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Sobering up

Suddenly, the NW Ark. real estate market isn’t so hot.

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Northwest Arkansas has grown faster than anyone could have anticipated. Sleepy pastureland overnight became subdivisions, office parks and strip malls. Traffic backs up amid road construction and snarls at rush hour on a freeway not yet 10 years old. Internet map sites like Mapquest can’t update Benton County quick enough to keep up with all of the new local streets.

The lure of easy money proved irresistible to would-be developers.

“There were a lot of people who jumped on the bandwagon,” said Tom Terminella, a familiar name in Northwest Arkansas real estate for almost two decades. “Every hairdresser and fireman and a lot of people who were in banking got in.”

The dizzying pace of expansion was as evident in the pages of new society magazines as in the economic statistics. Ambitious developers joined with start-up bank executives to unveil high-profile projects at glitzy functions.

Now, the hangover from the big party has set in. Despite a steady population increase of about 1,100 people a month, there’s a serious oversupply of residential and commercial property. One economist estimates 112.9 months of housing inventory — more than nine years’ worth — at the current rates of absorption.

“Houses were being built at such a pace that even the fantastic growth of Northwest Arkansas couldn’t keep up with it,” said Kathy Deck, the associate director of the Center for Business and Economic Research at the Sam M. Walton College for Business at the University of Arkansas in Fayetteville.

That reality has sobered everyone. Formerly eager developers are scaling back their plans, and their once-trigger-happy bankers are re-evaluating lending practices.

It adds up to a mood best described as chastened, though most believe the situation temporary. The unanswered question is, how temporary?

The chastened mood is reflected in Brandon Barber’s voice as he talks about the adjustments he has made in his business over the last few months.

Now the chairman and CEO of the Barber Group, a residential and commercial real estate development company he founded almost three years ago, Barber embodies the fast-paced roller-coaster ride of Northwest Arkansas’s boom cycle. Eight years ago, he was a recent graduate of the University of Arkansas and working for a bank in Fayetteville owned by his father-in-law, John Ed Chambers of Danville.

“I got the opportunity to see people jumping in the speculative market, more on the residential side,” Barber says. “I jumped out there and built spec homes which sold at the time, just like everything else was.”

Eventually he left the bank to focus full-time on residential construction and land development, incorporating the Barber Group in February 2004. His timing coincided perfectly with what would become the most profitable two years in the regional real estate market. First he focused on building large residential communities, mainly in Fayetteville, where stricter zoning regulations meant he had fewer competitors than if he built in other nearby cities.

With the money from those projects, Barber upped the ante by introducing high-profile mixed-use developments, starting with the Legacy Building, which, at seven stories, already towers over Dickson Street in Fayetteville. The building includes 37 expensive condominiums scheduled for completion by early 2007, an upscale restaurant expected to open this month, and high-end retail shops.

And not long after starting construction on the Legacy, the Barber Group broke ground on the $300 million Bellafont development in Fayetteville, with 750,000 square feet of mixed-use space on 26 acres across from Procter and Gamble’s new building.

These were projects designed to get attention, and Barber embraced the limelight, becoming a feature on the social circuit by chairing charity galas and inviting society magazines to photograph “private” events promoting his properties.

“We were trying to find projects that were more creative, that don’t fit into the mold of normal residential,” Barber said. “Because of their size, they end up being more high profile. Also, location guides it more than us wanting to be that. We’re at the corner of Main and Main on most of these projects. We want to be where most of the people can see us.”

In early 2006, the residential market began to flatline, especially at the higher price points, as the supply of new housing stock outpaced the demand. The change prompted Barber to adjust his strategies. “We haven’t tried to hide the fact we’re trying to get out of the residential side,” he says.

“We were spread out too much,” Barber acknowledges. “Now, as opposed to 50 projects, we can focus on seven or eight projects. … We’re definitely not as greedy, for lack of a better word.”

But Barber is still thinking big. With the residential real estate market saturated, he is turning his attention toward building hotels, including a proposed $100 million, 22-story Westin Hotel in Rogers and a nine-story boutique hotel on Dickson Street called Divinity, which some Fayetteville residents are trying to block on zoning grounds.

As for his existing properties that aren’t selling as well as he hoped, Barber says, “We have set up some more creative financing and we’re going to wait for the market to come back and let the grass grow. I feel confident in the market over the next five years.”

Tom Terminella is a little more circumspect.

“In the last 24 months it’s been rather entertaining to watch this unfold,” he says. “It’s a very challenging market. I watched a lot of development that didn’t make sense at the time it was happening. Now, with the correction in the market, it makes absolutely no sense.”

The problems are worse in Benton County than in Washington County. “I feel like the multi-family and the single-family residential home sites, pretty much at all price points across Benton County, are oversaturated with inventory,” Terminella said. “In Washington County the numbers are considerably better.”

There is also a glut of unoccupied commercial real estate in Benton County — about 500,000 square feet in Bentonville alone — although there is less concern about it, because the presence of Wal-Mart’s corporate offices there is expected to generate a continued demand for office space, retail and service economy businesses.

“When I started this job five years ago, Bentonville had a commercial vacancy rate of approximately 8 percent,” said Rich Davis, the vice president of economic development at the Bentonville Chamber of Commerce. “There was not a whole lot of class A and B commercial space available. Then we went through an expansion phase, and now we’re running about a 25 percent vacancy rate. That’s not necessarily a bad thing, though. The good news is that there is now availability of affordable class B business and retail space. The bad news is that there is now availability of affordable class B business and retail space.”

The biggest problem, in retrospect, was the rush to build luxury homes priced at $200,000 and above. Part of that was due to the boom mentality, but developers also became entangled in market pressures that sent land prices up. Once they acquired an expensive lot, it seemed the only way to profit was to try to sell an expensive house there.

“When we first decided to do it, there was zero availability,” relates Travis Kershner, who started his development company two years ago, as the market took off. “Land prices went so high so fast, and people were buying lots like crazy. The more they would sell, the more prices went up. The homes needed to be at $250,000 or above to make a profit because of the price of land.”

Kershner, however, focused on building smaller houses priced under $200,000, which always have been most in demand and which continue to sell easily today.

“At the time people were buying anything,” he says. “You could build specs and everyone was buying them. But there were too many spec homes in that high price range. What was selling back then was always smaller homes. People would pay too much for land, in my opinion. We were able to get lots that still had margin and built smaller homes because that’s where the demand was.”

Other property developers have caught up with Kershner, according to the most recent Skyline Report, a quarterly examination of the Northwest Arkansas economy sponsored by Arvest Bank and prepared by the Center for Business and Economic Research at the Sam M. Walton College for Business at the University of Arkansas in Fayetteville.

The report not only shows that housing starts in the third quarter of 2006 decreased to their lowest point in two years, but that the average value of a new building permit was $165,000, down from $178,000 during the same period a year earlier. “This indicates that developers are beginning to focus on less expensive housing units,” according to the report summary.

Some developers didn’t get the message early enough, however. Betty’s Homes, based in Bella Vista, became the most prominent casualty of the recent market slowdown when it filed for bankruptcy on Oct. 20.

The homebuilding company got deep into upper-end real estate, putting up houses priced near $300,000. Now it owes almost $1 million dollars to a wide range of material suppliers and around $9 million to banks.

Then, in late November, First Federal Bank of Arkansas foreclosed on another home builder, Calloway Investments, which defaulted on $4.93 million worth of construction and mortgage loans.

Nearly everyone involved in the industry believes the banks deserve some of the blame.

“Credit has been easier than it should have been to get,” said Brian Glenn, the chief lending officer at Legacy Bank, which opened its doors in April 2005. “There was a lack of what we would call solid pre-lending analysis. The market had been so good for so long, decisions were made to continue to make loans because of the assumption that things will continue to keep working.”

Legacy was among several start-up banks that sprouted up in the last two years to take advantage of the rapidly expanding Northwest Arkansas economy. Along with new branches of existing banks, they provided an open stream of capital.

“No doubt when you go from 10 bank charters to 30 in a two-year period of time, those institutions have to lend money to justify their existence,” Terminella said. “All of them have been responsible lenders, but it was too much, too quick. It was financing projects to part-time developers and part-time builders, as opposed to those who do it for a living. I think smart, calculated land planning and land development is one thing, but just to provide credit to anyone who has a reasonable idea is what got us into trouble.”

Mark Ryan, the executive vice president and loan manager for the Rogers branch of Arvest Bank, the largest bank in the region (it’s controlled by the Walton family), maintains that Arvest anticipated the slowdown and did not participate in the riskier real estate lending.

“We started becoming a little more aware of the increasing supply in the residential market,” Ryan said. “This was 12, 18 months ago. … We did change our lending approach fairly early on to be a little more selective as far as the areas we were loaning money, in different subdivisions. There were some of the other banks that were more aggressive after those types of loans than we were.”

“It was definitely not hard to get 100 percent financing,” Kershner said. “Anybody could buy a spec home and get financing from a bank. Then the banks started getting stung and that slowed down.”

Glenn makes no apologies, however. He says Legacy loaned close to $300 million over the last 18 months, and a “great part” of that was for real estate development.

“Really, if you want to play in the game up here, you have to be involved in real estate,” he says. “Because we’re new, we’ve been involved in seven subdivisions, we’ve done some speculative residential house loans for builders. We picked our spots there and tried to deal with people who were established in the market. ’05 did its thing, and in the first quarter of ’06, we felt the faucet starting to turn off. By summer it was off.”

As a result, there is speculation about more bankruptcies among land developers, which could set off a chain reaction that affects contractors, suppliers, and ultimately the banks.

“You almost have to be inside those banks to know how they are situated internally,” Ryan says. “You hear rumors all the time about builders filing bankruptcy, turning in houses. This bank and that bank is going to take a hit. It’s always hard to confirm the rumors. We all may take some losses, depending on the market. Obviously, if you’re a smaller bank, it’s going to hurt more than if you’re a larger bank.”

“We’re seeing more materialmen’s liens,” Glenn points out. “Subcontractors or general contractors have been filing liens against developers for non-payment. The people who had some staying power have held on and I think over the next 6 to 12 months, some people will have more staying power than others. Of course, Betty’s Homes filed, and we’re starting to see contractors file suit. That’s just now starting, and I would expect to see more of that. If they can’t service interest payments, banks get on that either by filing suit or foreclosure. There are rumors flying all of the time.”

Kathy Deck, the University of Arkansas business researcher, is less pessimistic.

“The new banks were looking to get their money working in the marketplace, and they were happy to lend away,” she said. “But when banks have to foreclose, that’s the worst possible outcome, so they’re going to help builders get their houses sold so everyone gets out of this ok.”

In fact, the market slowdown may amount to a dark lining on a very silver cloud. The population of the region is still increasing, the economy is still growing, and some developers think the current downturn may bring some long-term benefits.

“I think this is a healthy absorption,” Barber says. “Everyone was doing some kind of speculative development. This gets everybody back to their day job. That’s good for builders and developers up here. I think this is a healthy turn to where you just have to survive it. People are blowing things out of proportion. We’re selling lots every week, things are still selling.”

Barber also thinks that the banks have learned their lesson.

“They’re going to analyze their credits as much as developers are going to analyze their decisions in the future,” he said. “I think that’s a good thing, too.”

“The bottom line is that inventory is up, pricing is down, and the availability of credit has never been better,” Terminella said. “People who do take advantage of the correction in the market will be the first people to get the benefits of when it recovers, and we look for the market to recover in the first quarter of next year.”

Kershner said, “The only part of the real estate market I wouldn’t want to be in is I wouldn’t want to be owning any of these big homes. Everything else is just clicking along. Northwest Arkansas sure isn’t slowing down.”

Deck agrees. “The point I always make is that nothing has happened to the demand side of this economy,” she said. “When you look at job growth, et cetera, those things are in great shape. What happened is on the supply side. Everybody and their brother decided to build houses in Northwest Arkansas. Everyone ramped up at the same time to meet this need. And that means houses got built in the wrong places at the wrong price points because folks weren’t looking at the whole market, just their little piece.”

It’s going to take some time for the housing market to arrive at a healthy realignment, however. Deck said the excess inventory is beginning to have effects on overall home sales as average price increases decline. “If the inventories sit, there will be pressures on the market,” she said. “If they cut prices on new homes, it’s going to directly affect what’s going on in the existing market as well.”

The lower prices could spark some movement, according to Glenn, although not enough to overcome the huge supply of housing stock.

“We would say that the supply-and-demand problem is probably going to take a minimum of 12 months to significantly start correcting itself, and it will probably be closer to two years before we start getting normalcy back,” he said. “By this summer, some buyers who have been standing on the sidelines, thinking they will get a better deal if they wait, you may see them get in the game in the first two quarters of next year. But because there is such a supply-and-demand problem, I don’t see how it can correct itself in 12 months.”

Gary Head, the chairman, CEO and president of Signature Bank, another start-up bank founded in 2005, said, “We have a little oversupply at this point. But there are still over 1,000 people a month moving here. Hopefully it will take care of itself.

“It can’t be Mardi Gras every day,” Terminella said.

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