It’s been a while since I last put up a blog post but recent events make me just HAVE to put out a few thoughts about the consequences of low commercial loan rates since there is now news that our Federal Reserve has decided to keep interest rates artificially low until at least the middle of 2013 to help boost our sluggish economy.

At first glance, low interest rates seem to be a great benefit to commercial real estate investors since the cost of borrowing money is low.  It should be much easier to qualify commercial properties for acquisitions and refinances now since low interest rates mean a larger bottom line for you and your investors if you are buying and holding commercial income properties.  But, much like a party where you don’t get the gifts that you want and expect, there can be some unexpectedly bad surprises waiting a few years from now if you are one of those who were convinced into buying or refinancing now without taking a hard look at the numbers.  If you do get caught up in the low-interest-rate euphoria and start accumulating commercial properties at these low commercial loan rates, you may find out first-hand the problems with keeping commercial loan rates artificially low and how they can wreak havoc on your real estate portfolio.

I already posted, very briefly, on how artificially-low interest rates can damage the future of your commercial real estate investments when interest rates start to rise.  But let’s get into this a bit more deeply to get a better idea of how this can happen.  As always, let’s keep in mind the issue regarding artificially-low commercial loan rates and what we can do to keep from becoming more victims to our government’s well-meaning, but flawed, influence on the private sector.

Most commercial mortgage loans in this country are amortized over a 20- to 30-year period but have a much shorter term that requires a balloon payment to be made to pay off the loan in full.  Many commercial mortgage loans are also interest-only loans which means cash flow, during the loan term, is higher than for amortized loans but this also means that the balance never gets paid down so the balloon at the end is the full amount of the principal originally borrowed.  Rather than pay off these loans at their terms while keeping the properties, however, borrowers typically try to refinance the loans or sell the properties.  This is where the full fury of miscalculated commercial loan debt can show us the consequences of low commercial loan rates when the free markets are not allowed to determine the costs of borrowing capital.

The hazards of using low cost capital for short-term commercial loans has also been outlined by Real Capital Analytics so this is nothing new.  But the scary part is that, as a whole, I agree with Wall Street veteran, John Gutfreund, who once said that people have short memories.  A person is usually rational, intelligent, and sensible.  But when people start grouping together and allow for a “mob mentality” to dictate their decisions, disaster often results that could have been avoided with just a little thought and foresight.  When commercial loan rates are low like now, all it takes is a little bit of time to forget the damage that was done prior to this and why these commercial loan rates are being forced to such low levels by our government powers.

Let’s take an example using commercial loan rates and terms taken from Steelhead Capital Investment Advisors as of August 10, 2011.  As can be seen, term limits for retail loans are usually much shorter for the retail commercial asset class than they are for multifamily.  Let’s assume that on August 10, 2011, you purchased a $3 million retail strip center with a 5-year term, a 6% interest rate, and interest-only payments.  Remember from our news story above that the Federal Reserve intends on holding interest rates low at least until the middle of 2013.  But also keep in mind that the credit of our country was just recently downgraded by Standard & Poor’s in part because the United States came dangerously close to defaulting on our $14.3 trillion debt and also since there appears to be no true resolution on how to reduce this national debt.

So if commercial loan rates are to rise, how far up could they possibly go?  Let’s see what history can teach us.

If we take a look at historical LIBOR rates, an index that is used to determine the interest rates on many commercial mortgage loans, it isn’t unreasonable to believe that, in the next five years, interest rates could rise 200 basis points (2%) from their present values from, for our example, 6% to 8%.  Five years ago, interest rates were about 5% higher than they are now but we’ll be “conservative” and assume only a 2% increase.  Can we assume that interest rates will rise?  I believe that we can.  As risk increases, so does the cost of borrowed money.  A person who has marginal credit can expect to pay more for car loans, mortgage loans (if they can even get a mortgage loan), and other personal loans than a person with pristine credit, so why should this principle be any different for an entire country that has recently had its credit rating downgraded?  I expect an increase in commercial loan rates within five years.

Now let’s plug in our numbers from our hypothetical retail center purchase with an interest-only commercial loan with only the commercial loan rates changed from 6% to 8% five years later when it is time to refinance the property.  By the way, while we do sell a full version of the investment property calculator used to calculate these results as shown below (plug, plug), the free version of this investment property calculator can be obtained just by opting in to receive our emails.

One of the most important parameters that any commercial lender looks at is the Debt Coverage Ratio, also called the Debt Service Coverage Ratio.   Lenders typically like to see that this ratio does not go below 1.2 or 1.25.  Just by commercial loan rates rising from 6% to 8%, we see that the debt coverage ratio has decreased from a comfortable 1.48 to a disturbing 1.11.  Remember that the principal balance stays the same during this time since we put an interest-only loan on the property.  I seriously doubt that any conventional lender will let you refinance into a loan resulting in only a 1.11 debt coverage ratio.  The only way to maintain at least a 1.2 debt coverage ratio is to somehow increase net operating income by increasing operating income, decreasing operating expenses, or both, and I don’t see very many drastic increases in operating income given our sluggish economy.  This is a typical example of what I expect to happen if my prediction is correct about increases in commercial loan rates within the next several years.

So how do we buy a commercial property and keep a beautifully cash-flowing property from turning into an 800-lb alligator that chews on our backsides in a few years?  I can think of three ways immediately.  First, buy a property at a low enough price to be able to flip it to a long-term investor.  Second, build the effects of higher commercial loan rates into your offer prices.  Third, buy only properties where you are certain that you can add enough value to offset higher commercial loan rates, i.e., buy properties that you can reposition, not momentum plays that are already operating smoothly with debt coverage ratios that are close to violating lender limits.

If I’ve not scared you away with my narrative on commercial loan rates and how you can get hurt by them, I’d like to present a few possible retail-class deals below where people may have gotten caught in that trap and that you may be able to purchase for yourselves:

If nothing else is of interest to you in this post, I hope you will at least keep in mind that low commercial loan rates aren’t always good, especially for short-term loans, and that you don’t buy into the “must buy now” hype without accounting for rate increases.

In our present economy, where are the best investments for 2011 in the multifamily asset class?

Multifamily assets seem to be the most popular commercial class of real estate in which to invest.  For sure, it is the asset class that most commercial real estate gurus sell to the general public since it is the easiest to get financing for as well as the easiest to understand since apartment rental units are almost just like single-family houses in that everybody needs a place to call “home”.

I opened up the most recent issue of one of magazines to which I subscribe, Multifamily Executive, and saw that they just released the “20 Hottest Multifamily Markets for 2011” based on multifamily permit activity in 2010.  I think this should be taken with an ever-so-small grain of salt since these numbers could be easily influenced by a number of things such as government subsidies, or other incentives, and not just by shifting demographics as indicated in this article.  As an example, I own a rental property in a low-grade rental neighborhood here in Aiken, South Carolina, where houses can normally be bought in the mid-$20,000′s to the low-$30,000′s.  But if you look at some recently recorded deeds, you might think that houses in this neighborhood are selling in the $90,000′s to just over $100,000.  What the recorded deeds won’t tell you is that the City of Aiken is using grant money to not only buy houses in this neighborhood but also to provide homeowner loans at extremely low interest rates with little to no money required for down payments.  It is actually much less expensive to “buy” a house there than it is to rent one.  Now imagine if you moved to Aiken from California and see what you think are “cheap” rental houses and ended up paying $90,000 for one in that area.  Given the rental market there and without being able to obtain the same kind of low-cost financing as what the City provides to owner-occupants, you’d get stuck with an overpriced rental house in a low-grade neighborhood.  Likewise, be wary of anyone who tells you that they know where the best investments for 2011 (or for any year) are for real estate.  Keep in mind that value all comes down to supply and demand, both of which can be drastically influenced by overall macroeconomics and not just by buyers communicating with sellers.  It is one thing to WANT to buy a property, but it is another to actually be able to BUY it.

The above caveat being given, the writer of the aforementioned article is quite knowledgeable and credible.  He writes for one of the premier trade journals in the multifamily industry so his words are not to be taken lightly.  But don’t just go stampeding to invest in the markets he cites just because he says these may be the places for the best investments for 2011.  There are probably many equally great deals, as well as potential partners, in your own backyard, i.e., right where you live even if you don’t happen to live in one of these 20 markets.

Along the lines of finding partners “in your own backyard”, and on to another rant, there is an overly-confident real estate investor who lives in my hometown of Aiken.  Let’s call him Hal.  Hal and I tried to work together about a year, or so, ago to purchase multifamily investments.  We both learned from one of the top apartment investing educators, David Lindahl, who owns over 7000 apartment rental units, himself, so David definitely has the credentials to properly teach multifamily investing.  The problem with working with Hal was that Hal wasn’t a careful guy and he didn’t know how to properly apply the Lindahl teachings but stubbornly thought that he knew (for someone to think they know something but they really don’t is not only hazardous to their wallets but also to yours if you try to work with these idiots).  Hal was more than willing to take risks…with MY money.  I recall an apartment complex in Dillon, South Carolina that Hal put under contract, since he was confident that it was a great deal, and for which I trusted him and put up the entire earnest money deposit.  After taking two days to walk the property together and get a better idea of the Dillon market, I contacted the owner to tell him that we were canceling the contract since the financials for it were hopelessly intertwined with those of another property in a different state.  The owner, to save money, had both properties’ financials tied into only one set of accounting books so we couldn’t verify the performance of the Dillon property alone.  Hal and I spoke with the attorney who held my money in escrow and she told us that the money couldn’t be released back to me since the contract, which Hal got from an Internet download and insisted was legal here, didn’t have the proper provisions to do so under South Carolina law.  The ONLY thing that saved me from losing this money was that Hal was the one who actually signed the contract, not me.  I only put up the earnest money so I was able to get the money released.  I was royally pissed at Hal, who never once apologized for his mistake that could have cost me my earnest money deposit, but I thought that he just made an error in judgment and learned from it so I decided to keep working with him, albeit with a lot more caution.

Two weeks later, Hal called me to say that he had put the Dillon property back under contract.  When I asked him for the price and terms, he told me that he put it back under contract FOR THE SAME PRICE AND TERMS.  Folks, when I was a kid, we did a science experiment in junior high school showing that earthworms can learn to avoid unpleasant stimuli like ultraviolet light and electric shocks.  This taught me that even earthworms can learn.  When Hal put the Dillon apartments back under contract for the SAME price and terms, this taught me that Hal CAN’T learn.  A good Rule of Thumb is to NEVER work with anyone who is dumber than an earthworm.  From that day on, I stopped returning Hal’s phone calls and will never again try to work with him.  Trying to work with people like Hal is just a waste of your time.  Prescreen your partners carefully and make sure that you’re both at least equally intelligent, so much the better if you can partner up with people who are MORE intelligent than you.  This advice applies whether you are looking for good multifamily deals and partners locally, or if you decide to look in the much ballyhooed places for the best investments for 2011 as proclaimed in Multifamily Executive magazine.

As long as this post is on locating the markets with the best investments for 2011 for multifamily complexes, I’d like to list possible prospects in each market that are in my database for those who have the knowledge and resources to hunt them down.

Much in the same spirit as David Letterman’s Top 10 Lists, some possibly good multifamily deals in the locations where you’re supposedly able to find the best investments for 2011 are:

Keep in mind that highlighting the well-publicized markets above is based solely on permit activity, but your best investments for 2011 could be where you least expect to find them.

Commercial Mortgage Defaults

It was officially announced, yesterday, that the U.S.  exceeded its self-imposed national debt ceiling of $14.3 trillion. I see this as yet another blatant symptom of our fiscal disease that could cause a new tidal wave of commercial mortgage defaults soon.

From my discussions with commercial lenders, there has been a lot of increased activity in commercial mortgage loan originations as the vultures are swooping in to pick up good deals with a lot of “equity” left on the table by lenders who got burned by the economic downturn by taking deep discounts on these assets.  But I don’t think that people are buying at low enough prices to avoid another wave of mortgage defaults.  I believe that there is a lot of hype about the “commercial deals being at the bottom so the only way prices can go is up” sort of thing and that people are ignoring the huge red flags indicating that our economy is not a healthy one.  I’m guessing that our government leaders will just keep raising the debt ceiling to higher and higher levels without adopting strong enough measures to reduce our national deficit.  Accordingly, our debt will just keep rising until there is eventually a true default on the debt.  Financial expert, John Mauldin, refers to this interesting phenomenon as “kicking the can down the road.”

In a previous blog post, I gave supporting evidence on why a rise in commercial mortgage interest rates will result in many more mortgage defaults.

A quick recap of that post is that most commercial mortgage loans are interest-only loans that must be refinanced regularly but an increase in interest rates upon refinancing will increase loan payments, reduce cash flow, and put many income properties into negative cash flow situations.  The end result?  A drastic increase in mortgage defaults.

Apparently, Treasury Secretary Timothy Geithner has stated that “Interest rates for state and local government, corporate and consumer borrowing, including home mortgage interest, would all rise sharply” upon the U.S. defaulting on its debt so the possibility looms that the present buying spree of commercial real estate could be the formation of a mini-bubble that will pop within the next few years.  To those actively investing in commercial real estate, I suggest you keep your powder dry for just a while longer and you may be able to get some really smokin’ hot deals soon.  When the number of mortgage defaults rise, you will be in great shape to pick up heavily discounted properties.

Let’s look at the basic four options that commercial mortgage lenders have when their borrowers face imminent mortgage defaults and their loans can’t be refinanced since property values have decreased to below allowable refinancing limits (a common occurrence these days):

• 1. Modify the loan with the borrower (a variation of “extend and pretend”).
• 2. Sell the note to a third party at a discount from the principal balance.
• 3. Accept a discounted payoff of the loan principal balance and release the lien.
• 4. Foreclose on the property or take back a deed in lieu.

While the first option is a valid way for lenders to avoid taking a true loss, the last three options are the ones that SHOULD result in a lender officially showing a loss on its books right away from mortgage defaults.  But the last option, taking back the property via foreclosure or deed in lieu, has a gaping loophole that allows lenders to “kick the can down the road” and avoid having to show an immediate loss on its books.  Here’s the trick: Lender hires third-party company to “buy” the property at the foreclosure auction or get the deed in lieu of foreclosure from the owner/debtor.  This third-party company now owns the property, but only as the trustee of a trust that has the lender as its sole beneficiary.  *VOILA!*  The lender has just taken a property back without having to immediately show losses from mortgage defaults on its books.  Ever hear of “money laundering” by drug lords and organized crime syndicates?  We are now in the age of “property laundering” with the only difference being that taking properties to the laundromat for a thorough cleaning is still legal.  This is commonly done by lenders to disguise mortgage defaults.

To be fair to lenders who “launder properties”, not only is this legal, they still have to show the properties as being REO (real estate owned) in their financials but present accounting practices often allow them to defer having to show losses until the properties resell so, while legal, this tactic is only delaying the inevitable losses that result from taking back properties with little to no equity.  I think that paying attention to the macro view of what is going on with our government lending policies will give a better vision of the commercial lending future than watching all the noise and other minutiae that many people seem to be caught up in.  For now, those who are playing the commercial real estate game based on gratuitous media hype are playing musical chairs with the person who hurries and gets to sit in the last chair being the loser, not the winner, by snapping up a property at too high of a price tag and not being able to do anything with it.

For my fellow vultures who are still in the buying frenzy, let me list a few properties that show up as Lender REO’s in the multifamily asset class, since those are the easiest to get financing for these days, in my database so you can feed at the carcasses with the other scavengers in your areas.  I can only reiterate that I think that things will get worse so if you do buy, it would be prudent to buy with caution and factor in higher mortgage loan interest rates lest you have your own crisis with mortgage defaults:

Party hearty but with caution on anything you buy these days.  Let the others buy right now at what I believe are inflated prices and don’t go for the “you gotta buy now” hype.  Be conservative with your maximum offer prices and stick to them.

Don’t become just another statistic in the upswing of mortgage defaults that I see coming soon.

So what’s the deal with the commercial lending environment?

In the midst of news and hype claiming that “our real estate markets have bottomed out and now is the time to buy real estate!!!”, I think this would be a good time to bring up how present commercial lending practices may be setting us up for a really big fall in the next few years.  I’m guessing that the coming years will have many more commercial mortgage loan defaults than what we are now seeing unless commercial lending and government policies are drastically changed really soon.  This will have a pretty direct effect on our overall economy.  But just how bad will it get?  I’m stocking up on cases of cheap macaroni and cheese and Ramen noodles even now as I type this just in case…

It amazes me how the backing of well-marketed news channels seems to give reporters and TV news anchors the credibility to talk about things they really don’t know much about.  For example, Maria Bartiromo is a financial news anchor at CNBC.  She is a very good news anchor who happens to report on financial events that occur mainly on Wall Street.  But because she is on a highly-publicized news channel like CNBC, somehow she was positioned as being a financial analyst and not just a news anchor.  Maria even authored (or was it ghost-written?) a book, “Use the News: How to Separate the Noise from the Investment Nuggets and Make Money in Any Economy“, to capitalize on her attempt to be known as a competent financial analyst.  I remember almost getting caught up in the hype to buy Maria’s book when it first came out until I remembered that all she does is read out loud from Teleprompters and interview true financial analysts.  She has no real qualifications to be called a financial analyst other than having learned the vocabulary from many years of working Wall Street’s business and social scenes.  So when I read a recent New York Times news story saying that “For three straight months, the nation’s employers have delivered solid job growth, easing some concerns that the economy could be stalling” but that has contradictory data in it showing that the unemployment rate rose as well, I had a pretty good idea that the writer of the article did not fully understand the data but just told us what he heard someone else say to him.  Someone like Harry Markopolos, who was one of the first people to uncover the Bernie Madoff Ponzi scam, is a true financial analyst (and investigator), not the news reporters and TV anchors who merely tell us what has already happened by looking in the rearview mirror.

The above being said, I should include a disclaimer that my background is as an engineer, not as an economist, so keep that in mind as I ramble on about the commercial lending outlook.  While I have a background that includes engineering economics, perhaps more relevant to this topic is that I happen to enjoy reading about what is going on in the financial world and like to treat it all as a big spreadsheet where I can play “what if” games in my mind to try and project the financial future.  But I’m not going to write a book on economics or financial projections and try to fool you into thinking that I know all about the financial universe, either.  Nor will I claim to be one of the many real estate and business ”gurus” who say that they never lost money on a deal from being wrong about the future.  I’ve made nice profits but have also taken big losses as well.  Any investor, who has been in this business for a number  of years, who tells you that they never took a loss is either blatantly lying or isn’t really an investor and is making money under the guise of being a true investor by trying to sell stuff to you.

So with all the contradictory data on our economy telling us that we are in for better times and that our future is going to suck for a while at the same time, what do we do?  What will really happen with the commercial lending industry?  I don’t know for sure but will take an educated guess and would like for you, dear reader, to try and poke holes in my logic so I can learn as well.

Investing is more than just numbers.  Investor sentiment, i.e., human emotion, plays a big part in how assets are going to perform and what returns on investment will be realized.  Regarding commercial income properties, capitalization rate (“cap rate” for short) has typically been more useful as an indicator of investor sentiment than as an indication of what kind of returns you can expect to get on your money invested in a deal.  Keeping in mind that our most recent recession supposedly started in December 2007, let’s take a look at how commercial real estate cap rates varied both pre-recession and afterwards.

When the market was booming prior to 2007, investors gambled on the future by assuming that net operating income (NOI) would always increase each year.  This increased demand for commercial income properties drove purchase prices up and cap rates down as people paid premiums with the belief that their purchased assets would “grow” into their purchase price, much like how you might buy big clothes for a young child assuming that the child will “grow” into them.

Around the middle of 2007, people started to realize that maybe things weren’t so hunky dory and decided to take less risk with their money by buying commercial assets at lower prices and driving cap rates upwards.  In an ideal world, in order to achieve the same investment returns, purchase price should fluctuate proportionately with NOI such that cap rates should remain approximately constant.  But as can be seen, cap rates started rising rather drastically from the middle of 2007 til 2009 when some economists believe that our recession ended (Hah!).  This shows a complete change in investor sentiment in that they no longer want to try to ”grow” into the future but have realized that there is no guarantee that the future will produce income growth.  Using the previous “growing child” analogy, it’s as if you realized that your child stopped growing after buying clothes that were too big with the expectations that the kid would “grow” into them, and then realized that it ain’t gonna happen after watching the poor kid trip around in them for several years.

Therefore, investors today, especially those in commercial lending, are still very protective of their principal amounts and pay lower prices for commercial assets which, in turn, drives cap rates upwards.  Being a quant is fine and dandy but you can’t put investor sentiment into a math equation and expect to get accurate results consistently.  So we are still in a time when investors are very cautious about their investment funds which is why cap rates remain higher than pre-recession levels.  It will take both better market fundamentals as well as increased investor confidence to get our commercial real estate markets to where they were when times were good prior to 2007.  Better market fundamentals, alone, won’t do the trick.

Okay, so all this cocktail-party psychology is nice, but where are the commercial lending and real estate markets headed?  How will an understanding of economics help us understand and project the future of these markets?  My opinion: it would probably be more appropriate to view this from the eyes of a political or social scientist rather than think about this like an economist.  Let me explain my thinking.

Most commercial real estate mortgage loans are interest-only loans.  Prior to 2007, this served two important purposes.  First, because the principal balance was never paid down, it ensured repeat business for the lenders when the loan term ended and property owners would refinance them into new loans.  Second, the payments on interest-only loans are significantly less than amortized loan payments on the same principal amounts so this helps property owners by giving them higher cash flows as well as the lenders by reducing the chances that there would be defaults on loan payments.  Here’s the problem…

According to the Congressional Oversight Panel, $1.4 trillion in commercial real estate mortgage loans are coming due by the year 2014.  Because of the previously described combination of deteriorating market fundamentals and lower investor confidence levels, properties have lost as much as 40% of their values from when many of these loans were made at the height of the market back in 2007.

How does this affect commercial lending?

Many of these loans were based on the London Interbank Offered Rate (LIBOR) interest which were at ridiculously low levels during the height of the market and have since been driven even lower by government policies.

Unlike many residential mortgage loans, typical commercial mortgage loans are not amortized for 30 years.  They are often interest-only loans that become due in less than 30 years, e.g., five to 25 years, after which it is standard operating procedure to refinance into a new loan with similar terms.  As mentioned in a previous blog post, our country is $14.26 trillion in debt and running at a deficit easily exceeding $1 trillion a year.  The only ways to reduce this debt are to increase income and reduce expenses.  Inevitably, interest rates will rise because of politics.  LIBOR will rise.  Commercial mortgage loan interest rates will rise.  The commercial mortgage loan debt service will rise as well upon refinancing into new loans with all of these loans coming due if the lenders want to even refinance at all.  I doubt that landlords will be able to squeeze enough income from their tenants to match the increased debt service and can only see increases in commercial mortgage loan defaults coming our way just from term expirations and not even including payment defaults.  Also, many lenders will not be able to allow refinancing since loan-to-value (LTV) will have drastically increased above their maximum limits because of decreases in property values.

While this has been a very simplified post on what we may expect in the commercial real estate markets, there are still plenty of good deals to buy as long as you factor in the effects of politics and investor sentiment into your purchase price.  To close this post, I’d like to ring the dinner bell for my fellow vultures with a brief list of commercial properties from my database where loan terms have come due already.  If you can negotiate directly with the lenders or owners, you may be able to get some incredible deals:

Bon appetit, my fellow scavengers!

Eat hearty by taking advantage of the present commercial lending environment rather than becoming a victim to it.