Wednesday, July 1, 2009

Now The Story Can Be Told

Today, I woke up from a nightmare. A five year nightmare. The story is so unbelievable it could have only happened in REM state. But it happened for real. And, for the first time in five years, Lisa and I can exhale.

It all started at the end of 2002, actually. I'd read a fantastic book called The One Minute Millionaire: The Enlightened Way to Wealth by Mark Victor Hansen (the Chicken Soup for the Soul series) and Robert G. Allen (No Money Down). It was a double book that was half fiction and half guidebook. And it was inspiring. I was under no illusions that million-dollar income would be obtainable quickly. Guided by the book, however, I assembled a team of people that included my wife and two trusted friends. We started out working on how to create the kind of wealth that would get us out of the rat race of every day work. I'd created an intention to earn $1 million by the end of 2004. I wasn't sure how it was going to work -- or if it would work -- but I was determined to see $1 million flow into my bank account over a two-year period.

I had just changed jobs from a mid-level manager to sales at my then-employer. The real estate market was on fire nationwide, and I sold one of the most lucrative mortgage products available: short-term construction loans to small-volume homebuilders who were building on speculation. My income in 2003 doubled what I made in 2002. With a young Max to care for and a wife who was set on being a stay-at-home mom, that was really all the incentive I needed. By the end of 2003, business was literally booming and I was a superstar at work. At the end of 2004, Lisa and I had made $915,000, just $85,000 short of our goal. It was definitely something to be proud of.

But I was unsatisfied. I was unsatisfied because I was watching men and women, many of whom were not as smart as I was, make money hand over fist in the real estate development business. A 26-year-old Latino man in Hesperia with a high school education was building entry-level homes and had $10 million in sales in 2003, and had $1 million cash in the bank.

I was definitely on the wrong side of the transaction!

It had always been my dream to become a homebuilder. I couldn't think of a better way to contribute to the growth of the economy and to the enrichment of so many families than to build a product that required so many hands from so many different businesses. And so, with my partners, we resolved to start a business building homes on spec.

My partners had family living in a little town up in Kern County called Tehachapi. About 100 miles north of Los Angeles. Remember that name now. It was home to a prison, a lot of horse farms, some sod farms, and not much else. But Sunset magazine had rated it one of the best places to retire in California: wide open space, cheap land, and beautiful scenery. So, with the help of these relatives, we got introduced to a real estate agent and started looking for dirt.

We recruited family members to invest in our business by putting up the capital to acquire this land and promised them a 15% return on their money. It wasn't hard to rack up that kind of return in that market. Not hard at all. We'd found a property to buy and put in an offer. It was located on a street called Bold Venture Drive in a community known as Stallion Springs. All the streets were named after people, places, and horses that were known in the racing business. There was a golf-course, a general store, a gas station, and not much else out there. Not even a church or a school. It was unincorporated county land with no public sewer system, a water-stock company that provided water, and only private propane companies for gas. And yet, the community was more than 20 years old and was well established. It was where we got the name for our company: Bold Venture. Seemed fitting. But we lost out on that property. We quickly found another one, on a street called Hambletonian Drive. Our bid was accepted and we closed in July 2004. The closing was problematic, as the seller had tried to weasel out of the deal at the last minute when she'd seen that we'd negotiated such a great deal.

Here's the first of the "coulda-woulda-shoulda" (CWS) moments: we shoulda taken that problematic closing as a sign of trouble to come.

Meanwhile, in 2003 my partners' relatives had put money down on a vacant lot in a new development on Scarlet Oak Drive in the city of Tehachapi. They were looking to have a new home built for them to live in. But, when the time came for them to buy the land, they didn't have the money. We did, and we took their place in the purchase contract and bought the land. Because the price had been agreed upon a year before the actual purchase date, we got a great deal and walked into an equity situation.

Finally, we acquired a third property, a 2.5 acre lot in an unincorporated community called Oak Knolls. The lot fronted the main street in the neighborhood and had a great flat pad that sat up above the street, offering any homeowner a scenic view of vineyards, mountains and rolling hills. All of these lots were cash purchases.

Now we needed to decide on homes to build and financing. We picked a standard plan from the Scarlet Oak developer. Permitting was simple and trouble-free. For Hambletonian, I discovered a novel plan that could save us time and money. A co-worker of mine had financed about five projects for a local real estate developer who was building modular homes. These are factory-built homes that resemble traditional site-built homes, but the pieces, or modules, conform to the dimensions of the flatbed trucks that transport them to the site. You've probably seen them on the freeway, red flags affixed to their sides and rears, with pickup trucks leading the way displaying a "wide load" sign. At the site they are craned onto a foundation and assembled, then finished like any other home.

I got the number of this developer and contacted him about working together. Our idea was to have him do all the construction work at a reduced rate while giving him a share of the profits. We drove up to Tehachapi to meet him at one of his projects and discuss the particulars.

Upon meeting him, he walked us through one of his modulars that was nearing completion. It was a very messy job, but I know from experience that construction is a messy business. There is always a big clean up at the end and the house looks brand spanking new.

But, here's the second CWS moment: we shoulda noticed that this guy was a bit off, a little slimy, and not too in command of his work. In hindsight, what we had seen was an example of some wretchedly bad construction work.

We discussed the idea of working with this guy. Lisa had not met him, but she was opposed based on what we'd said. CWS moment #3: I coulda listened, I shoulda listened, and I woulda listened to Lisa had I any sense at all. But I was seduced by dollars and a persistence to achieve my $1 million goal. So I didn't. We agreed to work with the guy. Big mistake.

The contractor put together a contract for the construction work. The cost was far higher than we'd anticipated. He was over charging us and he knew we knew it. So I started getting a little upset with him and reminded him of our deal. He dropped his price to a range we could live with given our projections.

Now, because he was an "approved" builder with the company I worked for, and had been given five loans to build these modular homes, that the company was comfortable with his work. So I didn't do as much due diligence with this guy as I coulda (CWS #4). We applied for financing through my employer, and because of my reputation there, and my income, the loan sailed through.

Simultaneously, we had obtained a separate construction loan from another bank for Scarlet Oak. We decided not to build on Oak Knolls until the other two were sold. That was probably the best decision we'd made in hindsight. Because the nightmare was starting to gain momentum.

In September 2004, we started both projects at the same time. Scarlet Oak was by far the better-managed project. It went without a hitch. In March 2005, we accepted an offer at a good price and made a healthy profit.

The idea with Hambletonian was that, because of the modular construction, we could have it done by the end of the year and sold by spring as well. But that didn't happen, not by a long shot.

The contractor was supposed to have begun work immediately. But he came to us in September with an idea. Because of the view on the lot, it would be better to reverse the floor plan. We agreed, and the order was placed in the factory for the revised floor plan. We were sure to tell him to make sure that the county knew about the change in plan. We later found out that he never did that.

We would call him repeatedly during the fall to get started on construction, but he said he was busy with another project and would begin in early November. We wanted to get started sooner to avoid the rainy season, which would make grading difficult and hamper our timeline. Still, he didn't get started until mid-November. He staked out the corners of the house and started to excavate for the foundation.

Then he called to say that his backhoe was pulling up enormous amounts of boulders out of the ground. He suggested importing hundreds of yards of dirt to raise the level of the ground rather than dig in. We agreed, but it increased our budget by about $10,000. We were not pleased.

Around Thanksgiving 2004, my partner and I had a fateful conversation that I will never forget. We were increasingly frustrated by this contractor's inability to stay on track, we didn't like his delays, and we felt that it might be a good idea to fire him. Of course, there was another CWS moment (#5) -- we shoulda followed our instinct. But, we decided to stay the course and at least get the foundation in the ground. We could deal with the home installation by finding another qualified contractor. We were behind schedule and looking for another contractor at that point, we felt, would have set us back even further.

But at this point, God had entered the picture. The fall and winter of 2004 had been the wettest in California history. We experienced so many delays that we didn't get the foundation done until early February 2005. We were now four months behind schedule, with only four to go before our loan matured.

Meanwhile, we found another great piece of property, on a street called Seabiscuit Drive. We'd found yet another contractor through our realtor, and we decided to build a site built home with him. We found a local bank to do the financing, and that project went off without a hitch. We sold it for a great profit in 2006, only a month past the loan's maturity date.

Back to 2005, now. Hambletonian was officially a mess. The house, which was supposed to be delivered in December 2004, had sat in the factory storage yard, exposed to the elements. It had to be cleaned up and partially rebuilt before it was delivered in late February. It arrived on three trucks on an extremely rainy day. The ground was so muddy, our contractor said, he had nowhere to put it on our property. So it was stored on a site he owned down the street and would have to be installed later. We told him to wait for us to come up there because we wanted to watch the installation. This was primarily because we no longer trusted him and wanted to learn how to do this ourselves in the future. He hired the crane and did it on another rainy day without us there. We were furious, but at least the house was on site and attached to the foundation, right? Well, not exactly.

For weeks, the house sat on the foundation, exposed to the elements, with no work being done. Inspections by the county had signed off on the installation and the foundation construction. But our frustration level had peaked and at the end of March 2005, we fired him. It took the local police force to get him off our property, and he had the audacity to claim he was "part owner" of the land and house. We settled that matter and told him to stay as far away from the project as possible. We obtained a lawyer and attempted to get him to disgorge the $250,000 he had basically stolen from us. He continued to offer to complete the house, but we refused and decided to sue him for the funds. During discovery we found out that this guy had never been licensed by the state to be a contractor, but had in fact either stolen another person's license or worked in collusion with that third party to get a license. Further, we found out that the house manufacturer had known about this all along. So we sued everyone. Eventually, we settled with the manufacturer for a paltry $9,000 and gave a third to our lawyer.

Now comes the nightmare in full force. A subsequent county inspection revealed that the house was improperly installed on the foundation and that the foundation needed significant repair. We had to hire another contractor and pay him $40,000 to lift the house off the foundation, do the repair work, and set it back down again. Because we discovered during that process that the foundation wasn't suitably square, the house was tweaked so badly that two of the exterior walls and the roof peak were bowed and bent. We would have to rebuild those two walls and the roof. We were now out of time with our construction lender (remember, my employer) and we were now forced to make the interest payments out of pocket.

Lucky for us, the profits we made from Scarlet Oak were available, but we knew it wouldn't be enough. So we decided to sell Oak Knolls. We made a healthy profit, enough to pay back the investors and have enough left over to shore up the Hambletonian project. When Seabiscuit got sold, we used those profits too, and even some of our principal.

Now, we got more time from the lender, but we were funding the construction repair ourselves. We hired yet another contractor (our Seabiscuit contractor refused to touch the place) and we completed the inside of the house, painted it, and got it ready for the septic tank installation in November 2005. This was when the nightmare threatened to overtake us entirely.

On Veteran's Day 2005, I was with Lisa and our kids at a museum when my partner called me. The septic contractor was preparing to dig the hole for the tank, but noticed that the house may have been built over the property line of the adjacent (vacant) lot. Holy shit! We were encroaching on the adjacent property? We hastily hired a surveyor and found, to our horror, that we weren't just encroaching: we were 35 feet over the property line, basically straddling two lots. Further we were five feet too close to the street.

How had this happened? In retrospect, we put the pieces together. The first contractor, when grading the lot, had probably knocked over the surveyor's stakes that had marked the property's boundaries and never bothered to replace them properly. Further, when he flipped the floor plan, he never got proper approval from the county, and instead of relocating his house corners, simply pivoted the house along one wall, causing the encroachment.

But why hadn't the county caught this? We found out that the inspector's office had undergone a change in personnel at the time, and no one was well versed enough in the job to notice. They also had signed off on that horrible foundation. But how does one obtain relief from a government agency? Easy answer: one doesn't and one can't.

I was discussing this situation with a mentor of mine, a guy who was an expert in construction financing. He said that the problem sounded like something the title insurance company could handle. Whenever a construction lender finances construction in California, it obtains an endorsement from the title insurer to make sure that the foundation is properly located on the site before disbursing funds to finance the construction of the foundation. The title company, in order to provide this endorsement, usually inspects the property. Sometimes they don't, in which case they take their chances if there is a claim against the foundation.

Well, I went to my lender, who contacted the title insurer about the problem. Big problem though: the lender never requested the endorsement, an endorsement that we had paid for in our our closing costs. So they didn't have proper insurance coverage, and the insurer refused to provide it retroactively (of course!). So we were stuck.

We were forced to contact the owner of the adjacent lot and offer to buy it. It was late 2005 and the market had peaked. We paid $65,000 for that property in March 2006, borrowing against the equity in our homes to pay for it. We also hired yet another contractor to do all the finish work, rebuild the outside walls and roof, install the septic tank, and do all the exterior concrete. Cost? About $80,000.

Further, we applied for and received a zoning modification from the county to avoid having to demolish our house entirely and move it back five feet.

What choice did we have? We couldn't have walked away. I was an employee of this bank, a prominent salesperson, and if we walked away, they would have been forced to foreclose on it. That could definitely have put my employment in jeopardy. However, my partners were in no such position. They wrote a letter to the CEO and worked out a deal through lawyers that gave us some of the money to finish the property so that we could refinance it.

Once it was complete, in April 2007, we started work on refinancing it. We obtained an appraisal for $370,000, which would have been enough to pay off the bank in full. However, we kept this information mum, as we knew they were conducting their own appraisal.

When their appraisal came in at $285,000, we pounced. We offered them $250,000 to pay them off in full, and they accepted (damn straight!). They forgave $66,000.

We refinanced and even obtained an equity line for another $72,000.

Meanwhile, in summer 2006, we had begun construction on a fourth project on Flare Drive, using the same contractor and lender as on Seabiscuit. But because of our nightmare, we fell behind on that one and missed the market.

Our business was now broke. We used the equity line to pay the bills and make loan payments. Until, of course, that lender froze the line at $41,000 because of market conditions. We'd listed both properties for sale right away, but we knew we'd entered a market on the decline. Just how far it had declined was not known.

There were zero offers and there was zero interest. We decided to rent both properties in 2008, and were able to afford the shortfall for a period of time. However, we knew that the only way we'd ever get to dispose of these properties was to short sell them.

For the Flare Drive project, the bank was absolutely unwilling to budge; they didn't accommodate short sales. We weren't behind in our payments, so they had no incentive to deal with us. We'd obtained two offers, for $20,000 and $40,000 short of the loan balance, but they refused both. After the tenants in Hambletonian broken their lease in October 2008, we were hit with another $1,600 a month in payments we couldn't afford. My income had dried up along with the real estate market and we were barely hanging onto our own homes. In January 2009, I was laid off, given a decent severance package, and we held on for dear life in 2009. I started a new job in May, but because it was 100% commission, I barely made a dime last year. I was terminated at the end of December.

In October 2008, the partners convened a meeting and decided to let the bank have Flare. It was such a beautiful property and we were so excited about the work we'd done, but there was no way we could continue affording it. In October 2008, we stopped making the loan payments, and in January 2009, the bank foreclosed, taking it in a trustee's sale in April 2009.

There was some good news on this front, however. The original construction loan had been made to Bold Venture, not to us personally. The foreclosure never hit our personal credit reports because individually we were not the borrowers. On Hambletonian, however, we had to take the mortgages in our personal names, and so a foreclosure there would have been devastating. We resolved not to let that property go that route.

Meanwhile, we were attempting in December 2008 to get the holders of the first and second mortgages on Hambletonian to accept a short sale offer we'd received. We owed these two lenders nearly $300,000; the offer was for $182,500.

Four months later and they hadn't figured out what to do, so those buyers went away. We immediately received another offer of $175,000 and resubmitted in March 2009. The holder of the first had sold the mortgage to Fannie Mae, which held the final decision in their hands. They appraised the property for $215,000, a completely absurd number. However, they had the power, so we started negotiating with them. We offered them 90 cents on the dollar ($193,500). They countered at $210,000 and said final offer.

Now, our partners did not have the funds to come up with half the money needed to meet that payoff figure. Neither did we, but we had family who could help. We enlisted their help and told the mortgage holder in writing we agreed to their terms.

But Fannie Mae then reneged on their offer. We were furious! How could they do this? We called our two US Senators, and the buyer called his congressman, to complain about Fannie Mae's behavior.

However, this turned out to be a blessing. Because of our complaint, the lender ordered another appraisal. It came in at our contract price of $175,000. Again, we agreed to terms.

After a few weeks of negotiating and a small scare with the lender for our buyers, we finally closed escrow on Hambletonian on June 30 for $175,000. All told, that project had cost us, in land, construction, interest, legal fees, and loan costs, about $600,000. While the construction lender had forgiven $66,000 and we will be facing another forgiveness this year of about $125,000, there is no way that we'll ever see our money back. We will, at least, be able to realize our loss and enjoy some amount of tax benefit.

And what happened to our first contractor, the one who ripped us off completely? Well, in the process of suing him, he of course went bankrupt, which had been our prediction all along. He attempted to defraud the US government by hiding cash, real estate and equipment, with family members and friends, but they caught onto his scheme and seized all his assets. He was discharged, and the court is now trying to dispose of his assets, which are probably worthless anyway. If we get $5,000 back, it will be a miracle.

I still believe in my heart that I am cut out for the real estate development business. We made good money on most of the projects we sold. But if I ever hear the name Tehachapi again, I will probably punch the mouth of the person who utters it.

1 comment:

Gary M. said...

Eric,
That's quite a story and I'm glad that you, your family, and your partners are mostly through with this nightmare now. You are a far different person to me now than the person I thought I knew.

I do believe that whatever doesn't kill you makes you stronger, and that it's always more important to try and fail, than to never have tried at all.

I have no doubt in my mind that you will get back on this horse and you will ride once again.
-G