The Construction Loan Net-Worth-to-Loan-Size Test

The other day we had a request for a new commercial construction request for an apartment.  The total project was around $10,000,000 with the borrower putting up the land, estimated to be worth $1,000,000 and then putting in another $1,500,000.  Things looked good until we got down to the net worth of the sponsors.

These gents were highly leveraged and only showed a net worth of $500,000.  What?  The sponsors want to borrower $7,500,000 and only have a net worth of a paltry $500,000?  When you dug down into their balance sheet, most of the equity was tied in an estimated equity of real estate.  Cash and investments were reported at less than $20,000.  Given these items, what financial strength does the sponsor have to support the deal?

An old rule that I learned when looking at construction projects is the sponsors on the project need to have a net worth at least as large as the construction loan they are requesting. This would especially apply in the case of a spec construction, but some other types such as an SBA guaranteed project would not necessarily apply.  In this case the $7.5MM loan would be matched with sponsors with at least $7.5MM of net worth, and not inflated equity net worth, but financials that are realistic. 

Now in times when lending is tight, some lenders want to see this ratio at 1.5 times or more.  In times when lending rules are easier, lenders rarely will go below a net worth to loan ratio of 0.75.  This project did not have sponsors substantial enough to pursue the deal further.  Now there may be a lender out there who is desperate to put loans on the books may close the loan.  We call that the greater fool theory.  You do not want to be the greater fool.

Back to our example, was the net worth only $500,000?  When one looks closer, if the land is free and clear, not listed on their personal balance sheet, and if their money they are putting into the deal as equity is not generated from other borrowers, that would be $2.5MM will be equity.  If we add that to the $500,000, they at least have $3MM of equity.  It still falls woefully short of the loan request, but at least it looks a little better.  We refer this to a case where this shade of lipstick looks better on the pig than it did in the beginning!  But it is still a pig.  The ratio is 0.40 and the request appears to be seriously flawed!

What does the ratio tell you?  If the sponsors do not have adequate net worth, or assuming the personal financials represent inflated equity numbers, the guarantors will not have adequate resources to help either with as cash from liquidity on the balance sheet, borrowing against an asset with equity, or cash from the equity of an asset that would be sold.  If something goes south on the project, the lender is stuck with finishing the project or foreclosing. 

Is this ratio set in stone?  Say you are close on a deal with a ratio of 0.85.  Perhaps most of the net worth is from unencumbered liquidity.  Maybe they have strong income, very low personal debt service, and a large amount of equity in marketable real estate with a very low leverage.  The lender should ask, “How easy is it for the sponsor to put more money into the project if necessary?” 

I have seen cases where the ratio is good, but the equity is from a large array of partial interests in other real estate projects that are all highly leveraged.  If this sponsor were required to bring more cash to the table, he would have had difficulty since he did not have the power to leverage the properties on his own and if he did, it would require quite a few properties to be pledged to generate any substantial amount of liquidity injection. 

Like all other ratios and guidelines in commercial lending, no one is the cure-all to answer all your risk questions.  Each one, when used appropriately, can offer insights into the financial situation of the various players in your credit. 

Will the Hospitality Boom Continue?

Hospitality had an incredible year in 2018.  The travel research firm STR reported U.S. hotel revenues at $218 billion, up $10 billion from 2017.  This is an all time high.  Profit also topped $80 billion.  Occupancy and revenue per available room (RevPAR) have both grown each year in the past decade.  Marcus & Millichap is predicting a 66.5% occupancy rate for 2019, which would be a 30-year record high. 

The questions are what has caused the bull market for hotels in the first place and how long can this last? 

Skyler Cooper, director of Marcus & Millichap’s National Hospitality Group, cites the extended period of U.S. job growth with higher earnings, economic expansion and consumer confidence all have led to higher leisure and business travel.  The industry has also benefitted from an increase of foreign investment, with 12.3% of new hotels being funded by sources outside the U.S.  The highest proportion of foreign investments land in New York, Miami, and San Diego. 

Large cities such as New York, San Francisco, Los Angeles, San Diego, Orange County, Boston, Miami, and Orlando have the highest occupancy rates.  Investment in these areas is often faced with high barriers to entry, less land that is available to build, high labor costs, more bureaucratic red tape, and longer construction time periods.  As a result of these challenges, secondary and tertiary markets with less hurdles to overcome are becoming popular, but even those areas are becoming crowded.  Cites like Austin, Texas, Nashville, Chicago, Seattle, and Detroit are all seeing substantial new supply. 

A lot of markets which have not had a good supply of hotels to support leisure demand in the past now are popping up with small hotels.  But this is not certain to get heads in beds if it is built.  There needs to be solid core demand generators and good supplement of leisure travelers.  One hotel I worked with in Denver had a very strong Sunday to Thursday crowd.  Their location to several sporting venues made anything on the weekend a bonus when the professional teams were in town.  But the business traveler made the bulk of the stable revenue stream.

Hotels seem to be on the leading edge of economic activity.  If the economy slows down, travel slows down.  More businesses will move away from the personal trip and opt for video conferencing (which will be more of a factor as technology progresses).  Individuals who may feel less real wage growth may delay some trips or select a less expensive alternative.  These trends tend to be on the front end of any economic trend, so any economic slowing will hit hospitality early.

Another headwind is the increasing labor cost and shrinking labor pool of possible workers in the industry.  One of the largest costs for a hotel could be housekeeping, desk, management, and sales staff.  Not only is there the increased cost to pay help, but there is also the high cost if you end up selecting the wrong employees. 

Costs for building new hotels has been increasing.  Some material costs are up with the new trade tensions and tariffs.  Construction costs on the labor side are edging up.  Contractors are seeing strong demand from apartments and mixed-use real estate.  The hotel developer is competing against strong demand in other real estate classes. 

Hotel rooms are also facing competition for room rentals from VRBO and Airbnb.  A few years ago, there was more panic in the industry with these competitors.  In some areas, the short-term rental market could capture 10-15% of room demand.  But now, the concern has subsided somewhat.  These players have been in the market for a few years and yet the hotel room rates and occupancy continue to climb.  Some municipalities are passing laws to level the playing field between a hotel and short-term rental.

Hotel developers should look at more factors than just the occupancy and RevPAR.  The growth rate of room rates, level of new supply, population growth, labor supply, employment growth, and infrastructure investment are all factors that should be considered.  Changes in demand should be inspected to see if this is limited to a certain brand, service level, chain, or even an event. 

Lenders are still looking at hotels, but the appetite is less than it was a few years ago.  Some are staying on the sidelines completely.  Others are complaining they are not seeing deals that are good enough currently.  It is hard to see the upside of a new hotel when you have high occupancy levels and not a lot of rate growth.  Increases in operating expenses, like labor, will have a downward pressure on operating profits.  Stress testing the historical or projected income stream is essential.  Having management that can identify any negative changes in the market and adjust quickly to bolster net operating income is important for the hotel to succeed.

Leverage rates should be lower on these properties.  Since there is a fairly high cost of basic operations just to keep the doors open, high debt service requirements will kill a hotel. Perhaps the ones which make it in the end are the ones who can put the extra 5-10% into the project. 

Who Spilled the Milk?

All failures provide learning experiences for us to grow from.  That is, if we are willing to take a critical look at the experience and accept the lessons!  Often, we are too busy to step back and view the landscape and history of a train wreck or worse, we just bury our head and ignore the hurt from the failure. 

This is true in any lending situation.  Anytime a loan goes south, it is a great learning opportunity for the lender and the team.  We must be willing to go to school on the loan and make changes in the places necessary. 

The first place to look is during underwriting.  Was the loan underwritten correctly?  Were any concessions provided to make the deal work which increased the risk?  Higher LTV?  Was a reserve account waived that should have been in place?  Were loan covenants weakened?  What loan exceptions were made to do the deal?

Perhaps the loan was underwritten according to your policy and procedures, but there are weaknesses in the actual policy and procedures.  One institution I worked for decided that they would not require any business financials on business loans that were below a certain threshold.  They decided writing these loans could not be underwritten efficiently.  After millions of fraud and losses, they changed their policy. 

One lender I heard of did a deep dive into a non-profit company and guarantors but failed to look at the operating director of the group.  It was a year after the loan was closed that they discovered racketeering charges toward the director which had existed prior to the loan closing. 

The second place to look is during the life of the loan.  Were financial problems adequately identified when they cropped up?  Was there an attempt to manage the credit and protect the collateral?  Was the borrower forthcoming with the problems or did they go into hiding? 

The life of loan look is not only seeing if problems were identified adequately, but were there adequate procedures to attempt to manage a problem credit?  One issue we learned was to have a standard for the quality and frequency of inspections for loans with commercial real estate as collateral.  One institution I was at allowed a quick drive by inspection on a piece of real estate which failed to show serious issues not viewable from the road.  Another one lost an SBA guarantee because they failed to do an inspection on the property within the proscribed time period allowed when an SBA guaranteed loan payment is missed. 

After this analysis, one should be able to determine where the milk was spilt.  Underwriting or during the life of the loan?   Was the problem isolated to this credit or a problem with your internal management structure, policy, and procedures as a whole?  Are there any changes which should be made there?  Was this a risk identification or risk management failure? 

This report should be written and reviewed as a group along with your policy and procedures on how to manage problem credits.  If you do not have these procedures, you should have a structure and plan on how to work through challenged credits.  Without this, it is like trying to run a professional football game without a playbook.  If handled properly, loan failures can be a marvelous learning experiences.  Perhaps this “spilled milk” report will help prevent future failures in the future. 

The Challenges of Alternative Energy Producing or Energy Savings Loan

Alternative or Green Energy has become a popular item in today’s world.  The opportunity to produce your own power or to install equipment which uses less electricity and is more efficient is appealing to most of us.  Not only do we save money, but we are also helping the environment.  Who would be against that?

Clearly there is a large upfront cost in producing your electricity or in purchasing equipment that uses less electricity.  Sometimes this comes to the lender in the form of a loan request.  How do you treat such a request?  Conventional wisdom would figure an estimate of the dollars saved in energy costs which could be used for other operational or loan servicing expenses.  Thus, one would add the savings back to the net operating income number and calculate debt service and free cash flow after based upon that.  But this leads to the question, “Will the borrower actually see these savings?”

A September 9 article from the BBC is titled, “Solar Panels: Thousands of Customers Complain.”  The article starts with a retired man from Rowlands Gill who took out a loan with Barclays of £10,000 over 10 years to install solar panels on his roof after being contacted by a salesman for PV Solar UK.  He was told the power savings would pay for the debt service requirements.  But the system fell woefully short and he had to dip into retirement saving in order to pay the loan.  An independent study found that even after 20 years of production, the income from the panels would not cover the loan.

The Financial Services Ombudsman has seen over 2,000 complaints and Barclays Bank is setting aside £38MM to deal with potential claims.

A little closer to home, in one of my banking positions, we had a food warehouse decide to update their entire cooler system with units which they were told, would use 2/3 of the power.  They made the decision to replace all of these, since the debt requirements were less than the projected savings on their electric bill. 

A year after the new equipment was operational, the company was seeing savings, but only 1/3 of what they were promised.  The company was able to continue to make all the debt payments, but the expected cash flow was not there. 

The City of Georgetown, Texas decided in 2016 to power the entire city by wind and solar sources.  They used grants and loans to establish their own power sources and purchase power from renewable fields with 20-25 year contracts for the energy.  By late 2018, the city was rethinking this structure as the cost of power for wind and solar energy ended up 20% higher than budgeted.  The city also paid more in 2016 and 2017 than was they expected to pay for power.  One city council member said the city’s accounting staff never considered what would happen if the price of electricity would go down when they created the forecasts. 

In the case of Georgetown, the higher expense is devastating to the city budget.  Power storage is also a problem.  Using only the renewable sources, there is enough power built up for electrical needs for one evening during a cloudy day in the winter. 

In each case, substantial amounts of money were spent on power producing or efficient electrical equipment or on renewable energy purchase contracts.  These all promised savings which did not materialize, leaving the owner with the additional cost of the debt or the opportunity cost of their cash investment. 

The lesson here for the lender, is to not fully count all the energy usage savings or the income from power generation from renewable sources when considering a credit request that would use renewable energy production or energy efficient savings when underwriting a credit.  True there may be some savings, but without substantial history, this projection is an unknown.  Basing your debt repayment on projected utility savings is risky and the projections often do not come true. 


Can Declining RV Sales Indicate an Economic Slowdown?

As an economics student, I enjoy stories of odd indicators to predict the economy.  Alan Greenspan had his dry-cleaning index where he thought a drop in dry-cleaning income is from a drop in disposable income.  He would also look closely at copper prices.  If prices were shooting up, this indicated more demand for copper in the building industry and showed future economic growth. 

 Another one is to watch the production of cardboard boxes.  When more are produced, there are more items that need to be shipped, indicating a healthy economy.   There have been some who have measured the width of ties and length of skirts as economic indicators.  Some think that increases in cheaper chicken consumption while seeing decreases in more expensive protein like beef are a sign of economic weakness.

One indicator is to look at recreational vehicle sales.  Now more than 80% of RVs sold in the US and made in Indiana and 65% of those come from the county of Elkhart, in the north part of the state near the Michigan border.  

Wholesale shipments of RVs are down 20.3% in 2019, following a dip of 4% last year.  Some manufacturers have been slashing output and cutting employee expenses with a shorter work week according to the Indianapolis Star.  The theory behind this being a leading indicator of the economy is that people do not purchase larger ticket items if they believe that tougher economic times are ahead.  Another item to look at are auto sales which declined 1.8% in year-over-year sales in July.

Michael Hicks, a Ball State University economist, states that since 1982 when RV sales were first tracked, that the recessions which started in 1990, 2001, and 2007 had two consecutive years of decreasing RV sales.  This indicator may not be complete accurate.  Kevin Broom of the RV Industry Association notes that RV shipments have dropped in five periods since 1981 but only predicted recessions which followed in three of the periods. 

Hicks thinks a large portion of the drop in sales is from increased costs.  Higher tariffs imposed on Chinese imports which are a big portion of RV supply inputs.  It is unclear how much of the drop in sales is from higher product costs and how much may be from trepidation over the future of the economy. 

Currently, we still see low unemployment, good wage growth, and consumer spending.  Time will tell if the RV indicator is correct in its current predication of a slowing economy.  It is fun to see how various factors interact to help us decode the future.

Mid-Year View of Agriculture

Looking back at 2018, net farm income without Market Facilitation Program money was below $60 billion, this was levels not seen since the 1980s.  MFP government subsidies totaled $5.2 billion and direct farm payments were slightly below 30% of all net farm income.  The Chief Economist at the USDA expects net farm income to increase slightly in 2019 but will remain below $80 billion annually over the next decade.  We will see subsidies exceed another $14.5 billion this year.  This trend has been repeated as every outstanding age for agriculture is followed by a decade of poor performance.  Agriculture net profits have fallen significantly from the $150 billion in 2012. 

The new farm bill was signed into law in December 2018.  This is similar but not a great departure from the 2014 farm bill.  The new bill did make some significant improvements in the USDA and FSA guaranteed loan programs.  It is interesting that 76% of the expenses in the farm bill are tied to nutrition programs and food stamps. Food stamp enrollment has dropped from nearly 48 million people in 2012 to down to 36 million in May 2019.

The Minneapolis Federal Reserve Bank is reporting a rising level of bad agriculture loans among the 531 banks in their district.  A current report from the Creighton University monthly survey of bankers shows that 40% of bankers believe their biggest challenge in 2019 is agricultural loan defaults.   Farm liquidity is weakening, and farm equity continues to burn off with refinancing operating lines which cannot be retired from operations.   Losses in working capital is generating increases in debt.  The USDA expects year ending 2019 farm debt to exceed 1980s levels. 

Farm values in the Tenth Federal Reserve District are stable and not declining rapidly.  Nationally farmland was up in 1.9% in 2018 compared to 2017.  There is still much wealth in farm land as leverage is relatively low.  Consider that in Iowa, 82% of the farm land is debt-free. 

One thing which may help improve prices is the drop in planted acres of wheat and soybeans this year.  Extremely wet weather and a longer winter prevented some farmers from getting crop in the field.  This has helped move some commodities prices higher, but not substantially.  On the critter side, the national cattle and swine herds are both seeing more in their numbers which is helping hold prices down. 

Perhaps the biggest wildcards in agriculture is trade.  U.S. farmers collectively export over 20% of what they produce.  We are the largest producer of beef, soybeans, and corn in the world and the largest exporter of beef and corn and second largest exporter of soybeans.  One of the focuses of Trump’s new trade deals is the level the playing field and give a fairer playing field for American agriculture.  But accomplishing this is causing some pain in the short term.  Sorghum exports to China have dropped by nearly 75%.  China is buying 74% less soybeans compared to last year.  But other countries are purchasing more beans so overall exports are down by 20% from last year’s levels. 

A factor in China may be the strong demand for pork and the dwindling swine population.  The average Chinese citizen consumers 88 pounds of pork a year compared to 33 pounds of beef and chicken combined.  On the production side, China represents 50% of the world pork production and 20% of the world pork imports.  Pork producers in China have a serious problem with African Swine Fever which has a 95% mortality rate and no known vaccine.  This disease has reduced the hog population from 8 to 16% and a reduction of 24 billion pounds of pork production from last year.  Total global pork exports will be around 19.4 billion pounds in 2019.  So, if all pork exports went to China, it will not fill the drop in pork production in China! 

As we see the negotiations with China grow more intense and then quiet, and we also see tariffs imposed and reduced, one issue to consider is Hong Kong.  For a quick history lesson, when Great Britain handed over Hong Kong to China in 1997, China agreed to allow the people if Hong Kong to operate as a democracy, even though it was owned by a communist country.  Some of the recent moves to restrict freedoms in Hong Kong have sparked protests from the citizens there.  If the situation ends with the Chinese army and tanks crossing into the territory, it will probably create a huge cooling in trade talks. 

This blog has hit some key points in agriculture this year.  To summarize, farm income is expected to increase from last year.  Agricultural loans are still a challenge and will be a major issue lender must manage in 2019. Most commodity prices should increase slightly from 2018 levels.  Farm management is very important in a time of weak profits and those who can get an extra 5% production, cut expenses by 5%, or lock in their prices just a little better will be the producers will be viable in the future.  Finally, trade will continue to be a wild card.

Managing Commercial Real Estate Interest Rate Risk with the SBA

We are in a current environment where interest rates have dropped substantially over the past year.  The 5-year US Treasury sat at 2.72% a year ago and is now at 1.43%.  The 10-year was at 2.82% a year ago and is now at 1.84%.  Yesterday, the yield curve remained inverted with the one-month T-Bill ending at 2.09%, while the 30-year T-Note ended at 2.04%. 

Inverted yield curves have been a signal to a recession.  Usually the recession comes 12-18 months after the yield curve inverts.  But in each case of rate yield curve inversions in the past, it is started with the Federal increasing the short end of the interest rates beyond the longer end.  Zach’s Investment Management cites that the low long-term yields prevailing in the current markets are partially attributable to special factors.  The Federal Reserve still is holding many long-term treasuries they accumulated through its past quantitative easing policy.  The United States is also viewed as a safe haven to invest in as we have one of the few industrialized economies which continues to grow.  Also, there is nearly one trillion dollars of sovereign debt which now is at negative interest rates.  Investors will put money in the U.S. with a positive yield and growing economy compared to some other countries with a negative yield and contracting economy.

This slight inversion, or really a flattening, of the yield curve is flashing a recession signal is yet to be seen.  But the important point I want to chat about is that your borrowers also know that the interest rates are lower.  Some of the current market rates are substantially lower today than the current interest rate on their loan.  As such, you may be experiencing requests to refinance their loan to take advantage of the current low interest rate.  As a lender, you may not be thrilled in giving up an asset that is earning interest at a higher interest rate for one that may be a point or two lower, or maybe even more!  But if you don’t bite on their request, the local banker down the street will be very accommodating to this request from a good borrower.  If you let the borrower go (and some borrowers, you will celebrate when they leave) you must replace that earning asset with ones at a lower market rate. 

One option may be to consider using the SBA 504 program to help refinance the loan on owner-occupied real estate.  Now this cannot be used to shift risk of a problem loan to the SBA.  It may be a tool that you can off-load some of the commercial real estate debt to a fixed interest rate loan of up to 25 years, and still keep a smaller first mortgage and continue to keep the relationship. 

The current interest rate for a 20-year 504 SBA loan for this month was 3.53%.  The 25-year rate is at 3.63%.  These are incredibly low fixed interest rate for borrowers.  The 504 loan is in a second mortgage position behind your first mortgage.  You still have flexibility to offer a fixed or adjustable interest rate on your first, you just have to have at least a ten-year term on your loan and an amortization that produces a repayment which is at the same rate or slower than the 504 loan.  These low interest rates are creating an increase of 25% nationally in 504 applications compared to the previous year. 

The 504 option may help you refinance some desirable commercial loan relationships that are currently held at other institutions.  It may also help get new business projects.  The typical 504 loan structure has a lender first mortgage at 50% of the project and an SBA 504 second between 30-40% with the borrower putting in 10-20%.  There are other requirements and you should check with us or with your local Community Development Corporation working with 504 loans for information on your specific project. 

Understanding Cash-On-Cash Return for the Property Investor

One thing you look at when you check out your brokerage or 401k statement, is the rate of return of your investment decisions.  This is calculated by taking the price appreciation and dividends earned on a stock, and dividing that total by the price you paid for the investment.  This number is usually annualized. 

As an example, take Coca-Cola (KO) stock.  A year ago, from the time I am writing this, the stock traded at $46.09/share.  Today, it sits are $54.33/share.  The stock paid dividends equal to 3.01% in the past year.  Now if you purchased Coca-Cola a year ago, the price of the stock has appreciated 17.88%.  If you add the dividend yield, you have a return of 20.89%.  Now we will focus on the cash-on-cash rate of return.  Clearly, there are other factors to consider when purchasing investments; appreciation, tax benefits, and after tax income are a few. 

The astute real estate investor will look at rates of return when considering investing in an income property compared to other alternative investments. Profit is made each year of ownership of an income property and realized at the time of sale.  The annual income percentage is calculated by taking the cash flow after debt service (CFADS) and dividing it by the cash investment the investor made to purchase the property.  As an example, if Joe Investor pays $3,675,000 for a net leased office building and receives $227,369 in CFADS, the cash-on-cash return is 6.2%. 

If the investor borrows money, it reduces the amount of money they have to personally spend on the property.  If the denominator is lower, than this should increase the rate of return, right?  The correct answer here is maybe.  Now we have all worked with borrowers who think the more money you can lend them, the higher their return will be.  This may or may not be the case.  It depends if the leverage environment is in a positive, neutral, or negative state. 

During most of the decade after the Great Recession, investment real estate in the United States was in a positive leverage environment.  If you were to add more debt to the real estate purchase, the cash-on-cash return would increase.  From an investor who is attempting to maximize their cash-on-cash return, borrowing more made sense.  Doug Marshall, author of Mastering the Art of Commercial Real Estate Investing, outlined three good scenarios using the numbers above and exploring the three different states of leverage.  First, consider the chart below for the impact of positive leverage. 

positive leverage.png

Again, note how in this case, the cash return increases as the real estate investor puts less of his money into the property.  This leads to the next scenario.  Can it be possible that the amount of debt has no bearing on the cash return?  The answer is yes.  Consider this chart. 

neutral leverage.png

If you think that adding debt or adding equity can change the cash-on-cash return, there are possibilities where this is not so.  Is there a possibility that the more debt is added, the lower the return will be? Consider the third chart

negative leverage.png

You will note the different factor in each of the three cases is the interest rate.  For a portion of 2018, a negative leverage environment was present in commercial real estate, meaning the higher the property loan, the worse the cash-on-cash return will be.  This situation curbed some astute investors’ appetite for borrowing on these real estate investments. 

The environment changed from positive to negative with a significant rise in interest rates that was not followed by an increase in the cap rates.  When interest rates rise, the higher mortgage payment reduces the property’s cash flow after debt service.  Lower CFADS lowers the cash-on-cash return.  To reduce this trend, the property value would need to drop or the cash flow before debt service would need to increase. 

A protracted negative leverage environment may point to a correction in real estate prices.  Other factors that may point to an drop in the real estate market could be increasing interest rates, moderating rental rate increases, excess real estate supply coming online, increasing vacancy rates, increasing rental concessions, or more regulation to restrict property owners.  Recent decreases in interest rates have moved many U.S. markets back to a positive leverage environment.  But if markets move back to the negative, buyers will pull back and may elect to pay capital gains and hold their money on the sideline instead of paying for overpriced properties. 

Lenders, and astute investors, the cash-on-cash calculation should be made at an interest rate that is stressed higher than the initial rate on the credit, especially if the holding period for the real estate will exceed the first interest rate and payment change for the loan.  Using an underwriting rate in the analysis is a sound judgement of the transaction’s ability to perform.  Will the property be able to experience a higher cash flow before debt service to offset the higher mortgage payment and keep the return intact?

Now again, the cash-on-cash rate of return is only one tool to consider when looking at a real estate investment.  It is important to understand this calculation and the part it will play in the buy or not buy decision.

The Thinking Part of Leadership

If you have ever closely watched a professional baseball game, one thing that sticks out is the how much strategy is applied to the game.  This starts months before game night with the coaches and general manager assembling the team to be on the field.  The starting pitcher and those pitchers in the bullpen are set.  The manager fills in the lineup card after considering his team members and the matchups they will face with the other team.  By the time the opening pitch is thrown, mounds of data have been reviewed and analyzed to create a game plan.  The resulting game we watch is not random, but it a result of the review and plan of the data.

Consider a general who inspects the field of battle.  He uses his training, assessment of resources, terrain knowledge, weather, and other factors to set up a plan to defeat the enemy.  His acts are not random.  They are the result of training, instinct, and analysis used to process current data and continue to make decisions for the war.

In many cases, the actions of the baseball team and the general may seem to be random or uncoordinated to the outsider.  They are the result of months and years of deep thought.  Leadership starts as an intellectual activity.  Action is the result of leadership that we can see, but action is the result of thinking.  The harvest of successful leadership actions must begin with the sowing of seeds of thoughts.  If the wrong seeds are sown, the desired harvest will not be seen.  Albert Mohler states, “Our actions may never reach the heights of our thinking, but you can be certain that the quality of your actions will never exceed the quality of your thinking.” 

Hence, good leaders are characterized by careful attention to thinking.  I believe a problem here is that most of us don’t want to put in the intense effort thinking requires.  We would much rather veg in front of the TV or check social media than engaging in focused, critical, and careful thinking.  Most flitter from thought to thought like a butterfly, without serious reflection, analysis, or questioning their own decisions.  Most are not seriously interested in the discipline and process of deep thinking. 

Leaders, like most others, operate on instinct, habits, and hunches at times.  What is different from a leader from a non-leader is the effective leader will bring these under the control of deep and right patterns of thinking.  Look at a well-run company.  It is not the result of luck.  The leaders there devote intense energy to thought. 

Leader’s thoughts must tackle the truth of today, no matter how harsh it is.  We tend to see through rose-colored glasses when we view problems that we hope will go away.  It is like the Peanuts cartoon where Linus asks Charlie Brown, “Is it better to solve a problem right away or think about it for awhile?”

Charlie Brown replies, “Definitely to think about it awhile.”

Linus asks, “So you can think of the right action for the problem?”

“No,” Charlie Brown replies, “so you can give the problem time to go away!”  Unfortunately, as leaders we sometimes take Charlie Brown’s view on problems.  While we do need to strategize, we must also use those thoughts as springboards for action instead of analysis paralysis.  I find this true in lending.  It is rare when a problem crops up with a borrower that just goes away on its own.  Oftentimes, they get worse.  The best end solutions for problem loans I have managed have centered around strategic thoughts shared with the borrower.

Successful leaders think strategically.  Why?  Strategic thinking simplifies what is difficult and forces us to ask the correct questions.  It matches strategy to the problem and prepares you today for an uncertain tomorrow.  Deep thinking produces the immediate responses to insure success and reduce the margins for error.  The problem is that good strategic thinking is taxing and requires intense efforts.  Some are not willing to give it. 

John Maxwell in his book How Successful People Think gives seven strategies to think strategically.  I believe these are valuable to consider.

1.       Break down the issue.  Focusing on smaller, manageable parts allow you to tackle a large task little by little.  Henry Ford said, “Nothing is particularly hard if you divide it into small jobs.”

2.       Ask why before how.  If you jump right into problem solving mode, how do you know you are solving the right problem?  Eugene Grace stated, “Thousands of engineers can design bridges, calculate strains and stresses, and draw up specifications for machines, but the great engineer is the man who can tell whether the bridge or machine should be built at all, where it should be built, and when.”

3.       Identify the real issues and objectives.  William Feather wrote in The Business Life, “Before it can be solved, a problem must be clearly defined.” 

4.       Review your resources.  A strategy that does not review the physical assets, people talent, reputation, and current reach is often doomed.

5.       Develop your plan.  Start with the obvious to bring unity and consensus to your team, then build momentum and creativity from that point. 

6.       Put the right people in the right place.  If you have the wrong person, you will have problems instead of potential.  If you have the right person in the wrong place, you will have frustration instead of fulfillment.  If you have the wrong plan altogether, you will have grief over growth.

7.       Keep repeating the process.  Olan Hendrix stated, “Strategic thinking is like showering, you have to keep doing it!”

Hopefully, some of these ideas will convict you of the necessary to carve out time regularly to think strategically.  This is a hard discipline which will pay great dividends.

Where Did All the Houses Go?

You may be in an area of the country where it is quite difficult to find a house to purchase.  Many places this is a seller’s market where the seller has more leverage on prices and terms than the buyers do.  Freddie Mac estimates the U.S. is about 2.5 million units short based upon the long-term growth projections.  The Urban Institute believes the situation is at crisis levels with annual shortfalls of 350,000 units a year due to underbuilding since 2009.  New-home construction has not kept up with population growth.  To understand the issue better, consider the following factors.

·         Housing starts total 1.3 million units in 2019.  The 50-year average is 1.6 million units a year.  Housing starts have been constrained after the recession due to shortages of land, labor, and materials. 

·         The U.S. housing stock is aging with the average house age in 2016 at 37 years old.  Now, over 50% of U.S. houses were built before 1980.

·         Today, millennials total 73 million people and baby boomers total 72 million people.  As the older generation ages, many are trying to downsize houses.  Millennials are beginning to buy homes.

·         The average seller has lived in their house for 8.3 years this year; this is a record high.

·         After the housing crisis, from 2007 to 2016, 31% of the growth in single family houses are rentals.

·         Note all this is occurring at a time when interest rates remain low and the availability of housing loans is plentiful. 

The deficit in house prices is driving prices higher for buyers and for renters.  The median existing house sale price in March 2019 was $259,400.  This is the 85th consecutive month of year over year price gains.  Rental prices are increasing as new rental stock is not growing as quick as population growth.  Additional inventory will help open up the housing markets to more possible buyers who have been priced out.  More rental stock will help moderate lease rates. 

Nationally, the crisis seems to be hitting the lower ends of the market harder.  Homes priced below $200,000 dropped by 8%.  Low priced inventories remain tight with only a three-month supply of homes priced below $100,000.  The upper end, with prices above $750,000, which is more than twice the national average price, is seeing more inventory with listing growth of 11%. 

One area of softening demand has come from foreign buyers.  According to the National Association of Realtors, Chinese buyers, which made up 25 percent of all foreign residential buyers in 2017, purchased 56% fewer homes in 2018 compared to the previous year.  Foreign investors from other countries have also pulled back on their appetite for U.S. residential assets.  A combination of the double-digit price increases and strengthening of the U.S. dollar have made these houses more expensive.  Also, slowdowns of other countries’ economies and clampdowns by some authoritarian governments on allowing foreign investment from the home country have also played a part in dropping demand. 

Though some drop in foreign demand helps price increases, solving the problem will involve many different actions.  On the builder side, creating more affordable units should help the lower price end of the market.  Perhaps more townhomes that allow for more units to be placed denser may help.  Prefabricated homes where part of the home is factory built to lower some of the cost may be another option.  This could drop construction time in half, but the public needs to get beyond the stigma that prefab housing is a sacrifice of quality compared to regular frame built.  Buyers also need to be patient when buying a newly built homes if they put a contract on a new unit that is just beginning to be built. 

Another option may be to use the new opportunity zones, one of the biggest tax breaks in decades which started with the tax overhaul in 2017.  The zones offer tax breaks to investors who improve property in one of around 8,700 designated areas nationwide.  Investors can reduce or postpone taxes from stocks, businesses, or investments by reinvesting them into these areas.  If they make “substantial improvements” and hold these for over 10 years, they may avoid taxes on future profits.  Designated zones are areas where over 30% are in a poverty status and unemployment is at 1.5 times the national average. 

Brett Theodos of the Urban Institute summarizes the possible impact of opportunity zones.  “The incentive is linked to appreciation, so its more likely to be used to build property assets that will appreciate over time.”  Some options are starting new businesses or building more multifamily housing.  This may help increase housing supply and lessen the pressures of low housing inventory. 

The Richmond, Virginia Association of Realtors created the Partnership for Housing Affordability, working with lawmakers to develop more affordable housing for the city.  The group created a community land trust to purchase and hold tax-delinquent properties which are turned over to nonprofit organizations to remodel and sell.  The land trust retains ownership of the land tract.  If the property is sold to an income qualified buyer, the land price is not included in the house purchase price.  When the house is sold years later, the owner keeps half of the appreciation and the other half goes to the land trust. 

Kansas City and Longmont, Colorado have created veterans as a population group with housing needs.  Both areas are creating tiny houses which are furnished that are available to homeless vets.  Vets can live in the homes rent-free while accessing onsite services to address employment and health needs.  As they secure solid employment and become healthy, they transition into permanent housing. 

In our current national housing situation, there are many different strategies which will need to be followed to help increase supply, stabilize prices increases, and create more housing opportunities for those who have been shut out of the housing market due to unaffordable housing with the current position of supply and demand forces. 

Identifying and Managing Rental Rollover Risk

Whenever you are financing commercial real estate that is leased to a tenant, there is a risk you must assess if a tenant will not renew his lease and the space sits vacant.  This will cause a drop in rental income for your borrower.  It may also increase expenses of keeping the space up with items such as utilities, maintenance, and property taxes.  The owner may have expense of tenant improvements (TI) and leasing commissions for a new tenant.  This risk is called rollover risk.

How does the lender identify this risk and how do they best manage it?  The first step is to consider the property type.  Residential rentals often have lease terms of a year or less.  It is common to have a bit of turnover among the tenants.  Focusing on the market vacancy rate will give you a good idea of the overall risk and you should underwrite the deal using either the market rate or your subject property’s vacancy rate, whichever is most conservative.  Neighborhood retail or office buildings may act like residential rentals if the market has strong demand and the subject property is attractive.

Further inspection is required if the rental property is larger, has significant amounts of the space leased to certain tenants, or is a special purpose property.  We looked at an office building in a major city with a large bank as one of the major tenants.  An analysis had to be done on the tenants, financial strength and what appeared to be their propensity to renew their lease in the underwriting.  Another challenge is a special purpose property.  A stand along restaurant building may have limited attractiveness and require much remodeling for a non-restaurant tenant.

On the other than residential rental properties, an inspection of the leases is important in underwriting.  The need for estoppels and subordination, non-disturbance, and attornment (SNDA) agreements are required from the tenants to validate the current lease terms and establish the relationship of the lender to the property. 

I once financed a building leased to the federal government.  The lease term extended beyond the term and amortization of our loan.  Thus, our rollover risk was very minimal.  Compare this to our office building of 70,000 sf with 65% of the leases of the space maturing prior to our loan term.  This became an important risk to consider in viewing the credit request.  The strength of the sponsors and guarantors will certainly be weighed as we consider how the risk is mitigated. 

At times the size of the commercial loan makes the risk greater than the sponsor’s financial support.  Some lenders will turn down the loan completely or limit the term of the loan, so it is shorter than the key lease.  If the commercial loan balloons at the same time of the lease expiration it the two are said to be conterminous.  This strategy does have risk.  What does the lender do if the key tenant does not renew as the loan matures?  If you call the note, the earnings from the property are now substantially depressed and it may be quite difficult for the borrower to find a new financing source. 

Another strategy is for the lender to hold back reserves for leasing commissions and tenant improvements.  Tis are leasehold improvements of custom interior finishes a landlord or tenant must make for office, retail, warehouse, or industrial space, to make the property useful for the tenant’s business needs for the property.  The amount of build-outs to be completed, or a tenant allowance, is typically negotiated up-front between the landlord and tenant and becomes part of the commercial lease agreement. 

Building a rollover reserve into a commercial loan greatly reduces the net proceeds to the borrower.  Borrowers do not like these reserves and you may lose the loan to a more aggressive lender.  Thus, you will have to judge how desirable the credit is compared to the overall risk for the credit, which rollover risk is a part. 

Another method may be to limit the loan to value to a level that you are comfortable in lending more if the sponsor needs financing to put a new substantial tenant in the building. 

Rollover risk is a part of the risk you will analyze when looking at the credit request.  It is important to identify this risk and to see what strategies can be implemented to manage the risk to a level acceptable to your credit standards.

The Low Margin Era of Agriculture

In a recent seminar, Dr. David Kohl advances that we have moved from a commodity super cycle peak to now an extended low margin era in farming.  By now, I hope that most producers have moved on from the peaks in prices we saw half a decade ago.  But multiple years of high prices are like an all-night party, the hangover effects tend to linger long after the soiree is over. 

New technology in agriculture will continue to keep supplies in excess of demand.  The producers who will survive the low margin era are those who are able to strategically embrace technology.  Nebraska had its first soybean field planted with a driverless tractor in May.  Last year, England had its first barley field successfully planted and harvested without a human setting foot on the ground.  These changes in technology will both lower the number of laborers and change the type of labor needed down on the farm. 

Another factor for the low margin era is the new worldwide resources of land that are going into production.  This year, new land which will go into ag production equals the size of the states of Vermont and Maryland.  Brazil, which is already getting two crops per year with some of their grain production is looking at how to now get three in a year.  This will continue to drive up supply.

Weather is always a huge factor.  We have seen producers in the middle of the U.S. this year who are not able to get a crop in the field due to the excessive moisture and flooding.  All these factors combined mean that huge profits we saw like the long home runs will be replaced with smaller bunt singles, base hits, and sac flies to get profits over the plate.  This will be a new era of managing expectations and a focus on the financial fundamentals of the producer. 

In the low margin era, the proactive producer will be the one who thrives.  These folks thoroughly understand and can effectively communicate their financials both on the farm and to external advisors.  They monitor their expenses and revenues be each line, knowing that a 5% increase on a revenue line and a 3% decrease in an expense line may make the difference between profitable and in the red.  Proactive producers have a well thought out marketing and risk management plan which they execute.  They are driven to outperform their neighbors in all areas.  All production assets of land, machinery, labor, and capital are fully employed.  Finally, they have a modest personal life and are not excessive spenders. 

Those producers on the struggle bus are often equity complacent.  They don’t seem to care about multiple years of losses as they have plenty of equity on the balance sheet.  They have growth issues with a lack of capital, technology, or management.  There is no transition plan to exit farming or know how to have the ranch successfully move to the next generation.  They are often unteachable, falling on one of two extremes.  The producer is either a victim with a cloud of problems that follow him like Pig-Pen, or he is the fount of all things farming and will not be taught anything new.  It is often in these families, you will see a lack of financial discipline and planning.  Spending will run wild and free. 

In the low margin era, it is more important now than in the past to accurately be able to monitor the management ability of your producer.  Everyone can close their eyes and hit a ball over the fence occasionally.  You want to see those who are heavily disciplined, working day in and day out to do the little things right.  We have a tool on the website that can help.  If you go to our agriculture tab here: at the bottom, we have an Excel sheet you can download called “Rating the Management”.  This sheet has 20 questions that rate the producer in areas of financial, production, marketing/risk management, and other.  I suggest that just as important as it is to risk rate your ag credits using financial analysis, it is also important to rate the producers.  Understanding these may help you know which ones you want to move out of your institution while there is still time and which ones are the ones to keep.

I would be amiss if we only focus on the producers in the current low margin era and leave out the lenders.  Some of you reading this blog may be in an institution which will not survive the low margin era.  The Federal Reserve is already raising the warming flag for small, heavy weighted ag credit unions and banks.  Some of you tend to want to bury your head in the sand and wait for this time to pass.  But you do not know when that will happen and when your head is buried, other parts of you are exposed!

First, make sure you are using financial statements and your analysis of the management as tools to communicate in your institution and with your producer.  Remember, you want to show the issues and give them options.  They will need to decide what actions to take. 

Next, make sure what the producer is saying is correct.  Is there actually grain in the bin?  Did the farmer contract his price?  Is there crop insurance?  The low margin era will test the honesty of some producers. 

Third, make sure you and all on your team are investing in continuing education, training, and personal development.  The time you think that you understand it all, is the time you will fail.  I suggest that everyone should have at least 40 hours, and probably more, training annually in areas of their job. 

Fourth, make sure you are calculating the financials correctly and critically thinking through what you are seeing.  Try to take off the friendship you may have with the producer or relationship with both of you coaching the same little league team.

Finally, remember as a lender you need to be conservative in good times, courageous in tough times, and consistent all the time.  By doing so, you can succeed as a lender in the low margin era. 

Mid-Year Agricultural Market Review

As I write, I am amazed that we are already in the second half of the year!  Where has the time flown? 

Now is a good time for agricultural lenders to take stock of the current economic conditions and then apply that knowledge as you assess your producers in your loan portfolio.  As I write today, soybean prices are off their May lows and have hit $9/bu.  Some of this increase may be on the news that China is agreeing to purchase American beans.  China also completed its first purchase of U.S. rice.  Corn prices have finally topped $4/bu.  Live cattle prices are down by 23% from their high earlier this year.  In any event, it will probably be a long time before we see prices at the levels we were at half a decade ago.  This is not primarily due to any trade issues; it is due to an oversupply of commodities in the world relative to demand. 

But even with some of the most recent rallies in prices, all markets are off their highs in 2012-2013.  The challenge is that operating expenses continue to climb, thus squeezing margins.  In many cases, you probably have farmers who have negative profits after factoring in living expenses.  One area that has stayed in the farmer’s favor is oil.  Now that the U.S. produces all its own oil and is now an exporter of oil, price swings from conflicts in the Persian Gulf are muted compared to what we would see decades ago. 

On May 10, the USDA released its report on World Agricultural Supply and Demand Estimates for this crop year.  The report predicts corn to drop to $3.30/bu. as abundant corn, beans, and wheat supplies in the coming year.  Soybeans will continue to have downward pressure.  Possible Chinese tariffs and a possible drop in Chinese demand due to the impact of swine flu on its hog population are cited.  This current ag economic cycle will put pressure on the average and below average business managers.  Farmers not being able to retire existing operating lines of credit are a leading indicator of additional ag risk to lenders.

Small agricultural based CUs and banks are at risk, if economic trends do not change.  The Federal Reserve of Kansas City published some recent trends showing small ag banks with assets under $500MM with at least 15% of their loan portfolio in ag production and real estate loans, have significantly increased ag originations since 2012.  This group accounted for nearly 50% of the ag loan originations in 2017-2018.  Another factor to consider is 22% of operating lines were done by non-regulated lenders last year. 

Consider that many of the lenders managing the larger complex credits are baby boomers in the twilight of their career.  Large complex credits are showing financial stress as issues like fraud are beginning to pop up.  Leading indicators of stress of heavy refinancing, increase in payables, declines in working capital, and partial liquidation are present.  When one considers all these factors, a perfect storm may be on the horizon. 

One may cite low farm bankruptcies and good debt/asset ratio as indicators that there is no crisis.  But these are lagging indicators of trouble.  Plus, debt/asset ratio has not suffered as land prices, which make up 83% of farm assets, have stayed strong.  Some of this is from demand from non-farm investors.  Other positive factors have been favorable interest rates and availability of crop insurance.  But, heavy land equity may lead to management complacency.  I visited with a producer in the past month who has experienced serious losses in the past four years.  Instead of setting out to make necessary structural changes, he is attempting to coast till he can sell his land, which is near a growing city.

What are some of the macro trends around the world to watch?  On the international trade scene, watch the new USMCA agreement which is replacing NAFTA.   This group has 450MM people, with a very young population in Mexico as 47% are under ager 25.  The countries are heavy in energy production with the U.S. as #1, Canada as #4 and Mexico as #8 in oil production.  As ag trading partners, Canada is our biggest customer and Mexico sits at #3. 

The other biggest international trade factor is China’s Belt and Road Initiative.  China has invested $248billion of the $1 trillion it has committed to spend in countries in improving infrastructure and technology as they develop stronger trade partners.  This investment has been in 68 countries around the world with much of this in the new 5G technology. 

As you look at the world economy, we are seeing the rising of Asia and the decline of Europe.  In 1990, China, India, and Japan totaled 15% of the world’s economic output.  By 2020, those three countries will make up 25%.  This comes at a time when Western Europe drops from 31% to 22% of the world economy.  By 2020. The CIJ countries at 25% will also outpace the 21% the U.S. produces of world economic output.

We are seeing a synchronized global economic slowdown.  China is reporting the slowest growth in 28 years and has put substantial amount of central bank stimulus.  Urban real estate in China is highly leveraged.  It makes one wonder how long the trend can continue.  In other countries, both Japan and Germany are at 0 or a slightly negative growth rate.  Slower growth rates mean slower global demand for farm products. 

To sum it up, we are facing some significant challenges on the macro level for ag lenders.   In future posts, I will try to address some thoughts about judging your operational financial acumen of your producer. 

Declaring Our Independence

July 4th of this year marks the 243rd year since the enactment of the Declaration of Independence in 1776.  This document is one of the most important in history and outlines the basic principles that outline our society.  The subsequent document, the U.S. Constitution, forms a frame around the principles outlined in the Declaration. 

Thomas Jefferson begins the document with a statement that when “one people dissolve the political bands which have connected them with another…they should declare the causes which impel them to the separation.”  A large portion of the document outlines 27 different reasons why King George of Great Britain has become a tyrant and thus the colonies are justified in ending their relationship as subjects. 

The audience for the Declaration is not only King George but also mankind.  The first paragraph state that “a decent respect to opinions of mankind requires that they should declare the causes which impel them to the separation.”  It seems the signers realize their actions should be recorded for the world to see, as well as the mother country.  As well read as the founders were, it also stands to reason they expected this document to withstand time and be a written record throughout history.  But the document’s audience is even larger than history as the last paragraph states an appeal to “the Supreme Judge of the world”.

The first paragraph cites “the separate and equal station” and the second, “that all men are created equal.”  These statements stand in stark contrast of a system of royals and commoners, or the ruling and subject classes of peoples.   They are saying, “King George, you are just like us.  You breathe, you put on your pants one leg at a time, you bleed red like the rest of us.”  This principal of all men being equal has been a struggle in our country.  Eighty-eight years later, this principal was in the forefront of our leaders when they ended slavery.  No, our country has not been perfect in this manner, but the foundation is stated in the Declaration. 

So where does this come from, that all men are created equal and that equally created humans have rights of “Life, Liberty, and the pursuit of Happiness”?  The opening paragraph identifies these as Laws of Nature and Nature’s God.  This is followed by the next identifying the grantor of these unalienable Rights as the Creator.  The founders recognized that all this is granted by God, who rules over all affairs of men.  This is an interesting concept.  Many countries are founded on rights that are granted to the citizens by government.  Here the founders show there is a Power higher than a governing class of people and thus these rights are “self-evident” and cannot be taken away.

This follows in line with other great documents like the Magna Carta.  Government is defined as where it can rule and how it acts as the servant of the governed.  The Declaration states it as “Governments are instituted among Men, deriving their just powers from the consent of the governed, That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to abolish it, and to institute a new Government, laying its foundation on such principals and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.” 

The United States is the first country where the ultimate rights are with the people and this is recognized as an obvious fact everyone realizes.  No government can grant or take away those rights.  Those in government cannot be tyrants but must be servants to ensure the peace and safety of the citizens who have granted the government the task to lead.  At the point of this writing, this concept flies contrary to most other countries and empires where citizens are servants of the government. 

The writers realize that this document will start a conflict.  Jefferson ends the next to last paragraph with a statement that we will hold the British “as we hold the rest of mankind, Enemies in War, in Peace Friends.”  The signers knew this document would be costly as it required them to pledge their lives, fortunes and sacred honor.  For some who signed it cost them these things.

On this Independence Day, I encourage you to take a few minutes and read the document that started the whole experiment in liberty which we call the United States of America.  Realize a few of the foundational principles that make us different from other nations.  Celebrate the liberty we have and what it is grounded in.

Splitting Hairs and Risk Grades

One of the challenges lenders face is how to accurately assess the risk at origination for commercial or agricultural credits.  The next challenge is to continue this review of the risk through the life of the loan. As important as assessing the risk is, it is more important to reassess your risk rating models and scale.  If you have a scale or model that is in error, then the risk in the entire portfolio will be misread. 

In measuring risk, the starting point is to figure out what you are trying to measure.  When you book the loan, and through the loan’s life, you need to assess what is the probability that loan will default or PD.   Default may mean different things to different institutions.  Many times, when default is noted from a Fannie or Freddie perspective, it is a loan which is 90 days or more delinquent on a payment.  Of course, there are other types of default, such as payments that are only 1 or 2 months late or not following through on a loan covenant.  But for the focus on a risk model, it usually has a goal of predicting the probability that a loan will hit a serious payment default or worse status. 

Say you have a risk rating scale that generates one single resulting scale, then you should be able to apply a certain percentage for loan loss for all the loans in a rating category.  An example is your least risked loans may all be cash secured, so there is no risk of loss.  The next riskiest category, you may determine has a 1/100 of 1% loss and so on.  When looking at a traditional Allowance for Loan and Lease Losses (ALLL), you should add the loss percentages in each of these categories together with any special allocated losses you have on loans that are doubtful or worse loans, you should have a total for your allowance for the portfolio.

But other factors must be considered other than a PD to figure the allowance.  The next question is what your exposure at the time of default would be, or EAD.  What would be the projected balances on the loan when it defaults.  Loan balances will decrease with regular amortized payments or with prepayments of principal.  This is the probability of attrition, or PA.  The general condition of the economy and the interest rate cycle play a part in PA.  For example, if you have loans at a higher interest rate compared to current market rates, there is a higher chance loan balances will decrease with refinancing higher interest loans for lower, current rates.  Other prepayments may come when collateral is sold, and proceeds pay down the loan. 

The next factor in loan losses is what loss you have given default or LGD.  By this step you have figured the PD, which is a factor of the company performance, financial status, and to some extent, guarantor support.   The EAD is based upon projected balances at time of default, which looks at the PA.  LGD looks at the loan to value, presence of government guarantees, and involves some look at the guarantor strength.  The LGD would look forward based upon the economic conditions and other data points you study to figure your new loan loss under the Current Expected Credit Loss, CECL. 

Mixing all these factors together could be done in one comprehensive risk rating model, but it can be a little challenging.  A bad rating in the PD can be overshadowed by a good rating in the LGD and vice versa.  There is value in splitting the risk grades of the PD and the LGD into separate models to figure a better figure for loan loss reserves.  This way both sides of PD and LGD, can be captured more accurately.

I once had a loan to a company who experienced a severe drop in business.  Their financial status as a borrower would put this at a doubtful or loss status as the borrower cannot make regular payments anymore.  But the actual loss I had was nothing since we closed a loan at a 25% LTV and believed the property value to be like the date we closed the loan.  The LGD was $0 due to our collateral position. 

Consider a loan with a government guarantee. If the borrower goes to default status, your LGD is first based upon the difference between the loan and the net collateral value after selling, administrative, and legal expenses.  This LGD could be split into two with the enforceable government guarantee being set for a full recovery and the non-guaranteed portion as a total loss.

On the other hand, I once had a loan to a doctor clinic apart from the real estate.  The PD here was very low with a long history of strong financial performance of the clinic.  But if something happened, we would experience a substantial loss.  Our collateral of used furniture, medical equipment, and computers would not bring ten cents on the dollar.  The LGD would be very high.  We lowered our risk with key life insurance on the doctor that would pay off the loan. 

Understanding each of the factors of PD and LGD is essential to your risk rating models which will impact your loan loss calculations.  Your goal here is to find reality and not skew a model one way or the other.  These rating models need to be reviewed constantly and changes made when conditions dictate. 




Lead Me with a Story

I grew up in an age of flannel-graph, puppets, and full color Sunday school art.  I knew stores of Noah and the flood, David killing Goliath, and Daniels in the lions’ den at a young age.  I could recount Samson’s strength, Moses leading the children of Israel, or Paul’s missionary journeys before I was proficient in math. 

Later, when our kids were young, every night was a request to read a story.  Sometimes it was from the Bible.  Other times it was Chester the Horse, or the classic, Peanut Butter Rhino.  My kids’ eyes used to light up as we flipped through the pages of the various tales.  I imagine that any parent experiences the same with their children.

This week, I was on the road visiting some commercial staff at a credit union.  The CEO, who has led his CU to an incredible growth, popped in the office and began to recount several stories on the golf course with prospects who are now members at the credit union.  The tales that he spun stayed with me for hours as I traveled down the road to my next stop.  I began to wonder why things were this way.  Why of all the things about the visit, the stories were the ones which stood out in my mind?

We are created as a narrative creature.  One thing that sets us apart from other animals is our part as keepers of stories.  If you note, most times you get together with a close friend that you have not seen in a bit, most of the time is taken with updates of life in the form of stories.  We cannot explain who we are without telling stories. 

The most important truths come alive with stories.  One of the older guys I have taught agricultural lending classes with is an incredible story teller.  I have found that explaining a facet of commercial lending, sinks in further with the hearer if I can dig up a story from the past.  I will have people recall the concept through a story than if I were to just cite various facts and figures.

Good leadership requires good storytelling.  Faithful leadership requires proper keeping and narrating stories that will help identify and execute the mission of the people he leads.  The strong leader will also know how her story fits into the larger story.  Many consultants focus on the importance of organizational mission, values, and vision, but these very important concepts mean very little unless there is a story of why we are doing what we are doing in the first place.  You start with the story and the rest follows. 

I am a history buff and have a minor in US history in college.  The reason I found this so interesting was a professor I had who was an excellent story-teller.  I could sit in his class for hours as he spun yarns about various events, people, and trends in history.  In fact, one of the biggest factors in selecting my major of economics, was because I had an Econ 101 teacher who was a great story teller and would could make the concepts of economics come alive. 

When I think of strong presidential leadership, the ones who could start with a story and end with action are often the ones who have made the most difference in our nation’s history.  Our most effective national leaders were masters in helping citizens identify with stories and lead others to do the same.  They then used this to rally the nation to a cause with the story being central.  I think of the fireside radio chats of Franklin Roosevelt, or the great Ronald Reagan standing in West Berlin asking for the walls to be torn down. 

Leadership that matters grows out of the leader’s own belief that the story is true, that it matters, and that it must grow and continue. The credible leader is based upon the leader’s identification of his or her story within the organization’s story.   Leadership that is disconnected from the story will often have no one following or worse yet, led to nowhere. 

In World War II, Winston Churchill rallied the British people when they were at their greatest crisis.  He told them of their history, how they were part of a centuries’ old civilization, of duty and sacrifice, how liberty was worth fighting for and how the right moral cause the British had in their struggle.  At the same time, in Germany, a very different story emerged.  Hitler told of great conquest, racial superiority, and elimination of any ideas that did not advance the German interest as he saw it.  Churchill’s story was true, Hitler’s was a lie, and the future of history was based upon which story prevailed. 

For those of you who lead, consider your story, and the story of your organization.  Do you know and understand your story and that of your group?  How well are you keeping the story?  How well are you telling this and living the story?  Success and positive leadership growth in your position and in life itself is based upon how well you are immersed and articulate the story. 

Retail Changes

It used to be that retail was based upon what people are buying.  People may go to Best Buy for electronics, Safeway for groceries, or Shoe Carnival for shoes.  Today what people are buying is now matched with how people are buying as determining the success of a store. 

Melina Cordero, the head of global retail research at CBRE captures this when she said, “Twenty years ago, when you wanted to buy something, you had to go to the store—it wasn’t a choice, it was an obligation.  But today, the store is no longer an obligation; it’s a choice.  We can choose to buy online as well as in the stores.  In addition, we have more choices than ever about where and from whom we buy.” 

How people are buying is forcing companies to look at brick-and-mortar storefronts.  Traditional stores are now creating a web presence to increase their reach or may be partnering with companies like Amazon or Etsy to get their product more exposure.  Online strategy must be considered when a retailer wants to increase business.  I have found that ordering items online and not having to go to the store, go through lines and haul all back home is a pain at times. 

On the other hand, strictly on-line retailers are finding value in strategically placed storefronts.  Some online stores like Casper, Untuckit, and Warby Parker are now opening physical locations.  Online shopping gives customers convenience, a vast selection, painless purchasing, and home delivery.  In-store shoppers can feel and interact with products.  They can take the product home right away and not have to worry about the time involved in shipping.  They also can develop the relationship with the retailer in terms of good service and advice.  

JLL notes that e-commerce retailers have plans for 850 physical locations in the next five years.  What many of these companies are finding is the customers prefer an omnichannel approach to buying.  Sometimes they want to purchase all online.  Sometimes apps are used to make a purchase.  Other times orders with convenient car pick ups are done.  Maybe the buyer wants to go in and experience the physical shopping experience where they can see and feel the product, develop a relationship with the sales people, and gain superior service after the sale.  A successful retailer today will be actively pursuing multiple channels in the sales experience. 

Cost is a factor driving the online retailer to consider the physical.  Marketing with Facebook and Google ads can only take you so far.  The spending may get higher than $10 per click just to push traffic to your website.  Then there is no promise that people will buy.  Now imagine an online retailer opening a physical location at the Mall of America, or any other place that will attract people from around the world to physically interact with their brand. 

This physical opening of a store by an online retailer produces “The Halo Effect” as dubbed by the International Council of Shopping Centers.  A physical store increases the overall traffic to a retailer’s website by 37%.  Emerging brands have a higher increase at 45%. 

I contributed to this when I was stranded in Minneapolis during a blizzard back home and needed to get clothes.  I stopped at an Untuckit store.  Now I have seen the commercials but never considered buying off their website.  The attentive staff helped me find my correct “Untuckit size” and I sent pictures of the various choices to my wife to pick.  I purchased a shirt and will consider buying something from the company online now that I have an experience with the product. 

For the retail real estate owner, these new trends present some challenges to the traditional methods of retail.  Landlords may move to shorter and more flexible leases to attract tenants that will drive traffic to their location.  Build out costs can be tricky as an online retailer may not have the capital to complete the work.  Measuring sales from a location is a challenge since the online retailer is offering an experience and may end up completing the sales transaction online later.  This may move rent overages from a hard and fast sales/sf to maybe a combination of sales + traffic/sf.  The mix in a shopping center is a challenge.  Do you just go for the solid credit tenant or focus on the cool new guys who may drive traffic but are not as financially sound? 

The lender may find a center that can cater to multiple channels of buying more attractive to others than those who only offer the traditional store experience.  This may become a factor to note when assessing the financial creditworthiness of the real estate or the retailer. 

Why Capitalism is Compassionate and Focused on Others

There is a title that immediately some of the readers will disagree with.  Some scream how unfair it is that some have more than others.  We see that with polls that show how 40+% of young American adults prefer a socialist economic system.  They have been taught to believe that a system of redistributed wealth is more compassionate than the evils of capitalism. 

These comments remind me of how often we encounter people who will cry out against something, only to be eventually have the same hidden issue in their own life but ten-fold times worse.  Often the protests are a diversion from their own failures.  My folks would say this is like “the pot calling the kettle black”.

A popular definition of capitalism is that it is rife with selfishness and greed.  No one shares anything.  They say it is a trickle-down economy, but it does not trickle.  Nobody gives away anything and capitalism is mean-spirited and uncaring.  It is easy to take the common voices at face value, but we must ask ourselves, is capitalism inherently selfish?

Andy Puzder, the CEO for Carl’s Jr and Hardees Restaurants for more than 16 years and a brilliant lawyer wrote a book in 2011 titled Job Creation:  How it Really Works and How the Government Doesn’t Understand It.  His latest book in April 2018 is titled The Capitalist Comeback.  He had a piece on Fox News a couple of weeks ago where he stated, “Our booming economy can still overcome progressive misinformation, propaganda, and myth.”

Puzder has a thought-provoking summary of the true focus of capitalism when he says, “In a capitalistic economy, the only way you can improve your life is by satisfying the needs of others.  That is by providing products and services that other people want at a price they can afford.”  When you think about it, this is true.  The only way you can succeed is if you change the focus from yourself to an outward focus on others.  You are forced to discover what the needs and wants are of others and then try to meet those with skills, talents, and items you have at an affordable price. 

I think this analysis is right on the money.  Capitalism also empowers the little man, the consumer as businesses vie for their attention.  This competition allows for many variations in quality and price, resulting in the best service or product at a price that people will pay.  “In a form of economic democracy, consumers vote with each dollar they spend, determining which businesses succeed and which will fail.  Henry Ford built cars for commoners, not for the nobility.  Steve Jobs created the iPhones for all of us, not government elites.  This is because the success of each business is determined by how well that business meets the needs of the masses—consumers.” 

Consider the production side.  Capitalism allows people to use their own time, talents, and treasure to develop skills and products as they see fit for the market.  There is no one centralized bureaucracy telling people what career they must pursue, what product they must produce, and where this must be completed.  People are free to develop these skills and products based upon their own free will and creativity.  They are not pigeon-holed into certain career at a specified location as a worker in a total command-and-control economy may be. 

Puzder paints an accurate picture of socialism that is different from what some in popular culture think today.  Socialism is the exact opposite of capitalism in its focus.  Instead of focusing on others and the market, in socialism you focus on yourself and your own needs. 

You succeed in socialism by getting more for yourself than others get from the limited amount of goods and services provided by the government.  People standing in a breadline in a socialist country are focused on getting enough to meet their need.  If you are lucky, you may be able to rise above the worker class and become part of the bureaucratic elite in a socialist society.  This drive is focused solely on self.  There is a same drive to succeed in capitalism, but there must be consideration given to the market and to others. 

This focus on others has provided the highest standard of living that has ever been known to man.  The capitalist model stands in strong contrast when one considers things we take for granted here compared to those which are not available in purely socialist countries.  North Korea does not have electricity available throughout the country.  In Cuba, most of the vehicles and appliances are like ones available in the U.S. sixty years ago.  In Venezuela, one of the richest countries in resources, food is very scarce.

Even though capitalism is outward focused, it is not equal in outcome, which nothing in life is.  But it offers the best focus on being better outside of ourselves.  I am reminded of a quote from Winston Churchill.  “The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries.”  When all around you is misery, it becomes very easy to focus inwardly.



Leadership Requires Convictional Intelligence

Talking about brain smarts is often a way to incite some conflict.  My wife and I once took intelligence tests and she outranked me on the scale.  At times she brings up those test results if we are in some discussions with each other.  Intelligence is controversial since it is inseparable from other kinds of issues.  In the middle of the twentieth century, educators, business, and political leaders thought that a person’s IQ was the key to unlocking the secrets of who would succeed and who would not.  I once was denied a job because my college entrance score was lower than what the interviewer had as a threshold.  I don’t think the interviewer appreciated me pointing out the abject absurdity of asking that question to a person who had taken the exam two decades earlier. 

Calvin Coolidge in his great quote on persistence notes that that genius is inferior to persistence as unrewarded genius is a proverb.  Education is inferior to persistence as the world is filled with educated derelicts.  Intelligence as mere intellectual ability is not a good projector of where someone will get in life or even about their ability to lead.  I once heard a college president say, “Be nice to your ‘A’ students as some may come back and teach at your institution.  Be nice to your ‘C’ students as some of them will come back and spend millions of dollars to erect a building on campus!”

Intelligence starts with the mental capacity to receive, process, and use knowledge.  But other forms of intelligence are just as necessary.  Howard Gardner, a Harvard psychologist, popularized the idea of multiple intelligences.  We may think of them as abilities.  Some of these may be musical intelligence, spatial intelligence, logical intelligence, or linguistic intelligence.  If all which was required for leadership success was a high IQ, then only those with the biggest brain would be the business tycoons, political leaders, and thought leaders of our society.  But, as we know, this is not always this way. 

In the past year, I read about emotional intelligence (EQ).  Daniel Goleman of Rutgers University studied 200 corporations and their leaders.  His findings showed that intellect was a driver of outstanding performance.  Skills such as big-picture thinking, and long-term vision were important.  But when the ratio of technical skills, IQ and EQ were measured as the ingredients of outstanding performance, EQ proved twice as important as all the others.  This was true for all jobs at all levels. 

Goleman identified skills of self-awareness, self-regulation, motivation, empathy, and social skills as important keys of leadership.  If a leader lacks elements of EQ, it really does not matter how smart he is.  Einstein was a genius, but he was not much of a leader.  Many of the world’s most mentally gifted people lack empathy and emotional skills to lead well. 

Another type of intelligence necessary for success is that of morals or ethics.  We often see examples in business or government where a moral failure may have produced a business success but led people to an outcome that was wrong.  We saw this with the push at Wells Fargo to build market share of its customers.  For years we knew of Wells as a place that trained people well but burnt through them with a heavy-handed management style that incited front line people to open accounts just to make sales goals.  Some did this jus to keep their jobs.  Some to make a bonus.  Some of these accounts were not real causing Wells to reap millions of dollars of profit, and a tarnished image at the same time.  Albert Mohler states that “financial intelligence will wreck itself without moral intelligence and the guidance of ethical reasoning.”

Mohler makes the case in his book, The Conviction to Lead, for a further type of intelligence necessary for leadership.  This is convictional intelligence.  A leader without any sort of base intelligence will not be able to communicate ideas effectively.  If a leader has a low EQ, they can’t connect with the people they are trying to lead.  A leader with misplaced ethics will lead people into a moral catastrophe.  But leaders who lack convictional intelligence will fail to lead people faithfully. 

Convictional intelligence begins with a basis in truth, and a strong moral compass.  For me, it begins with my faith.  The knowledge of truth should form habits that impact your thinking and rethinking as information is processed in the world around you.  Habits are part of all our lives.  Think about this morning when you awoke, cleaned up, got dressed and started your day.  You may not remember brushing your teeth or putting on your socks, but you did.  Some mornings you may not remember much about the drive into the office, yet you made it.  Why is this?  Your intelligence was at work in every one of these actions, but you are operating out of habit, reflex, and intuition.  These are three factors that point toward convictional intelligence. 

Habits of the mind tell much about us.  If you ignore the assistance of people around you, it points toward ingratitude.  If you devote yourself to constantly studying, it points to a habit or discipline of constantly improving. 

Reflexes are the second factor of convictional intelligence.  Much of this comes from attitudes.  Chuck Swindoll stated, “Life is 10% of my actions and 90% of my reactions.”  If you doubt that, think about how much of your workday is consumed with answering questions, responding to emails, and putting out fires.  Somedays, my entire time is one continuous set of reactions strung together.  Now reactions with proper grounding are very beneficial to leading others, while flying off the handle can stop progress in its tracks. 

The last part is intuition.  Steve Jobs was described as a master of intuition by people at Apple.  They tell how he would hold an iPhone prototype in his hands and run his fingers over each crevice and angle on the surface.  Then he would order modifications until it would feel right to his touch.  We call this trusting your gut.  I have asked our analysts once they have reviewed a credit and interacted with the borrower, “what does your gut tell you?”  A trained gut is often more beneficial than the sharpest mind. 

Convictional intelligence uses these things to lead.  It is also sprinkled with humility.  A good convictional leader realizes that he is always learning.  Churchill once said, “success was going from failure to failure with great enthusiasm.”  Another reason for humility is the knowledge that as a leader, someday and often multiple times, you will be called to give an account for your leadership.

High-Debt Borrowers Signal Warning and Can You Bank at the Post Office?

During my travels last week, I picked up a Wall Street Journal and found two articles interesting in the May 14th edition.  The first is by Bob Eisen and is titled “More High-Debt Borrowers Backed by Fannie, Freddie”.  It starts, “The gatekeepers of the American mortgage market are increasingly backing loans to borrowers who have heave debt loads, highlighting questions about mortgage risk as policy makers debate ways to change the system.”

In 2018, nearly 30% of all mortgages that Fannie Mae and Freddie Mac packaged into mortgage backed bonds, went to home buyers whose total debt payments exceeded 43% of their incomes according to Inside Mortgage Finance.  This share has doubled since 2015.  In my banking career when I was doing home loans, the threshold was at 36%.  I remember vividly when the limit rose to 38% and the debate within our shop, as to if this was leveraging customers too highly. 

But these hard and fast debt/income ratio goes out the window with the new computerized algorithms used to underwrite loans today.  But even so, 43% is extremely high and how does this happen? 

It appears an obscure half decade old rule made these mortgages with people with high debt loads possible.  This provision started after the Consumer Finance Protection Bureau introduced tighter mortgage lending standards after the financial crisis while at the same time creating temporary measures to avoid slamming the mortgage door shut on some borrowers.  This exception was nicknamed the “qualified mortgage patch” allowing Fannie and Freddie to lend to highly leveraged borrowers.  Fannie said two years ago it would guarantee mortgages with debt/income ratios between 45-50%. 

Let me wrap my mind around this.  In the mortgage crisis, we did see some bad actors.  Appraisers who inflated values.  Mortgage brokers who pushed deals through just to get a paycheck.  Bankers who financed houses to make their bonus and present a large source of income to their shops.  But we cannot forget about one of the largest causes of the problem—the secondary market.  Market makers created methods to purchase more mortgages, package pools of good loans with bad loans and call them all “investment grade” and expanded underwriting standards to make it so any adult with a pulse could get a mortgage or even several.  If the market would purchase the mortgage and no residual risk was posed to the appraiser, mortgage broker, or banker, then why not do it?  The main drivers behind the markets are the government sponsored entities of Fannie and Freddie. 

Some economists bring up a valid point that facilitating house loans to borrowers with a large proportion of debt requirements to their income has a negative impact on the broader housing market.  This can artificially inflate house values.  We saw this in the 1990’s, a decade with real income annually increasing around 3%, while average house values nearly tripled in those ten years.  The article quotes Ed Pinto, co-director of American Enterprise Institute’s Housing Center, “We have a huge shortage of housing.  You can’t address that shortage by driving house prices up through leverage, which is what we’ve been doing.”

Some wonder if we will face some retraction in housing prices when the “mortgage patch” provision ends in 2021 or whenever Fannie and Freddie decide to take underwriting standards to stricter levels as was common in the not too distant past. 

In the same edition of the Journal, in the opinion page is a column titled “Bernie and AOC Are a Credit Risk”.  The article states that two of the “loudest socialists’, Sen. Bernie Sanders and Rep. Alexandra Ocasio-Cortez called for capping interest rates on consumer loans at 15%.  Today’s median rate on credit cards at 21%, is too high given that banks can borrow from the Federal Reserve at 2.5%. 

But is that an accurate argument?  The writer points out that credit cards function as payment networks with functions such as processing countless small dollar transactions, sending monthly bills, offering on-demand customer service.  The cost of daily operation is high, yet in 2010 Congress capped the interchange fees that financial institutions can charge.  The result was many institutions found other ways, such as increased fees on deposit accounts to make up that lost income. 

In Economics 101, we learn that price ceilings on any good or service cause shortages.  Demand increases since the public sees this good as being cheaper, given its utility.  Supply for the good decreases as the producer now has less profit reason to produce (remember economics is:  people respond to incentive).  Shortages of consumer credit would hit with a cap and it would impact those folks who would benefit the most from the higher credit card rate when compared to options of a pawn broker or payday lender. 

But the pair has another suggestion to help address the lack of financial services widely available.  Let Americans get checking accounts or even low-interest loans, from their local branch of the U.S. Postal Service.  Credit Unions see constant market share being eaten away from banks and many non-bank competitors today.  Now we must worry about the federal government. 

The convenience is not at the USPS.  My local post office is open only 5 hours a day on the weekdays and 3 on Saturday.  The experience level of delivering financial service is not there.  How is the USPS supposed to set up an ATM network, deposit accounts, and underwrite loans with no deep experience in any of these areas?  How can they do this where it is anywhere close to break even financially with an entity that lost $3.9 billion last year and has unfunded pension liabilities and retiree health care of $100 billion?  Politicians would push the postal bank to further lower underwriting standards and fees as they fight those who are on the outside of banking services.  This strategy seemed to work great in the mortgage business.  The losses would be incredible and would be forced on the heads of the U.S. taxpayer.

We worry about entities like Apple, Starbucks, Amazon, or Wal-Mart for supplying banking services and how this impacts the landscape of our credit union members and those-who-could-be a member.  Now if the proposal from AOC and Sanders comes true, your new competition comes from a group with unlimited money.  The oversight for the USPS bank is not as concerned with sound financial management as they are pleasing the populace to gain more favor for the leadership whenever elections occur.  That, indeed, could be a challenging competitor for us.