to surveying residential lot values than the other two major research providers in the Atlanta market. Since lots rarely change hands in built-up areas, it is difficult to ascertain lot values from direct sales.

Instead Lincoln takes home resale prices and backs out the construction cost to arrive at the value of the underlying lot. Metrostudy and Smartnumbers rely on actual residential lot sales to reveal lot values. The problem with this market based approach is that it only reflects the sales of vacant lots in new subdivisions that are most frequently located in outlying areas of the Atlanta metropolitan area. The Lincoln Land Policy data is not intended to establish market comparables for actual residential lot sales. Instead it can be used as a gauge of the market feasibility for new housing starts at any given time.

For most of the history of the study, the residential lot “share” fluctuated within a quarter to a third of the value of the house sale price (house plus lot) as shown in the graph below. Lot Value as a Percentage of total House Value (Lot plus House)

Even during the housing boom of the last decade, we did not see the lot share deviate from the established range. I remember when shopping for developed lots, most tract builders would try to purchase lots at 20-25% of the finished home selling price. We saw lots for move-up and high end homes in the 25-50% range.

The current lot share value is 5% of the home selling price. So if the average lot is worth $8,000 and the lot share is 5%, then the average home selling price would be roughly $160,000. It’s fairly easy to see that if the average home price declines an additional $8,000, the value of the lot will go to zero.

What does this mean for home builders?

* It becomes very difficult to compete with resale homes when the average home price is roughly equal to the new home construction cost. The builder needs to basically get the lot for free in order to compete.
* Construction costs will need to decline by decreasing square footage and finish levels in new homes to bring the lot share back in line with historical trends.
* Builders will pass along the cheaper lot prices to the buyers through lower new home selling prices in order to stay competitive with resale homes.
* Since it is not possible to deliver new lots at $8,000 each or less, new homes can only compete with resales if the builders purchase distressed lots at depressed prices. Most new homes in the next couple of years will be built on foreclosed lots. * Builders must be extremely selective in determining the price to pay for lots and the location to build.

Reference: Davis, Morris A. and Michael G. Palumbo, 2007, “The Price of Residential Land in Large US Cities,” Journal of Urban Economics, vol. 63 (1), p. 352-384; data located at Land and Property Values in the U.S., Lincoln Institute of Land Policy http://www.lincolninst.edu/resources/

I got three calls today from real estate appraisers. Now that's a high number -- I usually average about one call a day but these calls were interesting in that the appraisers were not calling to verify specific sales comps from transactions that I brokered. These appraisers were calling to inquire with me to see if I knew of any comps at all for land sales in Henry, Clayton and South Fulton Counties.

Now I suspect the recent uptick in appraisal activity has to do with the 4th quarter and for that matter the year coming to an end. The problem is that the land market has been at a standstill for so long, the sales transactions of record are now too old to use in appraisals. Most appraisers don't want to use sales that occured more than 12 or 18 months ago. Some counties don't have a single transaction in this timeline and about half of the transactions that I've reviewed are not arms length sales -- they are deed in lieu transactions or transactions between related parties.

Unfortunately, those ordering these appraisals -- the banks who have foreclosed on land and subdivisions -- are quickly finding out that the only way to truly know the value of their property is to sell it. Appriasers use three approaches in valuing real estate: replacement cost, income approach and market comparables. The first approach does not apply to land since land cannot be "replaced." The second approach very rarely applies to land since most land in northern Georgia produces no income in its undeveloped state.

When no comparable transactions exist, the only way to know the value of land is to make the market by accepting offers for properties that have received reasonable market exposure. Once this starts to happen, we may start to see land trade hands again after over a year of almost no activity.

Add another acronym to the alphabet soup of programs for homeowners facing foreclosure. The Treasury Department rolled out its new HAFA program (Home Affordable Foreclosure Alternatives) on November 30th. This program is a last resort for borrowers unable to make payments, sell their property or refinance their loan. The HAFA program seeks to address many of the complaints surrounding short sales and deed in lieu of foreclosure transations.

Any agent that has worked a short sale, can attest to the difficulty and senseless time wasting involved in a short sale. The first problem is there is no accepted process to obtain a bank’s consent to a short sale prior to listing the home for sale. So homeowners and agents are forced to list the property without knowing whether or not the bank will approve the sale at the listed price. Many banks will only begin to speak with a borrower about a short sale when a written offer for the house is received.

The best way to generate an offer quickly is to list the price for an absurdly low price. The listing broker and seller use the first offer to find out what the bank would actually accept short of the loan payoff. Unfortunately, the prospective buyer and buyer’s agent unknowingly provide a valuable service for the seller but waste their own time and energy in the process since the list price on the house was never in the acceptable range for the lender.

Once the lender gives some guidance as to the price they would accept, the homeowner adjusts the list price to a more realistic number. The next offer has a much better chance, but not before the bank attempts to squeeze the real estate agents out of the deal by making him accept a lower than market commission rate as a condition of approval of the short sale agreement.

The Making Home Affordable initiative sent out an email today describing the HAFA program and the ways in which it would address the current concerns with short sales:

The HAFA program simplifies and encourages short sale and DIL (deed in lieu) options by:

• Offering eligible borrowers viable alternatives to avoid foreclosure;
• Providing a standardized process and time frames for handling viable alternatives;
• Allowing pre-approved short sale terms before a property is listed;
• Preventing servicers from attempting to reduce real estate commissions established in the listing agreement as a condition for short sale approval;
• Releasing borrowers from future liability for the debt; and
• Providing financial incentives to borrowers, servicers and investors.

Borrowers should be (or request to be) considered for a Home Affordable Modification Program (HAMP) modification and other retention programs before being considered for HAFA.

There are sample documents on the program website including a sample short sale agreement, request for approval of short sale, alternative request for approval of short sale, and deed-in-lieu of foreclosure agreement.