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Construction & Development Inching its Way Back to “Normal”

June 2010 InBusiness Article Thumbnail

photo by Mike Rebholz

June 1, 2010
As reported in the pages of In Business magazine.

From the lens of some area builders, the commercial building industry is looking up, even though construction projects are not as profitable as they were three years ago, and the competition for bid projects is more intense.

It remains to be seen whether that’s a case of people obliviously smiling with thin ice below them, but there is little doubt the building and construction industry has been a stressed segment of the economy.

Even with higher than usual unemployment in the trades, easing the labor shortage at least temporarily, Dane County’s built-in economic insulation is helping to some extent. The University of Wisconsin-Madison and various public improvements ensure there is some level of building construction, but vacancy rates for commercial buildings remain high and the lending environment isn’t helping.

Before, if 25% of a building was pre-leased, that was enough to get a construction loan. Now, with bank regulators demanding that financial institutions reduce their real estate portfolios, office projects have to be 75% pre-leased, if not more.

For the time being, interest rates are attractive, but projects still are judged on their individual merit with factors such as occupancy, the amount of cash in, and the strength of guarantors weighing heavily.

Dick Brachman, market chairman for Town Bank of Madison, noted, “The people really hurt in this economy are contractors that might have built things on speculation and are holding property, and that property is worth significantly less today than it was a couple of years ago.”

Some ancillary businesses are faring well, primarily plumbing and electrical suppliers who can control inventory expenses to a certain extent, and freeze wages. But complicating matters is yet another wrench in the credit works.

The Federal Deposit Insurance Corp. is jacking up insurance premiums on healthy banks in order to prop up failing institutions, which isn’t helping the capacity of banks that avoided foolhardy lending. “That’s a cost of doing business,” said Brachman. “We are not happy to pay it. We’re part of an industry that is really trying to help our customers stay in business.”

Build on That
In construction, timing may not be everything, but it’s hardly irrelevant. Before the recession hit with full force, some builders had jobs lined up for the 2009 construction season, while others were scrambling to find work.

Those companies with fortunate timing in 2009 may be doing more planning right now.

Tom Jilot, CFO of Ruedebusch Development & Construction, said the design-build company stayed busy through most of 2009, but now it’s a little slow as future projects are being designed. “It’s not so much that there are no projects out there,” he said. “There is stuff out there. Locally, it’s a matter of people who want to build getting the financing in order to do the projects. That’s the common theme.”

On the flip side, Ruedebusch is starting to see an increase in leasing over the past month or two, and that’s important in the interim because the company has been busy with planning, design, and engineering work, Jilot explained.

In addition, projects simply are not as profitable as they were three years ago, and to keep their workers busy, more builders are expanding their geographic reach and more are bidding on jobs they might not have even considered before. Others, like Ruedebusch, have made greater use of their own crews, relying less on sub-contractors.

Even with profit margins squeezed, 2009 was the second best year in the history of Miron Construction Co., but it took more time and effort to find opportunities, according to Vice President and General Manager Dennis Lynch. Whereas Miron was accustomed to bidding against five or six other contractors, all of sudden there were 20 or even 25 contractors competitively bidding for various jobs.

“That’s what we’ve seen, a lot more competition for fewer jobs, and you had to work a lot harder to garner those opportunities,” Lynch said.

Miron Construction, which employs 290 people in the Capital Region and 1,200 statewide, made a corporate decision not to lay people off and to find cuts elsewhere. Among other adjustments, it has experienced a change in its mix of public and private projects, ending the year with 70% public money and 30% private, a trend that is holding in 2010. “Historically, this office has been closer to 60% or even 50% public,” Lynch indicated. “Fifty-fifty is where we’d like it to be, but it’s a little more skewed toward public right now.”

The federal stimulus bill, with its funding for “shovel-ready” projects, has had more of a public impact on Wisconsin, but it helped Miron with public and private work. Stimulus dollars supported Miron’s role in the development of a biofuels plant in Park Falls and improvements to various wastewater treatment plants.

Lynch said Greater Madison’s commercial real estate market still has anywhere from 17% to 20% vacancy, and until more space is occupied, the area probably isn’t going to see much in the way of new commercial construction. However, he said tenant movement and tenant improvement (TI) work is up dramatically, an observation confirmed by others. “Even though we’re not doing the new buildings, we are still doing a fair amount of remodeling of existing space,” he said. “That will probably continue for awhile until the employment picture turns around.”

For Todd Jindra, building consultant and project manager for Building Systems General Corp., work is steady. He acknowledges that Building Systems General could be running at a higher level of capacity, but the upswing in volume is contributing to a sense of optimism in a company that is set up for longer, sustained commercial projects. Jindra noted that while some smaller contractors have turned to “TI” projects, Building Systems’ current project work includes the construction of a new Woodman’s store in Menomonee Falls, and work at Edgewood Campus School.

Still, the jobs are harder to get now. “I’m seeing contractors of much, much larger size than us, such as the [J.H.] Findorffs of the world, going after jobs that, three or four years ago, they never would have thought of going after,” Jindra said.

One year out from the recession and the federal stimulus bill, Joe Alexander, president of the Alexander Co., a developer and property holder, agreed the biggest construction players in Greater Madison continue to be the state, UW-Madison, and health care providers, and that it’s difficult to get financing in the commercial market unless the building is 100% pre-leased.

Alexander Co., developer of the Novation Campus in Madison, is diversified by geography and product type. With the help of stimulus dollars, the company has closed a $36 million development deal in Kansas City for the adaptive reuse of a former federal courthouse into 174 housing units. Alexander has not seen a huge impact with stimulus funds on private sector development in Wisconsin, but that doesn’t mean the stimulus lacked economic value.

“Certainly, there is plenty of impact regarding capital projects by the university in particular,” he said. “That’s an important function by helping to provide work, particularly for design, engineering, and general contracting firms. Those kinds of businesses, architectural and general contracting, were hit hard by the recession.”

Investor Relations
Rose-colored glasses are not necessarily sported by Kurt Welton, president and treasurer of Welton Enterprises. As an investor who owns buildings and pays the bills with management fees — development fees are mere gravy, he notes — Welton has run smack dab into new banking rules that limit the percentage of a bank’s net assets that can be consumed by loans to real estate investors.

At first, the limit was placed at 300% of a bank’s net assets. Since most banks had a lot more than that in their portfolios, they immediately told customers they weren’t doing any more, Welton said.

Not long after that limitation was established, the Feds handed down a more stringent requirement: a new limit of 200%, meaning banks would have to knock another 33% of these loans off their books. “A lot of this will get sold in fire sales and foreclosed on and that type of thing,” Welton predicted. “When they say the shoe hasn’t dropped yet in commercial real estate, I think that’s what they mean.”

As a result, people can more easily buy a property and move their business because the loan limits are placed on the investors, not users, Welton said.

Adding to the lending uncertainty is the higher FDIC insurance premiums banks are required to pay, in some cases many times higher than before. While this may be an extreme example in terms of the ratio, Welton said one bank saw its FDIC insurance increase 16-fold, and was powerless to stop it. At various levels, “That is what’s happening to every single bank in the country,” he noted, adding that well-run banks are being punished to favor the “high-flyers.”

Welton, who said deals are being negotiated despite the difficult lending environment, is working with eight different banks to refinance 21 loans. Admittedly, he’s never had to deal with anything this complicated before.
In one project, Welton Enterprises will remodel office space for a tenant that just signed a new lease; as part of another, it would build a new 90,000-square-foot building that will become the headquarters of a long-standing area company. “So there are deals getting done, but all of these deals have been a year or two in the works,” he said. “I just had a closing on a deal where we started talking two years ago, so there has been a lot of sitting around and waiting, and now deals are finally starting to pop.”

Another thing that’s happening is that commercial tenants have been led to believe that they should be able to get a better arrangement, but banks want more cash, higher debt-coverage ratios, and higher loan-to-value ratios in real estate deals. “That means I have got to charge more for rent, yet tenants think they are going to get half-off when they come back to the plate,” Welton remarked.

Another sign of industry change is what Welton now requires of builders. With past building projects, he rarely got a bond or letter of credit from a builder. Now, he tells builders that not only does he want a bond, he wants a letter of credit from each of their subcontractors and a layer down from that — the sub of a subcontractor, or a supplier.

Some residue from the recession will make that more difficult. In the late 1980s, when Madison became a Top 100 market, more Fortune 500 companies established a presence here. Now, Welton said, some of those organizations have left, believing they can serve Madison from Milwaukee, Chicago, or Minneapolis.

The “New Normal”
Whenever the economy emerges from a recessionary period marked by low pricing for construction services, and the economy begins to scale back up, the expectation of would-be building owners is that favorable pricing will continue, according to Lynch. “In fact, their costs typically begin to rise faster than owners think they should,” Lynch said, noting that it takes some skill for builders to manage this situation. “That’s the risk we’re heading into.”

Welton doubts the industry will ever return to the “go-go” days because some very hard lessons have been learned. Nevertheless, he predicted that a stronger foundation will be built. “There is not going to be a normal like there was,” he said. “The new normal is going to be, I think, a more cautious, a more coherent, and a stronger normal.”

Alexander believes normalcy will return when liquidity and lending standards return to a point where there is an opportunity to develop with some speculation, which will require a relaxing of today’s stringent pre-leasing requirements. “That’s good for developers,” he said, “and that’s good for builders.”

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