The Golden Rule of Lending - How Banks Got it Wrong by Dominic Mazzone
The Golden Rule of Lending - How Banks Got it Wrong by Dominic Mazzone. It's time to address one of the most incredible misconceptions in the current environment around real estate lending, which is the idea that all real estate lending is high risk. I hear this often and I understand where it's coming from since it seems to be the media's favorite topic, but this generalization needs qualification. Anytime you are evaluating risk, regardless of whether or not it is a traditional or alternative investment, there are basic factors to be considered that go beyond a rough generalization.
If I asked the general population their risk assessment of government issued bonds, I would probably get an overwhelming response that they are low risk. Now if I were to provide a little more information, such that the government bonds are being issued by the Zimbabwe Government, does is still sound like low risk? I didn't think so, and you came to that conclusion because we got past the generalization and into the substance. The same goes for any type of investment, with real estate and mortgage lending being no exception. In lending, the Golden Rule is don't lend against any asset that you could not easily sell to get your money back.
This also works for investing because investing in a tangible asset allows you to also sell it to get your money back. A simple enough philosophy, and one that Asset Based Lending funds have lived by and many other financial institutions died by. So, now that we have the principal down, let's get the risk out in the open. The real risk in real estate lending is not understanding valuations over the term of the loan, because valuations are the only thing protecting any asset.
Granted, we have seen some historical price depreciation in such a short amount of time that even some conservative lending models have been caught by surprise. This is one of the fundamental issues surrounding the credit crisis and the subsequent government bailout, but let's leave that for another time. When it comes to lending money either short-term or long-term, if the asset value is less than what you expected, you have a good chance of losing money. It is because of this that, in my opinion, residential lending is extremely risky in the current environment because there are no clear valuations anymore.
Appraisals for residential real estate are becoming somewhat worthless because a large part of the valuation process is based on comparables (prices paid recently for properties deemed comparable to the subject property). Since the supply of homes is swelling at an alarming rate from a bevy of foreclosures and property owners trying to sell their houses before they get foreclosed upon, prices are suffering. For example, if you try to sell your house for $500,000 but your neighbor who was being foreclosed upon sold for $350,000, then anyone buying your house is going to use that foreclosure sale as a comparable price and deem that your house is worth less than $500,000. Real valuations are actually pretty simple, and they are the price the market is willing to bear.
Right now in the residential market, we don't know how low that price is going to go. Income producing commercial real estate is an entirely different animal and that is because it has a non-subjective valuation formula. The income from commercial real estate is what defines the price, and deriving a valuation in this manner is called the Income Approach. The typical calculation that is used by most real estate professionals involves what is called the Capitalization Rate (CAP).
This is a simple calculation that takes the cost of a property and divides it by its income. CAP = Cost / Net income before debt. E post by haiyan902. g.
, a $1 million building that produces $100,000 of net income before debt has a CAP rate of 10%. This means that the investment is producing a 10% return before debt, and also that it technically could pay itself off in 10 years. The higher the CAP rate, the more income the property produces in relation to the price paid for the property. When evaluating a building with this approach, the devil is in the details and the details are the cash flow numbers.
If you take a conservative approach to the numbers, then you will get a conservative value. I realize it sounds simplistic, but what many banks were doing during the boom is ignoring realistic estimates of vacancies, costs, and other factors, and then taking all of this and allowing low CAP rates below 8. In this cycle, it's my opinion as well as many of my colleagues in the industry that we should now be looking at 10 CAPs Louis Vuitton handbags and above as that is where the market is going. In the alternative investment fund that I manage, we are now looking at 12 caps and above to properly mitigate risk.
The laymen might say that this approach is not very accurate because they could claim the property is in a great location where real estate is just perceived to be a lot higher. The answer to that is a perfect illustration of our old friends, supply and demand. If a property is in a great location it should command a better rental price thus increasing the cash flow which would increase the overall value. Any Asset Based Lending Fund that lends on assets, receivables, or real estate has number-driven guidelines that don't allow for subjective perception.
This was supposed to be the case in the underwriting rooms of banks, but the need for volume blurred the lines of reality. If banks were lending with income approach prudence on residential property, there would never have been the incredible perception driven appreciation in housing and the subsequent crash we are seeing now. Most people don't understand that the banks who loaned them money were selling the loans to someone else, so there weren't any direct or immediate consequences to the banks that used these liberal valuations. This lack of consequence helped create the credit crisis, the meltdown, and a bad connotation associated with Louis Vuitton Canada lending.
Real estate and real estate lending still remain very viable alternative investment options, but again it's the process that dictates the result. So remember, the next time you or anyone you know is going to lend or invest without heeding the Golden Rule, make sure the consequences are known because ending up with a lump of coal instead of a lump of gold is a lesson better studied than learned.