WEBVTT NOTE Boom and Bust in Property Development 1 00:00:00.000 --> 00:00:02.560 Welcome to sunny Las Vegas. 2 00:00:05.120 --> 00:00:07.000 Now there's a lot of distinguished scholars 3 00:00:07.000 --> 00:00:08.240 speaking at this conference, 4 00:00:08.240 --> 00:00:11.080 and I just wanna warn you, I am not one of them. 5 00:00:13.200 --> 00:00:17.780 But I am a banker and a construction lender, as Mark said. 6 00:00:17.780 --> 00:00:19.960 And so what I'm gonna talk about 7 00:00:19.960 --> 00:00:23.420 is not the Austrian business cycle in the theoretical, 8 00:00:23.420 --> 00:00:27.640 but in the actual mechanics of how booms begin 9 00:00:27.640 --> 00:00:32.640 and what leads to busts in commercial real estate. 10 00:00:32.880 --> 00:00:35.080 Now, most of the media attention has been on 11 00:00:36.400 --> 00:00:39.440 the residential housing boom and the housing bubble 12 00:00:39.440 --> 00:00:42.160 and when and how that will bust. 13 00:00:42.160 --> 00:00:45.280 But commercial property does not seem to be 14 00:00:45.280 --> 00:00:47.920 on anyone's bubble radar screen. 15 00:00:47.920 --> 00:00:51.920 But I think there is a considerable potential 16 00:00:51.920 --> 00:00:54.200 for a commercial property bust, 17 00:00:54.200 --> 00:00:59.000 especially out here in the fast growing West. 18 00:00:59.000 --> 00:01:01.960 Now, most bankers don't see it that way. 19 00:01:01.960 --> 00:01:05.040 There's in fact an article in this week's business press 20 00:01:05.040 --> 00:01:09.480 that says banks are still bullish on commercial real estate 21 00:01:09.480 --> 00:01:12.600 and that's despite rates increasing, 22 00:01:14.640 --> 00:01:16.680 lenders are still quite bullish 23 00:01:16.680 --> 00:01:21.680 on lending on commercial buildings. 24 00:01:21.680 --> 00:01:31.040 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. 25 00:01:31.040 --> 00:01:35.040 A lending surge ensues, creating a boom. 26 00:01:35.040 --> 00:01:47.560 However, 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. 27 00:01:47.560 --> 00:01:53.040 And then we have this cluster of entrepreneurial errors. 28 00:01:53.040 --> 00:02:03.560 The boom cannot be sustained and the malinvested capital is eventually liquidated and applied to other uses. 29 00:02:03.560 --> 00:02:13.000 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. 30 00:02:13.000 --> 00:02:17.720 And you'll get an idea of how real estate booms start. 31 00:02:17.720 --> 00:02:25.120 Because in my view, real estate booms start one deal at a time. 32 00:02:25.120 --> 00:02:30.040 Just what happens when the central bank creates liquidity and lowers interest rates? 33 00:02:30.040 --> 00:02:33.960 Well, we start with two important premise. 34 00:02:33.960 --> 00:02:42.400 The first, as a customer of mine told me a long time ago, builders build when lenders lend. 35 00:02:42.400 --> 00:02:44.840 Now, that's very important to keep in mind. 36 00:02:44.840 --> 00:02:50.320 Builders and developers do not build projects with their own cash. 37 00:02:50.320 --> 00:03:01.200 Debt and real estate go together like scotch and soda, for lack of a better analogy. 38 00:03:01.200 --> 00:03:05.520 Developers do not want to put any more money in deals than they have to. 39 00:03:05.520 --> 00:03:08.800 I mean, they've got better uses for their money. 40 00:03:08.800 --> 00:03:14.840 Fast cars, big boats, high maintenance wives. 41 00:03:14.840 --> 00:03:18.880 So what money they don't get from banks, they have to get from others. 42 00:03:18.880 --> 00:03:29.240 Now, they can go to investors and investors are going to insist on a significant ownership percentage in the project. 43 00:03:29.240 --> 00:03:33.520 That's called the golden rule, those who have the gold rule. 44 00:03:33.520 --> 00:03:37.000 Now, if they can't get investors, they don't want to give up that portion of the project, 45 00:03:37.000 --> 00:03:41.320 and they're going to go to mezzanine lenders and that's very expensive. 46 00:03:41.320 --> 00:03:46.480 18%, 20%, 2 points, 4 points, 6 points, very expensive money. 47 00:03:46.480 --> 00:03:53.560 So the more money you can get from a bank, the better when underwriting a real estate one. 48 00:03:53.560 --> 00:03:59.920 Now next, the next piece in the equation to make money, banks must lend money. 49 00:03:59.920 --> 00:04:06.800 When you make that deposit Tuesday morning, you can be sure that your bank is lending all 50 00:04:06.800 --> 00:04:15.800 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. 51 00:04:15.800 --> 00:04:21.800 Banks going to perform, it's going to be lending out 95 to 100 percent of its deposits. 52 00:04:21.800 --> 00:04:27.800 Banks are all about leverage and earning a spread on their liabilities. 53 00:04:27.800 --> 00:04:34.800 Now, of course, banks could lend on something besides real estate, but why would they? 54 00:04:34.800 --> 00:04:39.360 The first banking boss told me, you can't get hurt in the dirt. 55 00:04:42.160 --> 00:04:45.000 Now that's what passes for analysis in banking. 56 00:04:47.120 --> 00:04:51.560 We all know that real estate prices never go down. 57 00:04:53.560 --> 00:04:56.080 And of course, we laugh about that in this room, 58 00:04:56.080 --> 00:04:59.080 but if you talk to most bank lending officers, 59 00:04:59.080 --> 00:05:01.040 especially young ones, 60 00:05:01.040 --> 00:05:04.160 they've never seen a down real estate market. 61 00:05:04.160 --> 00:05:07.280 And if they have, it was very, very temporary. 62 00:05:07.280 --> 00:05:12.280 We have a few guys in town here that lent in Texas 63 00:05:12.280 --> 00:05:17.200 during the Texas crash and a few from Phoenix. 64 00:05:17.200 --> 00:05:19.780 But for the most part, the experience in Las Vegas 65 00:05:19.780 --> 00:05:23.260 in many Western cities has been very good in real estate. 66 00:05:23.260 --> 00:05:28.160 And that's led to the average community bank in Las Vegas 67 00:05:28.160 --> 00:05:33.160 has over 80% of its loans in real estate, 80%. 68 00:05:34.160 --> 00:05:38.600 and I read recently that Georgia banks are about the same thing. 69 00:05:38.600 --> 00:05:42.400 Their average is 78% of loans 70 00:05:42.400 --> 00:05:46.760 and Georgia banks are secured by real estate. 71 00:05:46.760 --> 00:05:51.760 And I suspect that it's that way in most of the Sunbelt cities. 72 00:05:54.120 --> 00:05:55.800 Now, by the way, just as a matter of reference, 73 00:05:55.800 --> 00:05:59.680 when hundreds of banks and savings and loans in Texas failed 74 00:05:59.680 --> 00:06:03.240 in the eighties, they were criticized 75 00:06:03.240 --> 00:06:05.120 for their real estate concentrations. 76 00:06:06.040 --> 00:06:08.940 The average Texas financial institution loan portfolio 77 00:06:08.940 --> 00:06:12.240 had 40% of their loans in real estate. 78 00:06:15.540 --> 00:06:17.340 Now, what we're really talking about here 79 00:06:17.340 --> 00:06:18.800 is construction lending. 80 00:06:18.800 --> 00:06:22.840 I mean, there's nothing that juices up a local economy 81 00:06:22.840 --> 00:06:27.600 or distorts a local economy like new construction. 82 00:06:27.600 --> 00:06:30.180 Construction workers go back to work, 83 00:06:30.180 --> 00:06:34.100 Material suppliers sell more of their products, 84 00:06:34.100 --> 00:06:35.500 title companies expand, 85 00:06:35.500 --> 00:06:39.700 engineers and architects hire more people, banks expand. 86 00:06:41.360 --> 00:06:45.220 Also, everybody wants to be a developer. 87 00:06:45.220 --> 00:06:47.020 You may be getting your teeth cleaned 88 00:06:48.260 --> 00:06:51.260 or your teeth possibly worked on or drilled 89 00:06:51.260 --> 00:06:52.780 and it's likely that your dentist 90 00:06:52.780 --> 00:06:54.340 is not thinking about what he's doing, 91 00:06:54.340 --> 00:06:57.460 he's thinking about his real estate deal he's done. 92 00:06:57.460 --> 00:07:02.700 I have at least one dentist who is a part-time real estate developer. 93 00:07:02.700 --> 00:07:06.580 Doctors, lawyers, whenever I go to a cocktail party, 94 00:07:06.580 --> 00:07:11.260 they want to talk to me about the project that they want to finance and do. 95 00:07:11.260 --> 00:07:18.860 They could care less about making half a million a year as a dentist or a doctor. 96 00:07:18.860 --> 00:07:21.100 And it was the same thing during the dot-com bubble. 97 00:07:21.100 --> 00:07:27.220 You had all kinds of people quitting their jobs wanting to be day traders. 98 00:07:27.220 --> 00:07:30.140 Now the other part of the local economy 99 00:07:30.140 --> 00:07:35.140 that has a boom is local government. 100 00:07:35.940 --> 00:07:37.120 They stick their hands out. 101 00:07:37.120 --> 00:07:40.860 They want more fees to provide those vital services 102 00:07:40.860 --> 00:07:42.520 of issuing building permits. 103 00:07:44.940 --> 00:07:48.160 Now, none of the municipalities here in the Las Vegas area, 104 00:07:48.160 --> 00:07:50.740 there's four competing municipalities. 105 00:07:50.740 --> 00:07:53.260 None can keep up with the demand. 106 00:07:53.260 --> 00:07:58.260 and recently the city of Henderson raised their fees by 77%. 107 00:08:00.940 --> 00:08:02.920 But they are promising developers 108 00:08:02.920 --> 00:08:05.300 that they are going to be able to fast track 109 00:08:05.300 --> 00:08:09.940 the procedures and streamline and they're adding staff. 110 00:08:09.940 --> 00:08:11.780 And so developers are thrilled. 111 00:08:11.780 --> 00:08:14.180 They think finally, we're going to get a quick response 112 00:08:14.180 --> 00:08:19.180 out of city hall, but developers have short memory. 113 00:08:20.940 --> 00:08:23.140 City of Henderson did this less than five years ago. 114 00:08:23.140 --> 00:08:25.960 they doubled their fees, said they were gonna add staff. 115 00:08:25.960 --> 00:08:28.480 They didn't, they added buildings 116 00:08:28.480 --> 00:08:31.280 and they didn't streamline the process. 117 00:08:31.280 --> 00:08:36.280 So again, it's local government that benefits 118 00:08:38.000 --> 00:08:41.120 by this boom in real estate development as well. 119 00:08:41.120 --> 00:08:45.520 Just as an aside, the government fees 120 00:08:45.520 --> 00:08:48.960 in a $200,000 home in Las Vegas now, 121 00:08:48.960 --> 00:08:52.000 and that's about the cheapest new home you could buy. 122 00:08:52.000 --> 00:08:57.000 The fees total $50,000 of the $250,000. 123 00:09:02.680 --> 00:09:04.480 Now construction lending is attractive 124 00:09:04.480 --> 00:09:07.760 because the high yields are generated by these loans. 125 00:09:07.760 --> 00:09:11.640 Lenders, we earn high upfront fees 126 00:09:11.640 --> 00:09:15.800 for relatively short term loans, 12, 18 month loans. 127 00:09:15.800 --> 00:09:17.400 That's why I'm a construction lender. 128 00:09:17.400 --> 00:09:19.400 I have a very short attention span. 129 00:09:19.400 --> 00:09:22.960 don't wanna make a loan more than 12 or 18 months. 130 00:09:22.960 --> 00:09:26.480 But that's really what pumps up the yield. 131 00:09:26.480 --> 00:09:28.600 And we can charge these fees 132 00:09:28.600 --> 00:09:31.040 because construction lending is risky. 133 00:09:31.040 --> 00:09:33.760 There's construction risk, there's governmental risk, 134 00:09:33.760 --> 00:09:36.320 there's lease up risk and there's interest rate risk, 135 00:09:36.320 --> 00:09:39.480 which we'll talk a lot about here in a moment. 136 00:09:39.480 --> 00:09:41.580 But banks love this kind of lending. 137 00:09:42.760 --> 00:09:44.920 And like a friend of mine who works for a competing bank 138 00:09:44.920 --> 00:09:48.480 says construction loans are like the crack cocaine 139 00:09:48.480 --> 00:09:49.520 to Bank Management. 140 00:09:49.520 --> 00:09:51.000 It's risky, they know it, 141 00:09:51.000 --> 00:09:53.680 but they are addicted to the loan fees. 142 00:09:53.680 --> 00:09:56.480 They have got to have the loan fees for those bottom lines. 143 00:09:57.480 --> 00:10:00.660 So now we have two people that desperately need one another. 144 00:10:00.660 --> 00:10:02.680 We have the developer who needs the money 145 00:10:02.680 --> 00:10:06.840 and we have the banker that needs to lend the money. 146 00:10:06.840 --> 00:10:10.360 So all they need is a little help 147 00:10:10.360 --> 00:10:15.200 from our friend EZ Al at the Federal Reserve. 148 00:10:16.280 --> 00:10:17.920 And if the Fed cooperates, 149 00:10:17.920 --> 00:10:22.080 and the developer and the bank can really, really go to town. 150 00:10:22.080 --> 00:10:25.240 So let's look at an average commercial real estate deal 151 00:10:25.240 --> 00:10:29.380 and see how this works. 152 00:10:29.380 --> 00:10:30.840 You can see it up on the board. 153 00:10:30.840 --> 00:10:34.480 We have about a 13,000 square building. 154 00:10:34.480 --> 00:10:36.780 I will tell you it's in a great location. 155 00:10:36.780 --> 00:10:39.240 It's down the street from a new hospital 156 00:10:39.240 --> 00:10:40.920 and it must be a good location 157 00:10:40.920 --> 00:10:43.120 because I live right down the street as well. 158 00:10:45.000 --> 00:10:47.680 A local doctor has leased 43% of the building 159 00:10:47.680 --> 00:10:50.480 going in and the rest of the building 160 00:10:50.480 --> 00:10:52.660 isn't leased yet or pre-leased, 161 00:10:52.660 --> 00:10:55.700 but given the location, the prospects are very good. 162 00:10:56.720 --> 00:10:59.540 So our doctor's paying 235 a square foot 163 00:10:59.540 --> 00:11:02.400 and our available space, we pro forma at two bucks 164 00:11:02.400 --> 00:11:05.400 and we assume 10% for vacancy. 165 00:11:05.400 --> 00:11:08.800 And the key assumption in there 166 00:11:08.800 --> 00:11:12.120 is that seven and a half percent interest rate. 167 00:11:13.140 --> 00:11:15.280 And that is how we get to that loan amount 168 00:11:15.280 --> 00:11:18.480 of $2,550,000. 169 00:11:18.480 --> 00:11:23.480 Now you'll notice that our total costs are $3,025,000. 170 00:11:23.480 --> 00:11:28.400 So anyway, the equity required is $475,000, 171 00:11:28.400 --> 00:11:30.120 which is about 15% of the deal, 172 00:11:30.120 --> 00:11:32.560 and most developers can live with that. 173 00:11:32.560 --> 00:11:34.680 They don't wanna, again, they don't wanna come up 174 00:11:34.680 --> 00:11:36.680 with any money, but if they have to come up 175 00:11:36.680 --> 00:11:38.680 with about 15%, that's okay. 176 00:11:39.880 --> 00:11:41.960 Now, the other thing I want you to keep in mind 177 00:11:41.960 --> 00:11:44.840 as because the interest rates are low, 178 00:11:44.840 --> 00:11:48.160 the cap rate used by the appraisers, eight and a half. 179 00:11:49.240 --> 00:11:51.480 And that's what generates our appraised value 180 00:11:51.480 --> 00:11:53.820 of 3,400,000. 181 00:11:54.800 --> 00:11:56.600 Now you can see why people wanna do this. 182 00:11:56.600 --> 00:12:00.840 They put in 475,000 in cash and you've got a project 183 00:12:00.840 --> 00:12:04.360 that's worth 400,000 more than the cost. 184 00:12:04.360 --> 00:12:07.160 So your cash on cash return is quite good. 185 00:12:07.160 --> 00:12:10.120 That's how people make money in real estate development. 186 00:12:11.960 --> 00:12:41.960 Now, 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 187 00:12:41.960 --> 00:12:55.640 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. 188 00:12:55.640 --> 00:13:10.760 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. 189 00:13:10.760 --> 00:13:15.900 Now that's quite a difference in the equity required. The equity more than doubles. 190 00:13:15.900 --> 00:13:18.280 So go back to our original premise. 191 00:13:18.280 --> 00:13:24.000 Real estate developers do not want to put any more money in a deal than they have to. 192 00:13:24.000 --> 00:13:29.480 And in all likelihood, this is a deal that may not have gotten done. 193 00:13:29.480 --> 00:13:33.280 They would have just decided that they, you know, they couldn't come up with that equity. 194 00:13:33.280 --> 00:13:40.040 Or if they came up with the equity, it'd be too expensive. 195 00:13:40.040 --> 00:14:10.040 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 196 00:14:10.040 --> 00:14:21.040 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. 197 00:14:21.040 --> 00:14:29.040 Now in our third example, we've got our building up, Dr. X is in there, we now have Dr. Y. 198 00:14:29.040 --> 00:14:39.840 However, because there has been more space built, and so there's more space on the market competing for tenants, 199 00:14:39.840 --> 00:14:42.320 We weren't able to lease it at two bucks a square foot. 200 00:14:42.320 --> 00:14:44.800 We're only able to get a $1.75. 201 00:14:44.800 --> 00:14:47.360 But we are 100% leased. 202 00:14:47.360 --> 00:14:53.200 But in the meantime, let's say that rates have gone back up to 11%. 203 00:14:53.200 --> 00:14:58.000 But we still had a loan of that $2,550,000. 204 00:14:58.000 --> 00:15:07.360 And all of a sudden, we have a 100% project that doesn't cash flow. 205 00:15:07.360 --> 00:15:15.280 and I hate it when that happens and that's really what's going on right now the Fed has continued to bump rates 206 00:15:16.560 --> 00:15:22.320 interest rates although they seem to be taking their their own sweet time at least on the long end 207 00:15:23.280 --> 00:15:28.640 tend to be going up and I think that's going to change the economics of some of these projects 208 00:15:28.640 --> 00:15:35.440 that were contemplated a year ago or started a year ago as they they go into this lease upstage 209 00:15:37.360 --> 00:16:00.360 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%. 210 00:16:00.360 --> 00:16:06.360 It doesn't sound all that bad. We've got 80% of the project filled. Everything should be okay. 211 00:16:06.360 --> 00:16:14.360 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. 212 00:16:14.360 --> 00:16:19.360 And all of a sudden, our cash flow is a negative $5,600 a month. 213 00:16:19.360 --> 00:16:27.360 Now, go back to that premise. The developer doesn't want to put any more money in a deal than he has to. 214 00:16:27.360 --> 00:16:44.360 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. 215 00:16:44.360 --> 00:16:51.360 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. 216 00:16:51.360 --> 00:17:11.360 Well, 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. 217 00:17:11.360 --> 00:17:19.360 Well, that's less than my loan amount. That means, more than likely, I'm going to get the keys to this thing. 218 00:17:19.360 --> 00:17:31.360 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. 219 00:17:31.360 --> 00:17:34.360 So banks are probably going to lose some money. 220 00:17:34.360 --> 00:17:45.360 And at this point, you know, the geniuses, those construction lenders like me, they were so smart when the market was good, 221 00:17:45.360 --> 00:17:47.600 will now be called the village idiots. 222 00:17:48.660 --> 00:17:50.880 And we will probably be expelled 223 00:17:50.880 --> 00:17:53.680 unless we can find a job in special assets. 224 00:17:55.860 --> 00:17:58.800 And by the way, I also run special assets. 225 00:17:58.800 --> 00:18:03.800 So I'm trying to cover both sides of this deal. 226 00:18:04.880 --> 00:18:09.260 By the way, our regulators actually don't like that. 227 00:18:09.260 --> 00:18:12.440 They seem to think that I am creating loans 228 00:18:12.440 --> 00:18:14.560 to give myself work in special assets, 229 00:18:14.560 --> 00:18:19.560 which is the bureaucratic mind really is shocking at times. 230 00:18:20.120 --> 00:18:24.400 But, and it's during this phase that we, again, 231 00:18:24.400 --> 00:18:26.680 in the Austrian business cycle theory, 232 00:18:26.680 --> 00:18:31.680 this is the liquidation phase and lenders take back loans 233 00:18:32.280 --> 00:18:36.160 and they, or take back property and liquidate them. 234 00:18:38.120 --> 00:18:41.480 Now, eventually though, the wreckage is cleared away 235 00:18:41.480 --> 00:18:59.480 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.