This Has All Happened Before and It Will Happen Again

Joshua Stein.
Joshua Stein.

Construction lenders are lending again. Developers are developing again. It’s great. But will they make the same mistakes they made in 2006 and 2007 all over again?

I asked my friend Bruce Davidson to walk me through some ways that construction and development loans can—and do—go wrong.

Bruce worked at a German construction lender before the financial crisis, then at the Federal Reserve Bank of New York helping to clean up the mess from that crisis, and most recently at Alvarez & Marsal, a global professional services firm with a focus on turnaround management and workouts.

Bruce told me stories of some disasters that crossed his radar screen—what caused them, what happened, and where the mistakes happened. Below is a composite of some of Bruce’s stories, with identifying details disguised to protect the guilty. The sequence is familiar—and worth remembering.

The story began with a developer who had a vision for a once-magnificent hotel in a great location far from the New York metro area. The hotel had three adjacent buildings. One was a hundred years old, a landmark. Another was built in the 1930s. It looked great, but needed repairs. Another, built in the 1950s, had never looked great and needed demolition or at least major renovation. And the developer wanted to add for-sale high-end apartments.

Mistake #1: The project was unfocused, confused, and needed to be executed in stages—a great way for budgets to get out of control.

Mistake #2: The developer overstated its experience and qualifications. And the lender didn’t ask the right questions.

The developer hired a local general contractor, who was bondable. The subcontractors delivered bonds, but the GC never actually did.

Mistake #3: Bonds help. Not getting a bond from the GC raised the risks for developer and lender.

The developer signed up a great hotel brand, complete with an extensive technical services agreement so the hotel would meet the brand’s standards.

Mistake #4: That agreement gave the brand total freedom to specify everything, including architects and other vendors, with no control over costs.

The developer started tearing open walls to reconstruct one of the buildings to modern standards.

Mistake #5 (or at Least Very Bad Luck): Harsh weather conditions and leaks meant that the buildings suffered far more damage than anyone expected. The budget got out of control.

The developer needed more money but couldn’t find more equity. The loan agreement prohibited the use of mezzanine debt. The seller of the hotel had agreed to defer some payments, so the developer eased some pressure by further deferring most of those payments, paying a small deferral fee and giving the seller an equity pledge.

Good Move: In consenting to all that, the lender insisted on a “deeply subordinated” intercreditor agreement that gave the seller no rights at all except the right to wait for a check—maybe.

The seller’s deferral wasn’t enough. The developer still needed more money. The lender was willing to lend more, but wanted more information—a market study, sources and uses, an updated budget, a schedule and an updated valuation.

Mistake #6: The developer couldn’t give the lender the information it wanted. The budget kept changing. The developer stopped paying real estate and other taxes. But the lender didn’t want to give up.

The lender eventually agreed to a workout, pushing back maturity, increasing the loan, bringing taxes current and giving the seller a little something.

Mistake #7: In retrospect, the lender probably should have started to foreclose. By doing the workout, the lender started to throw good money after bad.

The loan matured. The lender kept extending it. Values started to drop. The borrower stopped paying vendors.

Good Move: The lender finally started foreclosure and got a receiver appointed. The receiver made a huge difference, preventing the borrower from siphoning off cash. The receiver also brought some order to the chaotic construction process.

The lender took title and found an interim manager. Parts of the hotel were in great shape, easily rentable at premium prices. Others remained under construction. Revenue couldn’t possibly cover operating costs.

Mistake #8: The lender shut down the hotel. This cut off all revenue but only some expenses. And it made any future reopening much more difficult than otherwise.

An investor offered the lender more than 80 cents on the dollar for the loan.

Mistake #9: The lender demanded 82 cents on the dollar. The buyer said no. The buyer later said it was the best deal he never made.

The holder of the loan eventually sold the project —failed, closed, and dark—for 25 cents on the dollar.

This project’s road to ruin was all too familiar, a combination of unwarranted optimism, lack of due diligence, and some wrong turns. The lender didn’t insist on old-fashioned protective measures. The market didn’t help. As today’s market continues its exuberant rise, are we paving the way for more stories like this one?

Joshua Stein is the sole principal of Joshua Stein PLLC. The views expressed here are his own. He can be reached at

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