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.
We'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.