The Associated Press reported on a new failed bank last month, the Georgian Bank, which of course was in Georgia. Whelan Jennings would have sung about “just some good ol’ boys, never meaning no harm,” and would have narrated in backwoods lingo, you can’t leave that Boss Hogg in charge of a bag of money…The AP pointed to depressed real estate and many community banks as the culprit that led to concentration of so many failed banks in the Peachy State.
The reason every bank has failed to date is pretty much the same; the practice of real estate lending doesn’t work, combined with a market in which originators don’t hold loans to maturity. “Comparable pricing” is a bad method to lend money against as P.T. Barnum would have told you (history questions his “there’s a sucker born every minute” quote but we’ll assume), because it presumes a fluidity to real estate market and pricing, and doesn’t establish the underlying cost of building a home or building in general. If you tried to get a bank to buy into lending 3 X the cost of a car or some ridiculous amount of money against a coat, a bank would be conservative and suggest a trip to the shylock in your area. This reality is especially evident when the loan is like the child’s game “hot potato,” something taken for an instant by parties, each of whom earns something for the moment they carry the loan.
The comparable system in real estate makes no sense as it lends itself to shoddy lending practices in a market where banks sell into a pool or conduit structure. In the refrigerator business, companies cut price, offer special service and delivery incentives, and have to worry about burdensome fixed costs to be competitive. They also have to sell millions of appliances to earn their keep. The builders in housing can sell a couple of houses a year in a boom market and make what some might call “serious coin.”
Cap rate, the examination of value compared to triple net income on a piece of real estate, is the only true measure of value. Stop listening to your realtor™ and start caring about your money. Your realtor™ is like the scientist in “Schrodinger’s Cat,” a book about quantum mechanics in which we are reminded that observers influence outcomes. When your car salesman says, ” these babies sell for twice list price,” do you break out the checkbook? Why do realtors have credibility that drives markets? If a property earns $20,000 per year, it is worth between $200-300,000. There is no reason to buy real estate if it is higher than these guidelines, as there are “risk free” investments yielding 4-6% and real estate is not risk free.
There are other issues such as likelihood on a rock solid basis for rental income to continue. If an investor sees a Home Depot property in Flagstaff Arizona, the institutional market might have paid as much as 18-20X triple net (which is the term for gross income minus expenses) five years ago. If Home Depot ever went into bankruptcy or if the lease was up and they decided not to renew, the property could be virtually valueless (how many companies would be on the list that you could lease that configured space to?). It’s just that with risk should come a reduction in the multiple, but for some reason there wasn’t any.
Also when you look at cap rate value, don’t buy into the “zero interest rate proposition” that the government is selling. If you demand interest and fair return, you’ll get it. If you accept 1-3%, they’ll be all too happy to oblige. Know what land costs, and be aware of the benchmarks in areas to build, generally between $75 per foot and $300 per foot. I recently saw a home in Hollywood that was 17,000 feet that had been reduced from $12,9 million to $6.9 million. Perhaps you’d have no worries that some rich guy is buried in an extra $6 million profit for the builder (maybe you’re a builder and think that is great), but how about if the builder admitted that he spent $3.5 million to build the home? At the end, a bank (which is insured by the government that derives its ability to insure from tax collections) would make that loan. The builders repositioned trillions of wealth, as did banks with origination and brokers from sales, from an assembly of citizens to themselves. We must stop this from continuing in the future by establishing guidelines and building costs to educate buyers, and banks must lend based on value to ensure even Barnum’s sucker cannot get taken by a method that is more likely than not to happen everyday.
Be mindful, be careful and good luck!
John Flynn October 31, 2009