OPM or Opium? Which one were we smoking?

Mortgage and Lending with Crescent Bank & Trust

I'm a community banker and a commercial real estate lender. At the close of a recent Optimist Club meeting, a fellow Optimist posed this question: "Clark, how long do you think it will be before I'll be able to buy investment property again with a 10% downpayment?" I answered him as diplomatically as possible, but I was thinking, "If the system had been working properly and consistently, you should never have been able to do that in the first place." My point?

10% of acquisition cost isn't enough skin in the game in any economy.

Go to fullsize imageWe've all had it beat into our collective brain that Other People's Money (OPM) is THE way to go. All MBA's are taught that using leverage to your advantage is essential. The Robert Kyosakis of the world became Rich Dads on OPM. And, before you conclude that I'm starting to come across as a hypocritical banker, the commercial banking business model is based on attracting & profitably leveraging OPM. Am I criticizing Mr. Kyosaki and his real estate investment principles? Certainly not. But you cannot sustain a capitalistic economy on the concept of lending OPM without enforcing commonsense procedures & safeguards. Because bankers ignored many of those safeguards, OPM is now TPM (Tax Payers' Money).

A significant reason that bank policies, practices, and procedures are so highly regulated (and deposits FDIC insured) is that banks have always operated on OPM. As a community banker, I'm not lending the boss's money or the Board's money. I'm lending depositors' money. In terms of an expectation of prudence & diligence, I've always taken that as a much higher standard than if it were my own money.

With very few exceptions, the non-performing real estate loans at our bank (and I would venture to guess that this is the case at most banks) are transactions in which the borrower never had enough skin in the game.  This is of course the case with the Freddie & Fannie "Liar Loans" but it happened often with commercial transactions as well.  Over the past decade, bankers (and the Loan Committees we report to) giddily accepted greater and greater levels of risk because they drank their own Kool-Aid, believing there was no end in sight. At one point I actually heard a senior-level banker say, "There won't be another downturn like we've seen in the past. Greenspan's figured out how to keep the economy steady."  Come again?

There should never be a point in the future in which an investor can buy income-producing real estate with a cash injection of less than 20% of acquisition cost. Most common investor responses:

1- "But it's at 80% occupancy, traffic count's 140K, and the anchor's a bond-rated tenant on an absolute net lease with a 5% annual escalation. Doesn't that count for anything?"

2- "Wait a minute. It's cash-flowing at a DCR of 1.50. The center (building, development, etc) stands good for itself."

3- "OK. I understand that's your bank's policy. Sixth Ninth already approved me with nothing down."

It's Response #3 that played a significant role in putting us where we are today. In addition to borrower experience and creditworthiness, collateral location, strong (verified) cash flow, tenant quality, acceptable occupancy, and guarantor strength. a creditworthy non-owner-occupied transaction is one in which the borrower has skin in the game equivalent to at least 20% of project cost. Bankers who violated that principle (which was pretty much everyone at some point, following the lead of Freddie, Fannie, and their immediate competitors) are reaping what they sowed. 

I welcome opinions & responses from AR bloggers.

Posted by

North Metro Atlanta community banker, Woodstock, GA

Comments (5)

Maggie Dokic | Miami, FL | 888.883.8509 X101
eXp Realty LLC - Miami, FL
GREEN, CDPE, SFR, Pinecrest | Palmetto Bay |

Clark, I enjoyed reading your well written post.  I agree that even 10% is not enough for investments.  And it makes sense for owner-occupieds as well, but then we know most sales wouldn't be taking place today, at least not in my market.  The last 6 sales I've had have been interesting, split evenly down the middle, 3 cash deals, 3 FHA's 3.5% down.  At the end of the day, common sense is not so common.

Feb 20, 2009 01:15 AM
Goodbye Active Rain
Out of Real Estate

Clark,  Can I offer a suggestion to the guy who asked the question about purchasing a property with 10% buy-in.  My suggestion is have your person contact me and we will show him how it is done.

This is extremely easy to do and it can be done without no cash and no credit.  You just need to know how to do it and NR teaches people how.  All it is is creative ways to invest.  It can be done subject-to, a short sale, buying a house through a probate sale, negotiating with the seller directly.  It is possible all day long.

Thank you for the article!

Feb 20, 2009 01:33 AM
James "J.R." Samsing
Litchfield Park, AZ

I would agree that "skin in the game" is a key component of risk in investment lending (either commercial or residential).

But regarding owrner occupied residential mortgage lending, "skin in the game" is an inadequate indicator of risk. What value is a 20% down payment in a declining market where home prices have dropped 40%? I am frustrated by the discussion that mortgage loan defaults are the biproduct of lowered down payment requirements. Government and "zero down" programs have had higher rates of default so many are quick to surmise that the lack of a down payment is to blame. But these loans also allow(ed) a DTI up to 50% (or more) and with no asset or disposable income requirement. So not only did these people not have "skin in the game" but many also had zero disposable income and virtually no reserves. Therein lies the real problem. Even in a good market these loans would have a higher rate of non-performance. 

But none of the current troubles of today would exist if we were only talking about lending guidelines. High risk loans were priced to account for the higher risk (albeit incorrectly) and by themselves could not have brought down major investment and retail banks. It was the excessive leverage of the securitizers that turned $3B in losses on MBS pools into company killing $50B write downs. That's called borrowing OPM against OPM that has been used to insure OPM... 

Feb 20, 2009 01:57 AM
Clark Blackwell
Crescent Bank & Trust - Woodstock, GA

Maggie, There's no question that higher downpayment requirements adversely affect the overall volume of sales (commercial and residential). Though programs are available through FHA, VA, Nehemiah, etc, knowingly continuing to earn commissions on sales in which the homeowner has not shouldered an adequate portion of the risk is (over time) throwing the baby out with the bathwater. There's a moral hazard here, and -- on the scale that it has happened -- this can not be allowed to happen again.

Tony, Thank you for the suggestion. There's no question that it's possible to get in with no money down in specific instances such as subject-to, short sale, owner financing, etc. Pledging verified equity in other collateral in lieu of a cash injection is also a viable alternative.

My Optimist friend's a Realtor, a residential leasing agent & an experienced investor. He owns a portfolio of freestanding rental homes, a significant portion of which are presently vacant. We all assume that his occupancy rate will go to 100% shortly as more tenants enter the market.  

If it can be done creatively, he's already done it. Again, thank you for the suggestion.

Feb 20, 2009 02:11 AM
Clark Blackwell
Crescent Bank & Trust - Woodstock, GA

James, You are 100% correct about risk-based pricing, lowered standards, and the root of the problem: securitizers. Thank you for reading my blog.

Feb 20, 2009 02:17 AM