.Lehman, SunCal, and Alameda Point

Buried on the web site of major West Coast developer SunCal Companies is the story of a little girl named Courtney Faye Smith. Courtney has spinal muscular atrophy and cannot play on area playgrounds because none of them can accommodate her wheelchair. But SunCal, flush with cash from its partner Lehman Brothers – and newly named the master developer at Alameda Point – is going to do something about that. It is going to build “Courtney’s Sandcastle,” a wheelchair-accessible wonderment of wind chimes, topiary creatures, and plants that “emit aromas when touched.” The playground will boast an interactive musical pathway, a castle ringed by a moat, a ship sailing a simulated ocean, a sea serpent or two, a mist-breathing dragon, and a “rock mountain that comes to life with sensor-activated water features.” It will all be part of San Clemente’s new master-planned Marblehead Coastal development, and will serve as a draw to the 8.5-acre park that SunCal “will begin building for the public this fall.”

That article is dated July 2007. The playground has not been built. And according to the mayor of San Clemente, the rest of Marblehead Coastal is a “quagmire.” The public infrastructure and street improvements that SunCal pledged to complete have been so far behind schedule that in March the city authorized its attorney to sue the company if it did not see progress.

SunCal’s troubles in Orange County mirror the troubles the company has encountered elsewhere in California, from a bankrupt project in Bakersfield to a scotched development at Bethel Island, shuttered when the market slumped and then left to languish indefinitely. At Bethel Island, dug-up dirt blows downwind into houses and the company has to send in water trucks to dampen the stuff on windier days.

In recent years, SunCal has set its sites on the western East Bay, where the housing market isn’t as bad as many other areas of the state. SunCal is the master developer at two of the region’s biggest base conversions, the massive Alameda Point project, and the Oak Knoll Naval Hospital in the Oakland hills.

At Alameda Point, SunCal is in the planning stages of an ambitious effort to transform the toxic former Naval air station into a vast mixed-use development powered by a solar farm. At Oak Knoll, already in the middle of a long and costly process, the company hopes to build 960 units of housing, with 300 to 400 units potentially opening as early as 2010. That project has seen its share of delays, but SunCal remains hopeful that the market will rebound.

SunCal boasts of being the largest privately owned land developer in the West and currently has more than fifty projects in various stages of development throughout California and New Mexico. But for all its size and scope, some of SunCal’s recent publicity has been as toxic as the assets it bid big on in the years before the real estate bubble burst. And in the wake of the collapse of its biggest backer, the investment bank Lehman Brothers, SunCal’s spotlight at the center of the current crisis has some Alameda officials worried that yet another developer might have to walk away from its promise to develop the Point.

Observers such as Alameda City Councilman Frank Matarrese are watching SunCal’s travails as the planning process for Alameda Point moves into the next phase. “We have to be concerned about the entire health of the company if they’ve got these projects that are all taking hits,” he said. “We can’t afford the same scenario. We can’t go forward without infrastructure improvements because the roads, the sewers, the electrical out there is just not suitable. It’s not serviceable. And that has to happen in order to develop the land.”

SunCal says it‘s committed to moving forward in Oakland and Alameda and that the issues with other projects have no bearing on its work in the East Bay. As word of Lehman‘s collapse broke, the company began firing off press releases to communities across the West with assurances that all of its projects are separate entities. Some, in fact, are not funded by Lehman at all; its largest project is backed by hedge fund D.E. Shaw.

But even those who are eager to see the company’s projects succeed have cause to worry. SunCal has missed some of its early deadlines in the planning phase at Alameda Point, and as the process has progressed, it has had to obtain assistance from Shaw.

The question is what impact the developer’s woes will have on the long-stalled developments at Oak Knoll and Alameda Point.

With greenbacks from Lehman Brothers often in hand, SunCal had developed a reputation for big thinking and bigger bids. It put up $100.5 million for Oak Knoll, a move that left local developers “astounded and amazed,” according to the San Francisco Business Times. It outbid Donald Trump for a site in Los Angeles; grabbed up $250 million dollars worth of land in the now-troubled Inland Empire; planned a 25,000-home development that would have tripled the population of Barstow; and scored a 57,000-acre land grant twice the size of Boston west of Albuquerque.

The credit crisis has hit all developers hard, and like its industry peers, SunCal has suffered. Yet, it has been in the news more than others in its industry. The company has seen increased scrutiny ever since its partner Lehman Brothers announced in June that it had lost $2.8 billion in the second quarter of 2008.

“Projects With SunCal Drive Part of Lehman’s Big Loss” was the headline of a subsequent story from the Orange County Business Journal, where reporter Mark Mueller follows the Irvine-based developer closely. He documented staff cuts and attempts to restructure loans on some thirty projects, and reported a “buzz in the industry” that Lehman was negotiating to take over some of SunCal’s projects. “A number of developers and distressed-asset investors were believed to be considering bids for some of the Lehman-SunCal projects,” Mueller wrote. Of course, that was before the infamous conference call that signaled the beginning of the end for the nation’s fourth-largest investment bank.

And with that ugly call, the national press started paying attention to SunCal. Fortune‘s “How Lehman lost its way” instructed readers that “to understand what went wrong with Lehman Brothers, leave the canyons of Wall Street and head to the flatlands of Bakersfield.” There, readers would find the stalled SunCal development McAllister Ranch pitched as a 6,000-home community built around a golfer’s Eden designed by Greg Norman himself stretching for three square miles of “almost lunar landscape punctuated by a half-finished clubhouse and a golf course gone to weeds.”

Earlier this month, in The Wall Street Journal, “Lehman’s Bet on a California Developer Yields a Lesson on the Downside of a Boom” revealed that the besieged bank was scrambling to unload SunCal assets in advance of the end of its third quarter. One of the company’s last-ditch efforts to stay afloat was a scheme to spin off its real estate portfolio into a new company apparently nicknamed “SpinCo” inside Lehman’s harried halls. It’s a tactic known by the term “good bank/bad bank,” with the idea being that the bad bank would end up possessing SunCal’s real estate assets.

When the bubble finally burst, both SunCal and Lehman were splattered. Through its SunCal partnerships, its investments in mortgage-backed securities, and its spectacularly unprofitable $22.2 billion purchase of apartment company Archstone-Smith, Lehman risked more of its own capital on real estate than did its competitors who didn’t exactly escape the mortgage meltdown themselves. Due in part to doubts about the value of Lehman’s holdings in SunCal, outspoken hedge fund honcho David Einhorn even made a show of betting against SunCal’s stock. Lehman reduced the value of those holdings down by $600 million before finally collapsing into bankruptcy September 15.

Just a few days earlier, as Lehman was struggling to find a savior, creditors of Lehman-SunCal developments in Southern California filed involuntary bankruptcy petitions against a master Lehman-SunCal partnership and three of its entities, which were scheduled to foreclose at the end of the week. One of those entities was the partnership behind McAllister Ranch, the moonscape golf course now overtaken by weeds. The development finally got some tenants, but they weren’t concerned about the auction. According to a story in the Bakersfield Californian, the first and only residents of the ambitious master-planned community were a herd of sheep.

SunCal spokesman Joe Aguirre said the company is unable to comment on the bankruptcy filings or the three affected properties. But he emphasized that SunCal, as a privately owned company, finances each of its projects independently.

But evidence suggests that in the wake of Lehman’s financial woes, that may no longer be the case. Indeed, SunCal’s new financial backer has reportedly even asked the city for the right to replace the Alameda Point developer at its own discretion.

Local project manager Pat Keliher said last week that the financing for SunCal’s Oak Knoll project comes through Lehman. And Keliher said he’s been assured that Lehman plans to continue to provide that funding.

Keliher said he could not provide details as to how the funding will work within the larger context of the Lehman bankruptcy. “It’s so dynamic,” he said of what was happening within the firm and the US financial system as a whole. “I know that Oak Knoll is one of their crown jewels. It’s such a great piece of property that I think they’re very committed. It’s not just Lehman it’s Lehman and SunCal that are continuing to fund it.”

Aguirre of SunCal also indicated that Lehman expects to be able to continue funding all its partnerships: “We can tell you that Lehman has since assured us that they will fund ongoing construction and entitlement efforts at the projects they are involved in,” Aguirre wrote in a Saturday evening e-mail.

Meanwhile, Alameda Point has a new financial backer. SunCal had been self-financing the project through the early phases of its negotiations with the city. But in the last few months, the company made it known to city officials that it wanted to complete the entitlement process with the assistance of D.E. Shaw. “I’m really excited that we have a capital partner, especially one as qualified as D.E. Shaw,” Keliher said. “It’ll allow us a kind of seamless transition. … I’m very excited about that, especially in this market.”

Not so excited is Alameda Councilman Doug deHaan, who said he originally voted to select SunCal as master developer in the 2007 council vote in large part because of its supposed autonomy. Now he says he is rethinking the wisdom of his choice.

“They really played that very hard,” he said of SunCal’s pitch. “That they could make the daily judgment calls immediately. In other words, they did not have to go back and get the mother-may-I vote from higher up. The other portion was there weren’t stockholders involved that had to see profit all the time. That was one of their selling points. I kept on asking when I had personal conversations, ‘Can you last the long haul? Do you have the funding to last at least the two years of the initial project?’ And they assured us, ‘Yes,’ they had that money and they did not have to answer to anyone. In hindsight, that’s not the case.”

Councilman Matarrese who voted for a different developer also recalls SunCal selling itself as capable of going it alone throughout the first phase. “This is what I remember: they were going to be by themselves there. They didn’t need anybody. They were self-fundable and they could write a check for a hundred million dollars right now. And then, of course, the economy continued to slide and they had to bring in Shaw.”

DeHaan said it became clear to some Alameda city officials at the beginning of 2008 that SunCal was struggling with funding. “They went cold they had an inability to make the project go forward. They had no expenditures for almost six months.” And then April came and they asked the city for an extension on various deadlines.

Right about that time, recalls Assistant City Manager David Brandt, SunCal stopped making payments to its consultants. “Things weren’t progressing,” he said. “They weren’t doing the activity that was leading to progress. And at that point we kind of confronted them saying, you know, ‘What’s going on?’ And that’s the point where it became clear they needed an extension.” SunCal was late on a scheduled payment to the city, although only by a couple days, Brandt noted.

“This was at the same time that we were learning about Lehman Brothers going into the tubes,” he said. “And they had also stopped spending money, so we were wondering if they were having difficulties. And they pretty much acknowledged that they were looking for a new partner at that time. And that’s when they came up with D.E. Shaw.”

Brandt recalls SunCal advertising itself as having close ties to Lehman, and he, unlike some members of council, always expected it to eventually pair with an investor in the early planning phase.

The terms of the D.E. Shaw partnership that SunCal wanted apparently didn’t sit right with city employees. It raised a number of issues that would need to be resolved before the city would agree to amend its negotiating agreement with its chosen master developer. Among the concerns were D.E. Shaw’s unilateral right to sack SunCal and bring in an entirely new developer, its ability to take action on behalf of any new developer, and its desire to merge the funding for Alameda Point in a “$250-$300 million portfolio of seven to ten SunCal projects.” Moreover, SunCal considers the arrangement between it and D.E. Shaw confidential and has declined to reveal details of its portfolio to city officials. And if any nosy citizen wants to sue to see what’s in the term sheet, SunCal itself will have to shell out the legal fees. 

Brandt said the portfolio apparently combines eight to ten of the developer’s projects. “But we don’t know which ones they are,” he added. According to an accounting by the Wall Street Journal earlier this month, D.E. Shaw & Co. has a debt investment of around $200 million involving nineteen SunCal projects.

Brandt said he told SunCal representatives that if they wanted to bring in D.E. Shaw, they would have to amend their terms to comply with the city’s requests. He said he felt that SunCal was willing to make those changes.

Is he concerned about pairing with Shaw while not being allowed to see what’s in their portfolio? “Not really,” he says. “More than likely the Alameda project is one of the more risky projects in that portfolio. And our deal is going to be structured so it doesn’t really matter what happens to the other projects. If SunCal doesn’t perform, they’ll be out. And if they do perform they’ll stay in.”

But deHaan, on the other hand, is extremely perturbed about the new partnership and has brought it up at recent council meetings. “The hedge fund really bothers me,” he said in an interview. “What really concerned me and should concern everyone else is that this really is a high-profit investment to be in a hedge fund. There are certain driving forces that mean they have to make money. To make extraordinarily high returns. And that bothers me, because it can drive your project in a different direction instead of letting it mellow in the right way.”

That’s not an invalid concern, says Dennis M. Williams, a lecturer at UC Berkeley’s Haas Real Estate Group and managing director of real estate investment banking firm Northmarq Capital. “The issue with a lot of the hedge funds is if they don’t have really good real-estate expertise, that can be a problem,” Williams said. “Oftentimes they’re looking just for market dislocation, if you will. So they’ll just jump on something because it looks like a good opportunity, but if they end up actually being stuck holding it, that’s not really what they want to do.” 

Indeed, SunCal recently proposed a massive change in scale of the project, from the 1,800 homes long envisioned by city planners to between 4,200 and 6,000 higher-density units. Alameda voters would have to amend the city’s long-standing Measure A growth limits to permit a development of that scale.

DeHaan also points to Shaw’s relationship with Lehman as an issue requiring further investigation. Lehman holds a 20 percent stake in Shaw.

Williams said this should not be cause for concern: “The fact is they’re an investor, and bankruptcy isn’t going to trigger anything. It would be no different than if you owned a stock and you declared personal bankruptcy that in and of itself isn’t going to affect the stock. But clearly in this mess they’re in, they’re not going to be able to come up with additional dollars, so Lehman as a financial partner might be less capable of bringing a struggling project to fruition because they can’t bring additional capital to the table. I would think that would be your biggest issue.”

But deHaan insists that Alameda can’t afford to marry its project to a company heavily invested in peddling the very financial instruments that wrecked the housing market in the first place. After all, D.E. Shaw announced earlier this month that it was starting a new group devoted to mortgage-backed securities, the very thing that led to the nation’s current economic woes in the first place. Although many investors have been afraid to buy such securities, The New York Times noted that Shaw is undaunted. It sees a “major opportunity in the seized-up market for mortgage-backed securities” and is ready to step up its bidding on these complex securities that have been “punching holes in the balance sheets of many Wall Street firms, including Lehman, that still held these assets on their books.”

And who will be heading this new group? Richard McKinney, fresh off his stint as the head of the securitized products division at Lehman Brothers.