Blind trust: Developers live by amenities, and some die by them

    Scores of Bernard Madoff's clients are asking themselves today how they could have trusted the former wunderkind with their collective billions of dollars (see Friday's article below).  These were not only wealthy but also sophisticated investors, among them Fred Wilpon, the owner of the New YorkMets baseball club and others well known in the upper reaches of society in New York, Florida, Minneapolis and other cities.  For some of them, it may be too late to learn from their own mistakes, given the catastrophic losses they have suffered, including the overnight bankruptcy of their investment firms.  But those of us fortunate not to have been burned that badly can benefit by the lessons of such pyramid schemes.
    Most golf community developments are successful.  Of course, at a time of ascending real estate prices, virtually all of them were successful.  But now, as the landscape literally (and figuratively) changes, we see more and more of these communities in trouble, especially those opened in the last year or two.  Their problems remind us that, in essence, each of them is built on something of a pyramid.
    In its simplest terms, Madoff's illusion started when he engaged a group of initial investors to put up $17 billion, with the promise of consistent, above-average returns.  Because of the prominence of those early investors, and the promises made by the respected Madoff, other investors quickly joined in.  Madoff, it appears, used the second-stage investments to help pay the promised returns to his initial investors.  Word of his performance grew and he took on more investors, all the while sharing few details with his adoring followers; and he used those new dollars to pay both the first- and second-stage investors.  You can see where this was going; the bottom of the pyramid kept growing and feeding those above.  That was all well and good for the earliest investors, and the illusion could have been extended forever, at least theoretically, if the worsening economy had not turned Madoff's investors into nervous nellies.  They called for their money (reportedly a total of $7 billion), Madoff couldn't cover, he confessed the illusion to his sons, and they turned him in (sounds almost Shakespearean in a way).
    Of necessity, a golf community is built on a similar pyramid.  A developer borrows money from one or more lending institutions -- like Bernard Madoff's earliest investors -- on the basis of plans to sell home sites and build homes.  Those bank loans help the developer prepare the land and, perhaps, set up a sales office, hire staff, create plans for the on-site amenities and hire a golf architect.  In many cases, the developer plans to also build the golf course early as a way to encourage purchases of property ("dirt," as developers refer to home sites).  All this is done with an eye to engaging additional "investors."
    The bank loans support these early expenses, but the developer must sell properties to continue to build the amenities, such as a community center, clubhouse, pools, tennis courts, fitness centers, a marina, maybe even the barn and stables at an equestrian center...and to pay for all the equipment necessary to outfit these.  The pressure is on to sell dirt to continue to fund the amenities (and to begin to pay off the bank loans).  Trouble begins when a community can't sell enough properties to build the amenities on schedule.  Postponing amenities begins to make property owners nervous and savvy potential buyers wary.  When a developer is forced to let things slide a bit, the word gets out, property sales slow down, some property owners unload their lots, and a downward spiral begins.  In some cases, the developer cuts prices, which immediately depreciates the early buyers' properties (and depreciates their feelings about the developer) and adds to an odor of desperation hanging over the development.  This is all to say it is important for a developer to get the amenities in as soon as possible.  
    In the worst case, you get a death spiral, as at Grey Rock, a mountain community in North Carolina that not only never built its promised amenities but also found a way to sell more than 400 home sites over a couple of years to people who never built on a single lot (the developers themselves built one of those Southern Living showcase houses to help sell a few properties).  That is a clear signal that these were mostly speculators trying to catch a continuing up-tick in an irrationally exuberant real estate market.  One day, Grey Rock's developers just picked up stakes, left the site (and a few of their other holdings in similar shape) and declared Chapter 11.
    So what can we learn about the Madoff debacle and the lesson of Grey Rock when shopping for a golf community property?   Madoff promised consistent returns, no matter the environment, and over years - including the first year of the now official recession - he did just that.  That performance, of course, was too good to be true.  A developer is selling you the promise of a completed community, not just a planned one, and there are some tough questions to be asked about schedules and funding and the impact of the current economy on performance to determine if the promises are realistic.
    It is good to know something about your fellow investors in a community.  Are they speculators or serious about building a home there?  You don't want to be one of the few property owners interested in living in the community.  That is not only bad from an investment standpoint, but ultimately not too healthy for your social life.  If a community has been overrun with speculators, you will probably notice it by the paucity of homes built and the lack of amenities, a deadly combination.  Steer clear, no matter how good the deal seems.
    Look for promised amenities at least under construction or, better yet, completed and being used.  Check with the homeowners association to determine the costs of running and maintaining the amenities and the history of dues increases.  Remember that developers subsidize the amenities before they turn them over to the residents; if you buy in before the hand over, you and your fellow residents might be in for a bit of sticker shock.
    In the current environment, there are great bargains in new homes but also great bargains in re-sales that just might fill the bill for you.  All things being equal, if I had a choice between a new house at $400,000 in a community with amenities still to be built, and a $500,000 home that is six years old but in a fully built-out community, I would likely give the nod to the latter on the basis of lower risk.  Of course, that assumes you are buying a place to live in rather than as an investment.  If you choose to make a pure investment in real estate in the current environment, all I can provide you are my best wishes.