Lessons from My Father

Even though my father passed away several years ago I’m surprised how often I think about him.  Something happens during the normal course of my day, and it triggers a flashback of him.  It wasn’t a conscious decision to think about him, but rather some random thing happens and instantaneously I’m transported back in time forty years hearing my dad say or do something.  It happens all the time.  Does that happen to you?

My father in many ways was a good role model.  He also had his faults but as time passes the good memories of him are winning out and the not so pleasant memories are fading.  I hope that’s what happens with my two adult children when I’m dead and gone. 

As I said my dad was a good role model, but he was a lousy teacher.  I don’t ever recall him ever trying to teach me an important life lesson.  He just lived what he believed.  At the time, I didn’t understand the importance or appreciate what I was witnessing.  It was just my dad saying or doing what he always said or did.  It was nothing special, or so it seemed.  It was just vintage Dad.  But the older I get the more I appreciate the values that he lived.   

So what life lessons did I learn from my father?

LIVE WELL WITHIN YOUR MEANS

Growing up my family lived in a very middle class neighborhood.  The neighbor on our left was a grocer and the neighbor on our right owned a gas station.  Although my mom drove new cars, I can’t ever recall Dad driving anything but used pickups.  A vacation to us was visiting our relatives, certainly not going to a destination resort.  We lived quite modestly.  It wasn’t until I was in college that it dawned on me that my parents were financially well off.  Over the years there had been hints of my parent’s wealth but I hadn’t been able to put the pieces together.  That changed when Dad, who owned his own CPA practice, sold his business and retired at the age of 50.  He lived quite comfortably for the next 30+ years off the income generated from his investments.

TREAT EVERYONE EQUALLY

After retiring, my dad spent most of his days working on his tree farms.  Having grown up in the rolling farmland of Iowa he was in awe of the beauty of the forests in the Pacific Northwest.  About ten years before he retired he bought a parcel of logged over timberland and spent his weekends nursing the land back to health.  He was very comfortable working alongside loggers, foresters, and other blue collar workers associated with the forest products industry.  And they were equally accepting of him as one of their own.   

I’m not sure why (it’s a question I wish I had asked him) but he was politically well connected in Oregon state politics.  I remember back in the sixties he was a pallbearer at a funeral where a fellow pallbearer was Mark Hatfield, the then governor of Oregon.  Dad never showed preferential treatment to his wealthy friends.  Those in a lower socio economic class were treated no differently than the rich and powerful. He treated everyone with the same friendly Jimmy Stewart like manner. 

PUT TOGETHER WIN/WIN AGREEMENTS

Dad didn’t believe in win at all costs.  He proposed agreements that were fair for both parties, not just for him.  He had no problem leaving a little bit on the table if it meant getting the deal done sooner rather than later and with both parties satisfied. Sometimes the person he was negotiating with would attempt to take advantage of his desire to strike a fair deal and would respond back with some unrealistic and unjustified counter offer.  You see, not everyone plays by the same set of rules.  But for the most part, people intuitively understood that he was proposing an agreement that was fair to both sides and they respected him for doing so. 

Sometimes life’s most important lessons are better absorbed not through formal instruction but by the consistent actions of a role model over a lifetime. 

May God richly bless you and your family during the holiday season.  Merry Christmas!

Four Common Mistakes That Make Financing Your CRE Difficult, If Not Impossible

I’m surprised how often I am asked to find financing for a property that for one reason or another is obviously not financeable.  It’s as if the borrower wants the lender to forgo the use of common sense.  I’m going to let you in on a little secret: IT ISN’T GOING TO HAPPEN!!!  Anyone who is at all knowledgeable about commercial real estate lending realizes that lenders are risk averse.  They are not in business to take on any more risk than is absolutely necessary. 

So if you want to either refinance your property or to sell your property there things you must do a year or two before financing is needed to get the property to the point where I call it, “lender friendly.”  Not doing so will likely make it much more difficult, if not impossible, in getting a lender interested.  Here are four common mistakes:

1.   The property is in poor physical condition.  It’s a big turn off to lenders to see a property poorly maintained.  Why would a lender refinance a property for a borrower that is not willing to maintain his property?  If you want to refinance a property that has a lot of deferred maintenance you better have an excellent explanation as to why it’s in poor condition.  Better yet would be to get the big ticket items fixed prior to refinancing your property. 

2.   The occupancy rate for the property is below market calling into question the seller’s property management company’s ability to professionally manage the property.  If the property is self-managed you’re in deep trouble.  If the property is for sale some sellers or listing brokers think that providing a rent guarantee on the unoccupied space will satisfy a lender’s concern.  WRONG!!  It does just the opposite.  It’s a great big red flag that something is wrong with the property.  A better solution is to offer as much free rent as needed to get the vacant space occupied.  Offer the free rent at the beginning of the lease.  Once the free rent has burned off, then refinance or put the property up for sale.  You still need to disclose the free rent to the lender but it is much better to have your property at stabilized occupancy with free rent than to have a property with a high vacancy rate. 

3.   Operating expenses are well above normal for a property of that age and condition.  You need to investigate if there is a reason for this.  Is it an anomaly?  Are some ongoing maintenance expenses actually capital expenditures?  Can you explain why?  If you can determine that the additional expenses are costly one-time expenses then capitalize what you can identify and operate the property for a year to show what your operating expenses should be for a normal year.  If you rush to refinance the property with higher than normal operating expenses it will likely lower the loan amount because of the lender’s minimum debt coverage requirement.  And if you’re trying to sell the property, the value of the property will be adversely impacted because the NOI for the property will be lower than it should be.  Worst case scenario, the lower NOI could reduce the loan amount and thereby increase the equity required by the buyer beyond what he is willing to invest in the property killing your sale.      

4.   Most tenants are on a month-to-month basis (not a concern for apartment renters) or have only 1 or 2 years remaining on the term of their lease.  Most lenders will not accept rollover risk.  Again, proposing a rent guarantee on those tenants whose leases have expired or will expire shortly is a big turn off to lenders.  One way to mitigate risk is to identify when each tenant originally moved in.  If they have been a tenant at the property for 10 or more years then it is much less likely they plan to move once the lease expires.  But the best thing to do before you sell or refinance your property is to get as many tenants re-leased for as long as possible.  Once you’ve minimized the rollover risk then seek financing. 

Remember, it’s all about getting the lender as comfortable as possible with financing the property.  You’re asking the lender to lend you or your buyer lots of money.  Make sure to take some common sense steps prior to requesting a loan that makes it easy for the lender to say yes. 

Timing Is Everything When Financing CRE

They say that, "Timing is everything."  Right?  Well it certainly holds true when it comes to financing commercial real estate.  There are times during the year when trying to get a loan financed is pure misery and there are times when the financing "gods" are looking down benevolently on you.  But let me tell you a little secret: It's not rocket science to figure out when is the optimal time to get things financed.  It's plain common sense.  Shown below are the worst times and then the best times to get your property financed.

Worst Times to Finance CRE

1. June 10th through Labor Day - If you haven't signed your loan application before summer starts, good luck!  Summer is the time when kids are out of school and family's take long vacations.  Loan officers, underwriters, loan processors, real estate brokers, mortgage brokers, attorneys, appraisers, etc. all lose focus during the summer months and as a result the financing process slows down to a crawl, or so it seems.
2. November 1st through Year End - If your loan is not expected to close before year end, your deal will go to the bottom of the pile.  All the focus during the end of the year is to work on deals that will close before year end so loan officers can make their quotas and for those who have had a good year, to make their bonuses.

Best Times to Finance CRE

1. First Quarter - The best time of the year to start the financing process is during the first quarter.  Bankers are refreshed after the holidays and eager to start working on their annual quotas in order to acheive their year end bonuses.  Most insurance companies will be back in the market ready to lend.  As the year progresses, they become more and more selective on property type and quality of transaction.  
2. Labor Day through October 31st - People are back from vacations, kids are in school, and lenders are again eager to get their last round of deals started for the year so that they close before the holiday season. 
3. November 1st through the 15th - To paraphrase Charles Dickens, "These are the best of times and the worst of times."  No sane loan officer should commit to closing a loan in less than 60 days.  But those loan officers who haven't reached their quota, or have, but want to increase their bonuses even further go into "warp speed" trying to cram in the final deals for the year.  If the "moon and the stars" line up perfectly or they're just plain lucky they succeed.  I just found out late last week that I have a client that must close his commercial real estate purchase before the end of the year or he will experience adverse tax consequences.  There are less than 50 days to the end of the year and the deal is not yet under application.  I haven't closed a loan this year under 75 days, most have been considerably longer. And yet, I have four lenders who have committed to closing on this deal before year end. This just tells me there are a lot of hungry loan officers who want to get deals closed no matter what it takes. 

So when is the best time to finance commercial real estate?  It's plain common sense: Whenever your loan officer is highly motivated to get the deal done.

Source: The Importance of Luck and Timing in Real Estate, by Kevan McCormack, Metropolitan Capital Advisors

The 800 lb Gorilla in the Room

Whether Obama or Romney gets elected tonight, the next administration within the next four years will have two major crises that they will have to confront head on. One has been discussed frequently on the campaign trail – Iran getting a nuclear weapon, the other has been virtually ignored.  It's the 800 lb gorilla in the room.  We would prefer not to acknowledge that it even exists, which is, the inevitable financial collapse of Europe.

What most people don’t realize, or are unwilling to admit, there is no solution to the sovereign debt crisis in Europe. European leaders could assemble the brightest economist minds from all around the world together in one room, give them complete authority to act on the crisis as they see fit and it still would not change the ultimate outcome: Europe is going down. It’s inevitable. They are too far down the path to their own destruction to turn it around.

It’s only a matter of when, not if. True, they’ve done an excellent job “kicking the can down the road” these past three years and can continue to do so for some time to come but at some point the market is going to perceive their feeble attempts at a solution as putting a band aid on a gaping wound. When that occurs, market confidence will collapse taking down the European bond market and many of the European banks.

By now I suspect that many of you consider me a “nut job,” a “doom and gloom” type who thinks the world is coming to an end which I categorically deny. Humor me for a moment and for the sake of argument let’s assume my prediction is true. What then? How will this affect commercial real estate in the Pacific Northwest? To answer that question the following questions need to be answered:

• How will this affect trade with our largest trading partner, the European Union? We will see a substantial decline in our exports to Europe.
• How will this affect the U.S. economy? This will likely throw our economy into another recession.
• How will this affect our stock market? The stock market is affected by emotion. When things are good it soars far beyond any justification. When things are bad it plummets far lower than it should. In this case the stock market will initially plummet similar to what happened in 2008, maybe worse. At best it will be a roller coaster of a ride, soaring to new heights on good news and plummeting back down with any hiccup in economic news. This will not be a good time to be heavily invested in the stock market.
• How will this affect our bond market? It’s likely that Europeans will see our bond market as a safe haven and heavily invest in U.S. treasuries. If true, treasury yields, which are at historic lows, will likely go lower.
• How will this affect our financial institutions? This is where it gets ominous. The vast majority of our lending institutions should be unaffected. Only our five largest banks – Bank of America, JP Morgan Chase, Goldman Sachs, Citigroup and Morgan Stanley are heavily invested in credit default swaps on European sovereign debt. A credit default swap is a fancy term for bond insurance. Our five largest banks have insured a boat load of European sovereign bonds. When these European countries default on their bonds, these U.S. banks will be left holding the bag. Though these banks have confidently stated they have it under control, call me a cynic but I don’t believe them.  Between you and me, I hope they do. I truly hope they do because the alternative is these banks are going down.
• What response will the president (Obama or Romney) make to minimize the fallout on the American economy? This is where it gets interesting. The president has a very difficult decision to make: Does he let these five largest U.S. financial institutions go bankrupt? Or does he bail them out? Is the country in the mood to bail Wall Street out once again? Are these banks too big to fail? If he doesn’t bail them out will it not bring down the rest of the world’s financial system? Good luck Mr. President!
• So back to the original question: How will this affect commercial real estate in the Pacific Northwest? I think this can best be answered by looking back to the 2008 financial debacle. Four years ago some commercial real estate investors survived while others did not. The common denominator for survival was:
• Property type mattered. Apartments fared well. Office, raw land and single family subdivisions did poorly. Everything else was in between.
• Those properties that were modestly leveraged survived. Those that weren’t were taken over by the lender. 
• Those who have subsequently locked in long-term, low interest rate financing were the big winners.

When the Europe bond market collapses commercial real estate will be the investment that has the best chance to weather the economic storm. The stock market, on the other hand, will be a roller coaster basket case, the bond market will have incredibly low yields, and cash in the bank will yield no return. As long as investors invest in the right property type, leverage their properties modestly and lock in low interest rate, long-term fixed rate financing they will come out of this future economic crisis intact. And if inflation is the natural result of this disaster what better hedge against inflation than commercial real estate?

So am I a “nut job?” You decide.

John Mitchell's Economic Forecast - Is It Going to Stop?

I had the opportunity to hear John Mitchell’s economic forecast at the October 19th Commercial Association of Broker's breakfast meeting.  John always does an excellent job making a boring topic interesting.  There were no surprises in his presentation about the current economic situation, the gist of which was, the U.S. economy is growing, albeit at a slower rate than one would hope.

John began with a quick review of where we are:

• In the 4th year of economic expansion (hard to believe that's true but it is)
• 4.5 million jobs below our January 2008 peak
• 4.3 million jobs above our February 2010 trough
• 73 days until the Fiscal Cliff (read my previous post if you want a quick primer on the Fiscal Cliff)
• Globally experiencing economic weakness - Europe, Brazil, China, Russia, India are all either in recession or their economies are slowing down
• In the fourth year with short term interest rates at zero
• The Congressional Budget Office and the International Monetary Fund are both warning of a U.S. recession looming within the next several months

But I didn’t go to hear John Mitchell talk about our current economic situation. I went there to hear what he thinks will happen going forward. Accurately forecasting future economic trends splits the men from the boys, which reminds me of the Yogi Berra quote: “It’s tough to make predictions especially about the future.”

Not surprisingly, John Mitchell didn’t go out on a limb making any bold predictions about our economic future. Economists as a rule are not known for being risk takers. John Mitchell believes that our economy will continue to sputter along in the 2% growth range and that inflation will stay in check at about 2% for the foreseeable future as long as the Fiscal Cliff is handled responsibly.  

What was disconcerting to me was how negative his overall presentation was.  John by nature is an optimist.  He is always looking for a "silver lining." Normally if he says something pessimistic he tries to sugarcoat it with some positive news.  That was not the case this time.  My notes are filled with downbeat statistics.  The big three downers were:

• The economic recovery is growing at an historically slow rate when compared to all other economic expansions since WWII. 
• The Fiscal Cliff.  Congress and the president need to work together to avoid an economic crisis of their own making.  If not handled properly it will throw the U.S. economy into a recession.
• Monetary Policy.  The Federal Reserve is out solutions and nothing has worked.  Interest rates are at historic lows, Operation Twist, and Quantitative Easing have had only modest impact on the economy.  

When he got done, I had to fight the urge to give him a big hug and tell him things will get better. 

Whether that is true or not will depend in large part on who we elect in November.  I hold out no hope if President Obama is re-elected for another four years.  I'm not sure he even acknowledges that we have a serious debt crisis that will take us down the same path that Europe is traveling if we don't do something about it soon.  Mitt Romney talks a good game.  He at least says the right things but I'm skeptical he will have the courage to make the hard choices to get us back on track.  Is he a statesman or just another politican saying whatever is necessary to get himself elected?  I'm sure I've just offended both the Democrats and Republicans that read my blog.  Sorry.  I consider myself an equal opportunity offender.    

Fiscal Cliff Ahead: What it May Mean

Over the past few weeks I've been hearing the term "fiscal cliff" by the TV talking heads.  Some do a better job explaining what they are referring to than others.  So if you're confused or unsure of what they are referring to listen up. 

"Fiscal cliff" is the term used to describe a series of laws that are all expiring at the end of 2012 or are being implemented at the very beginning of 2013 that will have a dramatic adverse impact on the U.S. economy.  Among the laws set to change are:

• The end of last year's temporary 2% payroll tax cut and extended unemployment benefits
• The end of specific tax breaks for businesses
• The end of the Bush era tax cuts
• The start of new taxes related to Obamacare
• The automatic spending cuts resulting from the supercommittee not agreeing to a compromise budget deal 

Without congressional action, up to $600 billion of expiring tax cuts, new taxes and automatic spending cuts are set to take effect.  Some experts predict that if these tax hikes and spending cuts happen all at once the economy would experience a significant slow down throwing the U.S. economy back into a recession.  So the threat to our economy is very real.  

So what is the likelihood that Congress and the president will act responsibly and come up with an acceptable compromise to all parties?  So far Republicans and Democrats in Congress have shown little sign of agreeing on anything except that the other side is to blame for their failure to compromise.  I see four possible scenarios:

Scenario 1: Delay

A likely scenario is that Congress and the president agree to push the issue into 2013 after the presidential inauguration and the new Congress arrives.  If that happens, the tax cuts would continue, the tax increases won't take affect, and the spending cuts will be delayed.  The big problem with this scenario is postponing these difficult decisions continues market uncertainty.  This puts the business community on hold, delaying investments in capital expenditures and the hiring of additional employees.  I think this is more likely if Romney wins in November. 

Scenario 2: Modest Compromise

The lame duck Congress and the president reach compromises on some tax and spending decisions.  I see a scenario where both Republicans and Democrats cave completely on the automatic spending cuts to defense and domestic spending.  I believe this scenario is more likely if Obama wins the election. 

Scenario 3: Over the Cliff

Congress and President Obama fail to reach any compromise whatsoever resulting in the economy going over the cliff into the abyss below.  I would hope that there are reasonable politicians from both parties that could see that this scenario is not in anyone's best interest. 

Scenario 4: The Grand Bargain

In this scenario, Congress and the president reach a comprehensive deal addressing tax, spending and fiscal issues.  The new agreement not only answers the immediate issues facing the country but the agreement also tackles these major issues for the next 5 to 10 years.  Unfortunately I think you have to live in la-la land to believe this scenario. 

So which scenario is most likely?  It's anyone's guess and certainly there could be other scenarios not presented.  I'm personally very discouraged with the lack of leadership in Washington from both sides of the isle.  And yet the alternative of doing nothing is so potentially cataclysmic that I have to believe that even this Congress will do something.  They just have to.  My vote is for Scenario 1.  Any bets?  

Sources: Fiscal cliff ahead: What it may mean, Fidelity Investments, June 28, 2012; Give us a brake, The Economist, October 6, 2012; What is the Fiscal Cliff?, Thomas Kenny, About.com. 






 
  

QE3 - To Infinity and Beyond!

The recent news from The Federal Reserve reminds me of a saying by Buzz Lightyear. You remember ol' Buzz, the toy astronaut, in the movie series Toy Story. Every time he lept from a piece of furniture, he would proclaim with great fanfare, "To infinity and beyond!!"

That's more or less what Ben Bernanke said recently and I might add with about the same enthusaism. The Fed will try a new round of quantitative easing to jump start the economy. And Mr. Bernanke implied there is no cut off to this third round. He'll do it as long as it takes to get the desired results. Hence, to infinity and beyond is a good interpretation of his policy.

My friend Kevin Geraci of Zions Bank wrote a well written article recently on this subject. I don't normally quote verbatim news articles but I thought his was deserving. So here goes:

 

Two weeks ago, the Federal Reserve announced its third round of quantitative easing, more commonly called QE3, whereby the Fed essentially prints money and then buys assets with it in order to add liquidity to the financial system and bring down interest rates.

 

The ultimate goal of this monetary policy tool is to spur economic growth and lower the unemployment rate—the same promise we got in QE1 and QE2.   Further, the Fed also announced that it is also changing its interest rate forecast and now sees the Fed funds rate remaining exceptionally low through mid-2015 (previously it was late 2014).

 

The announcement of QE3 is wearisome for many and for many reasons.  While the stimulative policies are temporary and artificial, the laws of macro-economics typically are not.  Asset prices have been artificially manipulated and do not reflect long-term economic reality. So what?

 

Two weeks ago, commodity prices rose again as investors sought to hedge themselves against a falling U.S. dollar.  Quantitative easing serves to dilute the money supply still more, and naturally the value of the money declines.  This may be good news if you are an exporting business, but the falling dollar will cause commodities to rise even higher, exactly what we do not need in a recovering economy as essential commodities like food and fuel get much more expensive.

 

The FOMC, of which Ben Bernanke is Chairman, now employs a staff of about 450, about half of whom are Ph.D. economists.  Perhaps that is the problem - the lack of common sense in the ‘monetary market place’.  Perhaps Bernanke should employ a few middle-class workers on his staff as a ‘reality barometer’ to see first hand what is working and what isn’t!

 

And now the Fed states that instead of purchasing customary Treasury Bonds, it is going to purchase large quantities of Agency Mortgages (Fannie, Freddie and Ginnie), up to $40 billion per month worth, in hopes of stabilizing the housing market and creating more jobs.  As if the Government debt situation isn’t bad enough, the Government will own huge pools of 30-year fixed rate agency mortgages that over time (certainly before they mature) will be at interest rates less than the Government’s own Fed funds rate.  Now that is a good investment!

 

Little has taken place in the economy here, and elsewhere in the world for that matter, as a result of QE 1, 2 and likely 3.  Meanwhile, our national debt now exceeds our Gross Domestic Product for the first time since WWII.  So when our creditors start feeling confident enough in their own economies to start cashing in their T-Bills for higher yielding investments, where does our Government get that money?  Or, when our Social Security Fund, the only Federal Budget item that is funded via dedicated funding sources, wants to cash in its Treasury Bonds to pay for your retirement or disability, can we pay them?

 

Is it time to ask the wise men at the FOMC what they're doing?!

 

Be Proactive and Anticipate Financing Road Blocks Before they Happen

In the past, a borrower was typically asked to provide a simple financial statement with a credit check, and that was the extent of the credit items required.  Ah, the good old days.  In today’s environment, lenders have upped their borrower documentation considerably requiring an extensive amount of information on the borrower. 

I’m continually surprised by most borrowers who don’t know the necessary documentation they need to provide in order to get a lender interested in them.  They could avoid many of their financing problems if they anticipated the financing road blocks before they happen.  Shown below are seven of the more common examples of issues to watch out for:

1.   Minimum Net Worth to Loan Ratio – Each lender has different requirements but they typically require the borrower’s net worth to be equal to the loan amount.  Some require a borrower’s net worth to be as much as two times the proposed loan amount.  Find out what your lender requires before signing the application.  

2.   Minimum Number of Months of Debt Service Required of Liquid Assets - Again each lender is different but they typically require liquid assets showing on the borrower’s balance sheet equal to 6 to 12 months of debt service.  Find out what your lender requires before signing the application. 

3.   Complete the REO Schedule with all the Details Filled In – Many lenders are now creating a global cash flow spreadsheet on the borrower.  They want to see if the prospective borrower is generating a positive cash flow or slowly draining himself of all his cash.  Much of the detail required to determine his global cash flow comes from the real estate owned schedule.  Prepare the REO schedule before you begin talking to lenders so that when they ask for it, it’s ready for them.  If you need a copy of a REO schedule contact me and I’ll email you one. 

4.   Credit Rating & Explanations of 30 Day Late Payments – Run a credit report on yourself before you start looking for a lender.  Find out your credit score.  Most lenders require that your credit score be a minimum of 680.  If yours is not that high, you better have a good explanation.  Also you need to explain every payment that is 30 days late or more.  Put it in writing before they ask. 

5.   Explain Past Tax Liens, Judgments, Litigation – have written explanations with back up documentation already prepared before you sign the application.  Give the prospective lender your explanations and have him verify in advance of signing your application that your explanations are satisfactory and will not impact loan approval.  Do it before you sign the application when you have the most negotiating power, not after when you have little or none. 

6.   Tax Returns, not just Schedule 1040s, signed and dated including all K-1s – Lenders want all of your federal tax returns, not parts of them.  Typically, most borrowers forget to sign and date their tax returns and most times it takes two or three attempts to get all of their K-1s.  To speed up the process get it done correctly the first time. 

7.   Thoroughly Read the Application and Ask Questions Prior to Signing the Application – It is imperative that you understand every clause in the loan application.  Lenders become frustrated, and rightly so, when borrowers and their legal counsel voice issues at the closing table about lending requirements that were disclosed on the loan application.  Negotiate any onerous lending requirement prior to signing the application.

One of the truest statements ever uttered about commercial real estate is, “Time kills deals.”  A lengthy, drawn out loan underwriting process will at the very least move your deal to the bottom of the pile.  It has the potential of killing the deal altogether.  Many of these seven issues can be avoided if the borrower will be proactive and anticipate what the lender is going to require.  A good borrower, a good mortgage broker should work towards making the lender’s process as easy as possible to avoid ever hearing the words, “I’m sorry to inform you, your loan has been turned down.”  

Source: From the Analyst Chair: Anticipate the Road Blocks in Commercial Real Estate Finance by Metropolitan Capital Advisors Blog, September 4, 2012. 

CRE Delinquency Rates Continue to Plummet

The commercial real estate market is getting better.  What we've sensed was happening has numbers to prove our thinking.  There are two very insightful charts by SNL Financial that show the slow but steady decline in delinquency rates over time on commercial real estate loans.

U.S. commercial banks reported a delinquency rate of 5.28% on CRE loans compared to a high of 10.76% nine quarters ago.  Oregon has fared even better with a delinquency rate of only 3.04% on CRE loans. 

The asset quality of CRE loans has been improving at a faster pace than one-to-four-unit plexes (considered residential).  However, residential loan delinquencies have also declined by about 200 basis points to 12.66% as of the end of the 2nd quarter of this year. 

Looking at delinquency rates by state shows that the Northeast, the Plains states, Alaska and Hawaii have fared the best, while the Southeast and the state of Nevada have the highest overall delinquency rates.   

Source: CRE delinquencies continue to plummet; by Harish Mali and Robert Clark, SNL Financial, August 29, 2012

Fact or Fiction: We're going down!

I just finished reading, Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown by David Wiedemer, Robert Wiedemer and Cindy Spitzer.  As you can imagine by the title of the book, the authors are not too bullish about our future.  Let me restate that: they are down right pessimistic about our chances of correcting our economic ship.  As far as they're concerned it's not going to happen. We're going down in flames and we're going to pull down the rest of the world with us.  

Now before you go and find a bridge to jump off of, the world will go on, a new economic order will eventually emerge from the ashes and the U.S. will likely lead the way again, this time a whole lot wiser as we learn from the mistakes of the past 30 years that set us on this course in the first place.  That's the gist of the book.  
The question that we need to ask ourselves is: How true are the premises presented in the book that lead to this conclusion?  Are these authors a bunch of nut jobs or do they have valid points? While I don't agree with some of their conclusions, I believe the overall framework that they present is both logical and intuitive. Let's see what you think as I outline the basic premises of their book.

The authors believe that beginning in the early 1980s, with the decision to run large government deficits, six co-linked bubbles have been growing bigger and bigger, each working to lift the others, all booming and supporting the U.S. economy.  A bubble is defined as an asset value that temporarily booms and eventually busts, based on changing investor psychology rather than underlying, fundamental economic drivers that are sustainable over time.  The six bubbles are:

1. The real estate bubble
2. The stock market bubble
3. The private debt bubble
4. The discretionary spending bubble
5. The dollar bubble
6. The government debt bubble

The first four of these bubbles began to burst in late 2008 and 2009 which rocked the U.S. and world economies.  It's kind of difficult to disagree with this premise with maybe the exception of the stock market.  Was the stock market crash of 2008 as a result of a bubble? The authors make a compelling case (which you'll have to read) that the stock market crash of 2008 was in fact a bubble that was not supportable by sound economics.  

The second major premise of the book is that while most people think the worst is over, the coming Aftershock will bring down all six bubbles in the next two to five years.  Whoa!  So what's the evidence to support their view.

The authors go on to explain that money, like all assets, is also affected by the law of supply and demand.  If there are too many dollars available their value falls.  In the past four years The Federal Reserve, in order to avoid a collapse of our economy, has increased the money supply through Quantitative Easing from $800 billion to $2.6 trillion.  This is an unprecedented increase in the money supply. The final bubble to pop is the government debt bubble.  Our national debt in that last four years has increased from $10 trillion to $16 trillion!  Both the dollar bubble and the U.S. government debt bubble have been pumped up to offset the other popping bubbles.  Both are on unsustainable paths and they too will pop bursting America's and the world's economy.  

As I mentioned earlier I don't agree with everything they say in this book.  My fundamental disagreement is in the inevitability of the last two bubbles popping.  If present trends continue, i.e., we continue to avoid making difficult decisions, then I absolutely agree that the dollar and government debt bubbles will pop as predicted.  I also believe that nothing will get done to solve our economic problems until there is a crisis.  

The good news is there is a crisis looming which should get our politicians' attention: Europe.  There is no solution to Europe's debt crisis.  None.  Anyone who thinks otherwise is living in "la la land." Europe's days are numbered.  When they falter, and they will, this catastrophic event should give our political leaders the impetus to make the necessary, painful decisions to keep us from following Europe over the precipice.  Just like the days immediately after 9/11 both political parties will come together for a short period of time.  As Rahm Immanuel once said, "You never want a serious crisis to go to waste."  Let's hope they take advantage of the collapse of Europe to right our economic ship so we can avoid following in their footsteps.    

Why Inflation Is Just Around the Corner

Thirty years have passed since we’ve had a significant bout of inflation in this country.  At the peak of this inflation battle my money market account earned 21 percent interest!  That was the good side of inflation.  The bad side of inflation was banks pretty much stopped lending and the only lending getting done was seller financed or other creative forms of hard money lending.

For the past 30 years we’ve seen interest rates slowly decline on commercial real estate from 12 percent to now 4 percent or less.  I believe the days of ever lower interest rates are coming to an end.  In fact, I believe the days of double digit inflation is inevitable and I believe it’s just around the corner.

But before I go further on what I believe is in store for us as a nation, let’s review what inflation is and what causes it.

What is inflation?

Inflation is an increase in the price of goods and services not due to growing demand or shrinking supply for those goods and services (which also affects price) but due instead to the dollar losing its buying power.
There is a difference between real price increases and inflation.  The price of oil could be going up because we are running out of easy-to-find oil, or demand has gone up because China’s rapidly growing economy is demanding more oil.  That’s not inflation; that’s a real price increase due to the forces of supply and demand.

What causes the dollar to lose buying power?

The value of money is affected by supply and demand.  If there are too many dollars available their value falls.  When the money supply is dramatically expanded in an economy with no or slow growth, as is happening today, the value of the dollar will eventually decline.  In short, too many dollars (too much supply), relative to the slow growth of the economy (too little demand), leads to the falling value of the dollar, a.k.a, inflation.  Therefore, real cause of inflation is increasing the money supply beyond what is needed to keep up with economic growth. 

What is causing the money supply to expand so rapidly?

The Federal Reserve in an attempt to rescue the economy began in early 2009 purchasing $2 trillion in U.S. mortgage and treasury bonds with printed money.  The technical term for these big bond purchases is “quantitative easing” or QE. Then in November 2010 the Fed began more bond purchases (QE2), adding an additional $600 billion to the nation’s money supply over the next year.  Again the goal of the money printing is to stimulate the economy back to health.

How much has the money supply increased in recent years?

In 2008, before QE, the U.S. money supply totaled $800 billion.  Today, the money supply is $2.6 trillion or more than triple what it was in 2008.  This is a stunningly large increase.  Nothing like this has ever occurred before in the United States.

Why aren’t we experiencing inflation now?

A paper written in 1999 by Ben Bernanke, the Fed chairman, et.al., examined past periods of inflation and determined there is about a two-year lag between increasing the money supply and the onset of inflation.  It can be delayed further if the Fed takes other actions to create more lag time, which I’m sure they are trying to do.  It can be delayed but it can’t be prevented. 

Exactly when will inflation begin?

Good question.  The truth is no one knows when it will begin in earnest.  The authors of Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown believe that significant inflation will begin in the 2013-2015 range.

What does this mean for commercial real estate?

We live in uncertain times.  Many factors lie outside of our control to influence. As property owners refinancing our real estate is one area of our lives that we can be proactive and take control of the situation by locking in low interest rate, long-term financing.  Those who do will be the big winners. 

Source: Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown by David Wiedemer, PhD, Robert Wiedemer & Cindy Spitzer; John Wiley & Sons, Inc., 2011.

A Policy That Both Obama & Romney are Right About

It's not often that two presidential candidates agree on much of anything.  That's not good politics!  But I digress. 

Two weeks ago I wrote a blog post titled, Why Obama and Romney are Both Wrong About the U.S. Economy.  In this blog post I stated my basic premise that the U.S. economic model of the past 40 years is broken and cannot be fixed with the trite solutions offered by both parties.  It reminds me of the beer commercial where two groups of men shout at each other, "Tastes great" and the other group shouts "Less filling."  Rather than these trite slogans our major political parties shout at each other their equally trite slogans: "More government programs", "Less taxes" with no one listening to the other side's argument.  Kind of sophomoric isn't it?  

In this previous blog I outlined that there are only five ways to stimulate the economy: 

1. Increase exports
2. Decrease imports
3. Increase business investment
4. Increase government spending
5. Increase consumer spending

I discussed each of these five ways to stimulate the economy but quickly came to the conclusion we needed to focus our attention on consumer spending because historically 70% of our economy is driven by consumer spending. 

Many economists believe that excess household debt is the biggest factor holding back the economic recovery as 25 percent of all homeowners owe more on their homes than they are worth.  When you add the amount of credit card, auto loan and student loan debt to this mix the American public is awash in personal debt.  This leads to a situation in which people are trying to spend less than their income to get out from under their debt load.  And without consumers spending money the chances for a robust economic recovery go out the window.

A recent proposal that could change all this has been presented that has surprising support from both presidential candidates.  Romney advisers and the president are both in favor of allowing homeowners with little or no equity in their homes to refinance their mortgages.  With interest rates at historical lows this would substantially lower their interest payments with the potential of providing a major boost to the economy.  There are 80,000 households in Oregon that could benefit from this proposal.  Logically, why wouldn't you be in favor of lowering the interest rate on underwater borrowers?  It's a no brainer.  In many cases, these homeowners did everything right, but they are unable to refinance to today's lower mortgage rates.    

But Edward DeMarco, the acting director of the agency that oversees Fannie Mae and Freddie Mac, has refused to move on this proposal put forward by the Obama administration.  He believes that it would be a net loss to taxpayers, a conclusion not supported by his own staff's analysis which showed a net gain.  And of course Republicans and Democrats are squabbling over what to do about this impasse.  So nothing gets done as Congress adjourns for its summer recess.       

Admittedly this is a proposal by the Democrats in Congress.  Wouldn't it be refreshing if the Republicans would set aside partisan politics to support this legislation for the good of the American public (by the way there are plenty of other examples of Democrats acting childish too).  This legislation has the potential to spur the economy so that us all would benefit without costing the taxpayer a dime.  If Mr. DeMarco remains a roadblock, then its time to find his successor.

Source: Debt, Depression, Demarco: Lay the blame where it belongs by Paul Krugman, The Oregonian, August 4, 2012; Once again: Why not help people keep their homes? by Peter Buckley, The Oregonian, August 6, 2012. 

Why Obama and Romney are Both Wrong About the U.S. Economy

I'm reminded of the saying, "Fools rush in where angels fear to tread." With this week's blog post there's a good chance that I'll step on lots of toes, but what the heck I'm an equal opportunity offender.

One of the problems we are facing this election cycle is neither candidate has given the American voter the top three things they would do to get the economy going again.  They are both more concerned about trashing their opponent than providing us with reasons for voting for them. 

My premise is that the U.S. economic model is broken and cannot be fixed by the trite solutions offered by both political parties.  Since the 1980s 70 percent of GDP growth has been fueled by consumer spending.  As the economy expanded, our wealth increased - stocks, bonds and especially the rising value of our homes made us feel more prosperous resulting in our trading up for better cars, homes and vacations and at the same time taking on more and more debt.

Then came the Great Recession.  A recent Federal Reserve report indicated that the net worth of the median U.S. Household fell 39 percent from 2007 to 2010.  Feeling poorer, and rightly so, has resulted in Americans cutting back on purchases and even making token attempts to put money in savings.

So how do we get the economy going again?  The basic equation that summaries a nation's gross domestic product is:

GDP = C + Inv + G + E - Imp

Gross domestic product of a country is equal to its consumption (personal and business) plus investments plus government spending plus exports minus imports.  It is true for all countries and all times.  There are no exceptions.

What happens if C drops?  That means, absent something happening elsewhere in the equation, GDP is going to drop.  That circumstance is typically called a recession.

Therefore there are only five ways to stimulate the economy:

1. Increase exports
2. Decrease imports
3. Increase business investment
4. Increase government spending
5. Increase consumer spending

That's it.  Pretty simple, isn't it?  So what are Obama and Romney proposing and will any one of it work?  Both are emphasizing job creation as the key to their economic proposals.  But is it just rhetoric?  Let's look and see.

Increasing our exports - If you haven't noticed, Europe is on the verge of imploding economically.  At the very least they will be in a full blown recession before the year is out, which means less demand for our exports, not more.  The economies of other countries around the world are also contracting, certainly not expanding so the hope of greater exports fueling our economic recovery is highly unlikely.  We will have to look elsewhere to get our economy going again.  Both candidates are bloviating when they talk about increasing exports resulting from implementing some vague proposed policy.

Decreasing our imports - One area of enormous potential for boosting our economy is in energy production.  For every barrel of oil we produce in the U.S. it is one less barrel of oil we import.  From a purely economic argument, the environmentalists have no leg to stand on.  Romney is in favor of oil exploration, the president at best is very reluctant to do so.  The Canadian pipeline project, the exploration of oil off our coastlines and opening up the 1/2 of 1% of the Alaska National Wildlife Refuge that was proposed years ago would have a positive long term impact on our economy.  To prove my point, just observe what's going on North Dakota at the present time.  This state's economy is booming because of the vast oil reserves recently tapped.

More business investment - that's not going to happen until there's stonger demand for a company's products.  In the movie Field of Dreams, an Iowa farmer hears an ethereal voice whispering, "If you build it they will come" referring to building a baseball field.  There is no equivalent in business.  Demand by consumers must precede a businessman's rational decision to increase their production of more widgets.  But in fairness to Romney he is proposing to reduce the tax rate for businesses.  This is a positive first step as the U.S has the highest corporate tax rate among the most industrialized countries of the world.  Lowering the corporate tax rate would, over the long run, make it a more favorable business climate in the U.S.

Increasing government spending - contrary to what Republicans are telling you, higher government spending does promote economic growth.  It has to.  It's simple math.  But the problem of ever increasing government debt is that it puts a drag on our economy.  So in the short run, higher government spending does modestly stimulate the economy but over the long run it slows the rate of growth as more and more of the budget goes to making interest payments on the debt and less for investments in other segments of our economy.  In the long run higher government spending slows economic growth.

Increasing consumer spending - for the economy to get moving again the American public needs to lead the way.  So what are Obama and Romney proposing?

• In 2011 the president put into place, with the help of Congress, a payroll tax cut of 2% which directly goes into the pockets of all American workers.  This can only help increase consumer spending.  But the problem is this tax cut reduces the amount of revenue funding Social Security, which is slowly working its way to insolvency.  So the tax cut is helping the Social Security Trust Fund go insolvent more quickly than it would if the payroll tax cut had not been implemented.
• The president is also proposing to increase the tax rates on the wealthy so they "pay their fair share" whatever that means.  Increasing taxes on the wealthy may be good politics but it certainly isn't good economics to raise taxes on anyone in a slow economy.
• Romney on the other is talking about further tax cuts, which doesn't make any sense either.  Most economists agree that a further reduction in tax rates will explode our already enormous deficit.  And when almost half of all Americans didn't pay any income tax last year how effective will it be to lower tax rates even further?

Wouldn't it be refreshing if the candidates:

• Were talking to the American people as if we were adults?
• Would lay out in complete terms their economic plan and debate the merits of their plans.
• Would ask us to sacrifice a little for the good of the country?

Whoever becomes our next president I hope has the vision and courage to lead us during difficult economic times.  Unfortunately I don't believe either candidate has the "spine" to do the right thing.  The next president will have difficult decisions to make that have enormous long-term consequences.  It will be far easier to "kick the can down the road" and stay popular among his base than to lead and be villified for making the difficult choices.  I hope I'm wrong because this country is at a crossroads.  We can follow Europe down the path to destruction or we can make smart, difficult choices that pull us back from the precipice.  This isn't just another election.

Sources: Endgame: The End of the Debt Supercycle and How It Changes Everything by John Mauldin; June 30, 2012, Robert J. Samuelson, Washington Post. 

Surprise, Surprise, Surprise! Banks Downgraded

In my May 25th blog post I wrote:

"Are the U.S. financial institutions prepared for what is happening in Greece? The answer is, "It depends on which banks you're talking about."  The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks - Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo.  These six banks have definite exposure to what's happening in Greece.  All reports say that their exposure to Greek insolvency is manageable.  If you want to believe what the banks are telling you then we have nothing to be concerned about.  Call me a cynic, call me a "glass half-empty type of guy, but I don't believe it."

Last Thursday, Moody's cut the credit ratings of 15 of the world's largest financial institutions including five out of the top six largest banks in the U.S. - Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley and Goldman Sachs.  As Gomer Pyle would say, "Surprise, surprise, surprise!" 

Why were they downgraded?  Reasons given were:

• Marginal liquidity
• Exposure to the European debt and banking crisis
• Unspecified volatility and risk management problems in their capital markets activities

How will a lower credit rating affect these banks?

• It will make it more expensive for them to borrow money.
• It will make it more difficult to sell their commercial paper to money market funds.
• It will likely require them to increase their capital requirements.
• It will likely have an adverse affect on the value of their publicly traded stock.

Did Moody's consider all 15 banks equally in trouble?  No.  Moody's grouped the 15 institutions into three categories based on their relative credit-worthiness.

• The strongest group had solid capital buffers and "contained" exposure to the European crisis.  J.P. Morgan Chase falls into this category.
• The second group had varying risk factors, ranging from high dependence on capital markets operations to limited liquidity and exposure to Europe.  Goldman Sachs was in this category.
• The weakest group had experienced problems with volatility and risk management, and in some cases had weaker buffers than their peers in the industry.  Bank of America, Citigroup & Morgan Stanley were in this category.

Bank of America and Citigroup's credit rating are now rated two notches about junk status, while Morgan Stanley is three notches above. 

Are the credit agencies done downgrading the world's largest financial institutions?  Not even close.  Most of the European banks have been downgraded on several occasions over the past few years and I suspect that further downgrading of our largest banks will continue unless drastic improvement occurs over the next couple of years. 

It is hard for me to believe that one or more of these major U.S. banks will not falter and eventually collapse of its own bad decision making.  The real question is not if it will happen, but when, and more importantly whether those in authority at The Federal Reserve and U.S. Treasury Department have a comprehensive plan to contain the fallout when this occurs.  I suspect that they do have a plan and I suspect that they hope that they don't have to implement it.  That and $1.65 will get you a tall cup of coffee at Starbucks.   

Sources: Major banks downgraded by Moody's, @CNNMoneyInvest, by James O'Toole, June 21, 2002; A Sober New Reality in Credit Downgrades for Banks, DealBook, NYTimes edited by Andrew Ross Sorkin, June 22, 2012.

Another Questionable Decision by The Federal Reserve

The Federal Reserve last Thursday released a proposal that would implement a global agreement known as Basel III. This agreement is a regulatory standard that proposes minimum capital requirements and liquidity standards for all financial institutions worldwide.

I know what you’re thinking as I was thinking it too: I’m tired of reading another boring article on banking regulations. But I would encourage you not to delete this blog post before you get a “view from 35,000 feet” on how Basel III is going to impact the commercial real estate industry. It could have an enormous adverse impact on our industry if not implemented gradually.

From our perspective the most egregious new implementation being proposed by Basel III is assigning a higher risk weight to commercial real estate loans of 150%, up from a current risk weight of 100%. How does that affect the bank? The more risk, the more capital that’s required by financial institutions to have on hand as a buffer. So the more they lend on commercial real estate the higher their capital requirement. If they lend on other assets, home loans or businesses for example, they will not be required to hold as much in reserve.

So what do you think the banks are going to do when this new rule is fully implemented? Do you think they will lend more or less on commercial real estate? Of course, the tendency will be to lend less. And how do you think in real terms that will be done? I think there will be fewer banks lending on commercial real estate and those that do will find a plethora of ways to make it that much more difficult to get a loan approved and closed (as if we need more banking regulations to slow down the loan approval process).

This isn’t me just “crying wolf.” Fitch Ratings estimated last week that the world’s 29 largest banks will need to raise another $566 billion by the end of 2018 to meet these new international liquidity requirements against risk. Where is that going to come from?

I wonder why they consider commercial real estate so risky? The Great Recession was brought about by a housing bubble and lax underwriting standards for qualifying borrowers of home loans, not because of excesses in the commercial real estate industry. So why pick on us? Why make commercial real estate the scapegoat? The Federal Reserve needs to think this through and figure out what the ramifications are to our economy if this is fully implemented. Basel III ultimately means less lending on commercial real estate which means a slower economy which means fewer people being employed.

I’m all in favor of reforming the banking industry (remember I’m in favor of Dodd Frank) but increasing the risk weight for commercial real estate may be over the top. There’s got to be someone on The Federal Reserve Board of Governors who has enough common sense to understand this and has the courage of his convictions to push back. Don’t you think?

Sources: Basel III, Wikipedia; Fitch Ratings: World's Biggest Banks May Need To Raise $566 to Comply With New International Rules, Huffington Post, June 7, 2012; Fed ups capital buffer for commercial real estate, Market Watch, The Wall Street Journal, June 7, 2012; Federal Reserve unveils Basel III bank capital proposal, The Economic Times, June 8, 2012.