Boom and Bust in Property Development

0:00Welcome to sunny Las Vegas. Now there's a lot of distinguished scholars speaking at this conference, and I just wanna warn you, I am not one of them. But I am a banker and a construction lender, as Mark said. And so what I'm gonna talk about is not the Austrian business cycle in the theoretical, but in the actual mechanics of how booms begin and what leads to busts in commercial real estate. Now, most of the media attention has been on the residential housing boom and the housing bubble and when and how that will bust. But commercial property does not seem to be on anyone's bubble radar screen.

0:47But I think there is a considerable potential for a commercial property bust, especially out here in the fast growing West. Now, most bankers don't see it that way. There's in fact an article in this week's business press that says banks are still bullish on commercial real estate and that's despite rates increasing, lenders are still quite bullish on lending on commercial buildings. Now, of course, the Austrian business cycle begins with the central bank forcing down rates to a rate below what would otherwise be set by the market. A lending surge ensues, creating a boom.

1:35However, the new capital spending doesn't reflect consumer time preferences, including those time preferences of students of Hans Hoppe or ex-students, for that matter. And then we have this cluster of entrepreneurial errors. The boom cannot be sustained and the malinvested capital is eventually liquidated and applied to other uses. So what we're going to do is take a look at a real estate project and how a real estate lender would underwrite such a deal. And you'll get an idea of how real estate booms start. Because in my view, real estate booms start one deal at a time.

2:25Just what happens when the central bank creates liquidity and lowers interest rates? Well, we start with two important premise. The first, as a customer of mine told me a long time ago, builders build when lenders lend. Now, that's very important to keep in mind. Builders and developers do not build projects with their own cash. Debt and real estate go together like scotch and soda, for lack of a better analogy. Developers do not want to put any more money in deals than they have to. I mean, they've got better uses for their money. Fast cars, big boats, high maintenance wives.

3:14So what money they don't get from banks, they have to get from others. Now, they can go to investors and investors are going to insist on a significant ownership percentage in the project. That's called the golden rule, those who have the gold rule. Now, if they can't get investors, they don't want to give up that portion of the project, and they're going to go to mezzanine lenders and that's very expensive. 18%, 20%, 2 points, 4 points, 6 points, very expensive money. So the more money you can get from a bank, the better when underwriting a real estate one. Now next, the next piece in the equation to make money, banks must lend money.

3:59When you make that deposit Tuesday morning, you can be sure that your bank is lending all and all of it, that day or they already had, so don't be sitting on any checks or anything because your banks need it, they've already lent it. Banks going to perform, it's going to be lending out 95 to 100 percent of its deposits. Banks are all about leverage and earning a spread on their liabilities. Now, of course, banks could lend on something besides real estate, but why would they? The first banking boss told me, you can't get hurt in the dirt. Now that's what passes for analysis in banking.

4:47We all know that real estate prices never go down. And of course, we laugh about that in this room, but if you talk to most bank lending officers, especially young ones, they've never seen a down real estate market. And if they have, it was very, very temporary. We have a few guys in town here that lent in Texas during the Texas crash and a few from Phoenix. But for the most part, the experience in Las Vegas in many Western cities has been very good in real estate. And that's led to the average community bank in Las Vegas has over 80% of its loans in real estate, 80%.

5:34and I read recently that Georgia banks are about the same thing. Their average is 78% of loans and Georgia banks are secured by real estate. And I suspect that it's that way in most of the Sunbelt cities. Now, by the way, just as a matter of reference, when hundreds of banks and savings and loans in Texas failed in the eighties, they were criticized for their real estate concentrations. The average Texas financial institution loan portfolio had 40% of their loans in real estate.

6:15Now, what we're really talking about here is construction lending. I mean, there's nothing that juices up a local economy or distorts a local economy like new construction. Construction workers go back to work, Material suppliers sell more of their products, title companies expand, engineers and architects hire more people, banks expand. Also, everybody wants to be a developer. You may be getting your teeth cleaned or your teeth possibly worked on or drilled and it's likely that your dentist is not thinking about what he's doing, he's thinking about his real estate deal he's done. I have at least one dentist who is a part-time real estate developer.

7:02Doctors, lawyers, whenever I go to a cocktail party, they want to talk to me about the project that they want to finance and do. They could care less about making half a million a year as a dentist or a doctor. And it was the same thing during the dot-com bubble. You had all kinds of people quitting their jobs wanting to be day traders. Now the other part of the local economy that has a boom is local government. They stick their hands out. They want more fees to provide those vital services of issuing building permits. Now, none of the municipalities here in the Las Vegas area, there's four competing municipalities.

7:50None can keep up with the demand. and recently the city of Henderson raised their fees by 77%. But they are promising developers that they are going to be able to fast track the procedures and streamline and they're adding staff. And so developers are thrilled. They think finally, we're going to get a quick response out of city hall, but developers have short memory. City of Henderson did this less than five years ago. they doubled their fees, said they were gonna add staff. They didn't, they added buildings and they didn't streamline the process. So again, it's local government that benefits by this boom in real estate development as well.

8:41Just as an aside, the government fees in a $200,000 home in Las Vegas now, and that's about the cheapest new home you could buy. The fees total $50,000 of the $250,000.

9:02Now construction lending is attractive because the high yields are generated by these loans. Lenders, we earn high upfront fees for relatively short term loans, 12, 18 month loans. That's why I'm a construction lender. I have a very short attention span. don't wanna make a loan more than 12 or 18 months. But that's really what pumps up the yield. And we can charge these fees because construction lending is risky. There's construction risk, there's governmental risk, there's lease up risk and there's interest rate risk, which we'll talk a lot about here in a moment. But banks love this kind of lending. And like a friend of mine who works for a competing bank says construction loans are like the crack cocaine to Bank Management.

9:49It's risky, they know it, but they are addicted to the loan fees. They have got to have the loan fees for those bottom lines. So now we have two people that desperately need one another. We have the developer who needs the money and we have the banker that needs to lend the money. So all they need is a little help from our friend EZ Al at the Federal Reserve. And if the Fed cooperates, and the developer and the bank can really, really go to town. So let's look at an average commercial real estate deal and see how this works. You can see it up on the board. We have about a 13,000 square building. I will tell you it's in a great location.

10:36It's down the street from a new hospital and it must be a good location because I live right down the street as well. A local doctor has leased 43% of the building going in and the rest of the building isn't leased yet or pre-leased, but given the location, the prospects are very good. So our doctor's paying 235 a square foot and our available space, we pro forma at two bucks and we assume 10% for vacancy. And the key assumption in there is that seven and a half percent interest rate. And that is how we get to that loan amount of $2,550,000. Now you'll notice that our total costs are $3,025,000.

11:23So anyway, the equity required is $475,000, which is about 15% of the deal, and most developers can live with that. They don't wanna, again, they don't wanna come up with any money, but if they have to come up with about 15%, that's okay. Now, the other thing I want you to keep in mind as because the interest rates are low, the cap rate used by the appraisers, eight and a half. And that's what generates our appraised value of 3,400,000. Now you can see why people wanna do this. They put in 475,000 in cash and you've got a project that's worth 400,000 more than the cost. So your cash on cash return is quite good. That's how people make money in real estate development.

12:11Now, let's take a look at the second scenario, and we use the same assumptions, we still have Dr. XXXX, I don't know why I use that name, it just seems appropriate for Vegas, we still have our available space, we're assuming a 10% vacancy, but what I've changed is that interest rate, and it's quite a change, it's at 11%, and maybe that seems like that's a unrealistic, but up there in the corner, you can see that on January 1st, 2001 prime, the prime rate, which most banks work off of, at least in this area, was nine and a half percent. So when I would underwrite this loan on January 1st, 2001, to back into a 1.2 debt coverage, I only get a loan of $1,950,000.

13:10Now that's quite a difference in the equity required. The equity more than doubles. So go back to our original premise. Real estate developers do not want to put any more money in a deal than they have to. And in all likelihood, this is a deal that may not have gotten done. They would have just decided that they, you know, they couldn't come up with that equity. Or if they came up with the equity, it'd be too expensive. Now, after 2001, the Fed began lowering rates, and lowering rates, and lowering rates, and when you were assuming 6% and 7% for a takeout loan, virtually every deal that you looked at, pencil, and a lot of deals have been financed, and a lot of space has come online, and that's the message of what I'm saying here is that In the last couple of years, because of these low rates, a lot of projects, big and small, have been financed because of these low rates.

14:21Now in our third example, we've got our building up, Dr. X is in there, we now have Dr. Y. However, because there has been more space built, and so there's more space on the market competing for tenants, We weren't able to lease it at two bucks a square foot. We're only able to get a $1.75. But we are 100% leased. But in the meantime, let's say that rates have gone back up to 11%. But we still had a loan of that $2,550,000. And all of a sudden, we have a 100% project that doesn't cash flow.

15:07and I hate it when that happens and that's really what's going on right now the Fed has continued to bump rates interest rates although they seem to be taking their their own sweet time at least on the long end tend to be going up and I think that's going to change the economics of some of these projects that were contemplated a year ago or started a year ago as they they go into this lease upstage Now, if we can look at the last example, we still have Dr. X in there, and we have Dr. Y paying $1.75, but he didn't take all the space this time, because the markets deteriorated a little bit, and we've got available space of 20%.

16:00It doesn't sound all that bad. We've got 80% of the project filled. Everything should be okay. Well, it's not. We've got this $2,550,000 loan. Rates have gone up to 11% when we underwrote them at seven and a half. And all of a sudden, our cash flow is a negative $5,600 a month. Now, go back to that premise. The developer doesn't want to put any more money in a deal than he has to. Now, he may feed this a while, but my experience is, he'll stop paying, all four close, he'll file bankruptcy, and then at that point, we'll go get an appraisal. Now, you remember that appraisal we had last time? It was an 8.5% cap, and it was $3.4 million, and boy, this thing looked okie dokie.

16:51Well, now all of a sudden, if you do an as-is appraisal on this project and you cap it at, say, 10%, not an 8.5% anymore because interest rates have gone up, so cap rates have gone up as-is to the net operating income, all of a sudden my value is $2.3 million. Well, that's less than my loan amount. That means, more than likely, I'm going to get the keys to this thing. And then when the banks go to sell, bankers for some reason never seem to get the market value of something they're selling at REO, I don't know what it is. So banks are probably going to lose some money. And at this point, you know, the geniuses, those construction lenders like me, they were so smart when the market was good, will now be called the village idiots.

17:48And we will probably be expelled unless we can find a job in special assets. And by the way, I also run special assets. So I'm trying to cover both sides of this deal. By the way, our regulators actually don't like that. They seem to think that I am creating loans to give myself work in special assets, which is the bureaucratic mind really is shocking at times. But, and it's during this phase that we, again, in the Austrian business cycle theory, this is the liquidation phase and lenders take back loans and they, or take back property and liquidate them.

18:38Now, eventually though, the wreckage is cleared away and those memories of the bust have faded and the Fed will again lower rates and we'll all be back in business and the banker and the developer can start this cycle all over again. Thank you.