Commercial Loans and Fun Blog

In the United States, we have the very good habit of not executing our former presidents. If the former president of a country fears that he will be executed when he steps down, it tends to discourage him from stepping down.

A good example is President Duarte of the Philippines.  His police, army, and death squads executed 30,000 drug dealers and drug users during his six years as president.  He must know that there are a lot of angry drug dealers and families of drug users just waiting for him to relinquish power.  It is going to be interesting to see if he declares martial law at the end of his allotted single term.

President Xi faces a similar problem.  He is not supposed to serve much longer, but he has been installing his cronies into positions of power within the Chinese Communist Party ("CCP"), and they have changed the rules to allow him to run again.  He has effectively become Dictator For Life in China.  If he ever gets ousted, his enemies are going to want him dead.  He is too dangerous if he simply retires.

What does this have to do with selling your apartment in China?  President Xi is desperate to prevent a real estate crash in China.  Most Chinese people store 60% to 90% of their wealth in their real estate, as opposed to in the stock market here in the United States.  

If real estate were to crash in China, suddenly the Chinese people would feel much less wealthy.  They would stop buying so much stuff and start saving more.  Imagine if Americans suddenly reduced their spending by 30%.   Pow.  The American economy would hit a brick all.  The sudden slowdown in China could be far worse.

There is an unspoken deal between the Chinese people and the CCP.  As long as the CCP improves their lives by 5% to 8% every year, the Chinese people will tolerate the repression of the communists.  So what happens when the Chinese economy suddenly crashes?  I read somewhere that an incredible percentage of Chinese citizens are homeowners.  If real estate crashes in China, it will be like the stock market crashing here.  People are going to stunned, and spending will tank.

In China, the people may start to protest and riot.  Remember, the Chinese people are sick of the corruption and the restrictions on free speech.  President Xi "is living on a powder keg and giving off sparks."

Xi doesn't want to be dragged from power and shot.  He also probably thinks that he is a great leader and a brilliant military strategist.  He knows a bust is coming, and he has a plan.  As soon as the riots begin, he will invade Taiwan.  This will distract the Chinese people and unite them behind him.   Invading Taiwan could easily start World War III.  According to repeated war games, the U.S. loses.  We do NOT want riots in China.  No, sireee.

As I wrote earlier in the week, the Evergrande default is a dangerous spark.  Everyone in China must now appreciate that apartments there are greatly overbuilt.  The rich folks in China own their own apartments, plus at least one more more.  About 20% of the Chinese people own more than one apartment.  Now if you knew that stocks were over-valued and that a crash was coming, would you sell some of your stock?  You betcha.  Therefore you can bet that at least some folks in China are right now trying to sell their extra apartments.

I read this week that the CCP is starting to erect obstacles to selling apartments.  One technique is to refuse to transfer title.  

Part of me is hoping that the strategy works; otherwise, with buyers reluctant to invest in a declining asset, the sellers will start a bidding war to the bottom.  "I'll sell for a 5% discount."  "I'll sell for a 10% discount!"  "20%."  "30%!"  Real estate crashes in the U.S. tend to always be 45%, so can you imagine the effect on the Chinese economy if their consumers suddenly feel 45% less wealthy?

We do NOT want the Cheese economy to crash!

Think back to the beginning of the pandemic.  We were all absolute idiots to think that we could contain the pandemic to China.  It was like believing that you could have a non-peeing section in a public swimming pool.

Ah, Wendy Peffercorn...  Later got married to Squints and had NINE children.  Haha!  If you have never seen The Sandlot, it is a must-see classic, like The Princess Bride or Willow.

The economic forces lined up against President Xi of China are immense.  Most recently, the huge Evergrande default exposed the fact that China has 50 million to 65 million unsold apartments (condo's).  A huge percentage of China's GDP - called by many an "economic miracle" - has been in the construction of real estate.  Real estate in China is clearly over-built and, more importantly, misdirected.  They are taking cold, hard cash and building properties that the Chinese economy does not need.

A slowdown in real estate, where the Chinese people keep 60% of their wealth, is now a given.  The Evergrande default has exposed to the Chinese people that the emperor has no clothes, that real estate is horribly overbuilt.  A devastating real estate crash in China is also a very real possibility.  The Chinese Communist Party ("CCP") is powerful, but even the CCP lacks the economic wherewithal to stem a real estate crash, once a rout has started.

Since the Chinese keep 60% of their wealth in real estate, and since even the CCP can't force a nervous populace to buy things, a correction or a crash in real estate is almost certainly going to rein in this runaway Chinese economy.  At an absolute minimum, the Chinese people now suddenly feel much less wealth.  It's like learning that there are huge, previously unknown, blocks of Apple, Google, Facebook, and Amazon shares that are about to flood the market.  As my tiny and precious little granddaughter loves to say, "Uh-oh."

The Evergrande default also exposed a huge problem within China's "rapidly growing" economy.  They are building a lot of stuff that the world does not need and counting it towards their published GDP.  Suppose, for example, twenty million Chinese people spent years building buggy whips.  Western capitalist countries would never do this because the factory would fail within a year for the lack of sales, but in China...  Helloooo?  Fifty to sixty-five million unsold apartments.

China is not some economic miracle.  They have not discovered some secret sauce economic formula that makes their unique blend of governmental-private cooperation more economically successful that that of America.  Their economic miracle is merely the product of having 1.44 billion people and adopting a semi-capitalistic system.  

That brings up the fact that China is now shrinking.  Officially China's population grew by 7 million people last year.  That's nonsense.  The numbers were fudged to avoid embarrassing President Xi.   The fact that their population is declining means that future economic growth in China has to be the product of increased productivity.  Hmmm.

This brings up President Xi's war on big tech.  Threatened by the power of big tech (a legitimate fear in light of big tech's political damage in the last presidential campaign), President Xi has forced the recent retirements of a dozen heads of big tech companies - people like Jack Ma of Alibaba.  This would be like forcing Elon Musk, Jeff Bezos, and Tim Cook to retire.  Innovation would suffer.

Then there is the current energy crisis in China.  Here I can't blame President Xi.  He is trying to curtail the use of coal (air pollution, global warming); but the lack of power is slowing the Chinese economy.  Many Chinese factories are operating far below their capacity, despite demand.

Then there are the economic sanctions.  China claims they had no effect on them.  Don't believe it.  Add to this the growing dislike and distrust of China throughout the world.  If Wal-Mart can buy dresses from either Vietnam or China, guess who now gets the order?  Then there is President Xi's war on the Chinese stock market and foreign investment.  New foreign investment in Chinese factories has to be falling.

China is going to slow down - sharply.  Since non-peeing sections in public pools don't work, a worldwide recession is almost guaranteed.  How long do we have before it hits our shores?  Months, not years, I would guess.

Fortunately President Xi would rather be ripped from power and possibly shot, rather than invade Taiwan to unite his people.  I think I'll go buy an apartment on Taiwan or Guam.  :-)

Let me be very, very clear.  Even though China is our largest economic competitor, and even though there is scary chance we may soon go to war against China -

we do NOT want the Chinese
economy to crash.

If the Chinese economy were to crash, tens of millions of Chinese demonstrators would likely take to the streets.  Just imagine protests, like the pro-democracy protests in Hong Kong, taking place in every major city in China. 

They would protest the economic mismanagement of the country by the Chinese Communist Party ("CCP").  They would object to the CCP's authoritarian rule.  The protestors would demand freedom of speech.   The lifetime rule of Xi Jinping would suddenly end, almost certainly with his execution.

You can bet that President Xi would not be a huge fan of such an outcome.  Therefore, as soon as the Chinese economy started to tank and early protests started to appear, President Xi would order the invasion of Taiwan.  This would unite the Chinese people against a common enemy - the United States - and make them forget their economic frustrations.

President Xi would give no formal warning.  Those red Chinese jets that overfly Taiwan almost every day would suddenly continue on to real targets.  The Taiwanese Air Force would be wiped out on the ground.  Chinese DF-17 and DF-21 hypersonic missions would destroy U.S. airbases on Guam, as well as $150 billion worth of our F35-A's, still sitting on the ground.

Quokkas are real!

These same long-range missiles would likely destroy several, if not all, of our aircraft carriers in the South China Sea.  The U.S. Navy would never fully-recover.  If the Chinese were smart, Chinese submarines would surface off the coast of California and Washington State and destroy our shipyards.  Our ships destroyed in the South China Sea could therefore not easily be replaced.  Coincidentally a freighter passing through the Suez Canal will "accidentally" crash into one of the locks, making the Suez Canal unusable for the duration of the war.

Extremely accurate, submarine-launched, cruise missiles would fly into the windows of Northrup Grumman, Boeing, Lockheed, and Raytheon, crippling our ability to replace our tiny arsenal of conventionally-tipped missiles.  We lose this war.  Ten years later, China might even invade California.  China wants our land.  

Bottom line -

we do NOT want the Chinese economy to crash.

I admire clever, fun marketing.

Unfortunately, the Chinese economy is almost certain to crash in the next two years.  Imagine if 29% of the American workforce spent five years building anvils, and we stacked these unneeded anvils in huge piles north of the Arctic Circle.  This is what the Chinese have done.

The Evergrande default has revealed that the Emperor is buck naked.  China has built 50 million to 63 million unsold houses - more than enough unsold apartments (condo's) to house the entire populations of England, Italy, and Holland combined!  

Talk about some malinvestnments?  Wow.  A malinvestment is a boneheaded investment (think see-through office buildings, dot-com stocks, and subprime mortgages) that will never be repaid.

China financed all of this new construction with borrowed money, which of course the developers will never be able to repay.  President Xi and the CCP will bail out the banks, which is unfortunately the exact opposite of what they should do.  Xi needs to let the banks collapse.  He needs to allow dozens of large banks to fail.  Their presidents should go to jail.  Future generations of bankers need to remember with horror the consequences of reckless lending - but he won't.

The result of the bank bailouts will be the printing of more money, and painful inflation in China will follow.  But that's not the half of it.

The problem is not just with Evergrande, China's second largest residential builder.  Twenty-nine percent (29%) of China's GDP is new construction.  Almost certainly other large builders in China have made similar mistakes.  They have been borrowing huge amounts of money to essentially build anvils for the Arctic Circle.

"China is eating our lunch economically.  Their command economy is the better economic model."  Uh-huh.  This is certainly what we have all believed for years; but an 8% growth rate (now down to 6%) is not as impressive when a third of that so-called "growth" has been devoted to construction of anvils for the Arctic Circle.

And then one is tempted to ask, "If China's command economy was messed up enough to build 50 million to 63 million unsold apartments, what other boneheaded malinvestments have they made in other parts of the economy?"  Have they built 500 million buggy whips and counted their construction as "growth?"  

Since China has a command economy, can't they just print more money to cover their malinvestments?  China's Producer Price Index ("PPP") increased 9.5% in the past year, and that's the official rate.  A communist commissar would never lie about the PPP, would he?  I wonder what kind of inflation the average Chinese citizen is really enduring on his fixed salary?

The Evergrande default has made clear to me that China is not the economic miracle that has been touted in recent years.  Because the CCP will bail out Evergrande and the country's banks, the crash of the Chinese economy won't be some spectacular "Lehman Moment."

What is a Lehman moment?  Simply put, it's the fear that turmoil or crisis in one large company or country could spread to others.  When Lehman Brothers filed for bankruptcy, for example, it had a contagion effect on the other major financial institutions with which it had trading relationships.

I think a better definition of a Lehman moment is that moment when a bank, institution, or government suddenly realizes, "Oh, poop, we're NOT too big to fail!"  Haha!

But crash it will.  The CCP just can't keep creating more new money to paper over more and more boneheaded malinvestments (50 million unsold apartments - wtf?).  Eventually, this money creation binge will lead to raging inflation, and the average Chinese citizen will see his quality of his life plunging for the first time in decades.  

The average Chinese citizen will not be happy.  He will view the decline in living standards as a breach of his contract with the CCP.  He has tolerated the cruel thumb of the communists because the CCP promised to improve his life every year. 

I therefore make three predictions:  (1) Raging inflation will soon appear in China; (2) followed by massive, nationwide protests; (3) followed by a war against the United States.  Because our missiles absolutely suck and our arsenals of missiles are small, America will lose the coming missile war.

Still think I'm an amusing whack job?  Four Chinese warships sailed just 3.1 miles off the Alaskan coast ten days ago.  If I owned a home near a shipyard or a missile manufacturing plant in California or Washington State, I would at least buy a remote cabin in the mountains. 

Standing properties only, sorry.

My buddy and I were debating whether or not the U.S. will soon go to war against China.  His argument - an intellectually sound one - is that China would suffer horribly in such a war.  

Our bombs and missiles would destroy their harbors, shipyards, power plants, water treatment plants, railroad yards, and transport hubs.  Their international's trade would plummet by 50%.  (90%?)

In contrast, if the Chinese simply do nothing militarily, they will soon become the world's largest economic power.  Their people would only benefit from such restraint.  It's a compelling argument, right?

But here's the thing:  It won't be the Chinese people attacking us.  The Chinese people don't hate us.  Many of them would immigrate to America in a heartbeat.

No, the reason for the attack will be the ego of President Xi, their leader.  President Xi recently arranged to have himself appointed head of the Chinese Communist Party ("CCP") and the head of state for China for life.

The real money in CREF is in servicing fees.

President Xi has absolute power, and as the saying goes, "Absolute power corrupts absolutely."  Maybe this time is different, right?  Uh, huh.

Xi also has has very thin skin, and he angers easily.  For example, Chinese President Xi Jinping recently warned that, "Anyone who tries to bully China will face broken heads and bloodshed."  (July 1, 2021)

It's been thirteen months since I first made my prediction that the U.S. will be at war against China within three years.  I stand by that prediction.

Unfortunately, I also predicted that we will lose that war.  How can a democratic country like the U.S. or Germany defend itself against a sneak attack?  We are not likely to strike first.  This is why Russia and China are developing hypersonic missiles that can destroy our jets and missile launchers before they can even be used.

Russia is even working on a nuclear-powered (not nuclear-armed) hypersonic missile that can reach anywhere in the world.  Much of America's military might - aircraft carriers, airfields, jets, missile ships - will likely be wiped out in the opening minutes of the Taiwanese War.  Just remember what happened to the Egyptian and Syrian Air Forces in the opening hours of the Six-Day War.

Even if Biden died and appointed me king, I would have no solution to this first-strike vulnerability.  Missiles today are just too fast and accurate.  In a recent war game fought by the U.S. military, the Chinese Space Force quickly wiped out all of our satellites, leaving American forces blind.

After much of the American Fleet is decimated in the East China Sea, I have little doubt that the Chinese will come after our shipyards and missile factories on the West Coast.  That's what I would do.

Yes, we have shipyards on the East Coast, but the Panama Canal will be blocked.  It was no accident that both the Panama Canal and the Suez Canal were "accidentally" blocked by crashed cargo ships in the past 18 months.  Those were almost certainly Chinese (and/or Russian) trial runs for the coming war.

But the war won't affect you, right?  The war will be fought "over there" in the Second Island Chain, right?  You've got to stop smoking that California oregano.  :-)  Once our fleet is destroyed, Chinese subs and missile ships will be able to park 800 miles off the California coast and rain missiles down, with pinpoint accuracy, onto our power plants, our railroad yards, our water treatment plants, and our freeway interchanges.

Suddenly the American people will have no food, no power, and no water.  Please understand what I am saying.  When the Chinese win the huge battle for Taiwan, they are unlikely to stop.  

The Chinese want our land, and they are not afraid to use even biological warfare to eliminate our population.  COVID may or may not have escaped from that lab in Wuhan, but not 100% of that infectious disease lab was intended for civilian use.

Ancient Rome ruled the world for 800 years, until they lost just one battle - Andrianople in 378 A.D.  Just one battle doomed the entire empire.

It's not the Chinese people who hate us.  It's not that the Chinese people want war. The Chinese people will only suffer if they go to war.

Unfortunately, just one man - a man with absolute power over 1.4 billion Chinese - will decide whether or not China attacks. It is a terrifying truth that President Xi of China is becoming more aggressive and Hitler-like in his statements.  

And c'mon, once you've kissed 1,000 pretty girls and eaten hundreds of gourmet meals, wouldn't it be fun to play a Game of Thrones?  Kinda funny... and kinda not.

This is a fascinating story of how using a cap rate allowed us to value and sell a foreclosed golf course, and it helped my private investors avoid a loss and actually make a profit.

There are three methods of valuing income property - the cost approach, the sales comparison approach, and the income capitalization approach.  When the appraiser has arrived at a value using each approach, he then has to reconcile these three valuations to arrive at his final conclusion.

It is important to note that the appraiser must not just average the three results.  Instead, the appraiser should choose the most reliable approach to value and then temper that conclusion with the results of the two other approaches.

Now when valuing a fairly standard property type, like an apartment building, appraisers tend to rely the most heavily on the sales comparison approach.  For how much have other apartment buildings in the area sold?

Since there are bazillions of apartment buildings, the valuation process is generally straight forward.  How much did nearby apartment buildings sell for per door?  (Fancy CREF way of saying "per unit.")  What was their gross rent multiplier?

The real income in commercial real estate finance is in servicing
fees.  Work every day to build your loan servicing portfolio!

The cost approach is the valuation method least often used, mainly because it is too much work for appraiser.  Too often the appraiser just weenies out of using the cost approach, citing the bull stuff excuse that it is too difficult to "estimate depreciation."  

But now the tale gets juicy... and dark.

About four years ago, Blackburne & Sons made a $2.75 million loan on a gorgeous golf course in an affluent suburb of Chicago, a golf course course with a replacement cost of $13.2 million (according to the county).  Unfortunately the borrowers defaulted, and we foreclosed.

At first, the real estate brokers were telling us that our golf course was almost worthless.  Several thousand golf courses had already come back in foreclosure nationwide over the past decade, as Tiger Woods self-destructed and the sport waned in popularity. 

"This golf course sold for just $2 million," the real estate brokers would tell us  "This other one sold for only $1.5 million - about the value of Midwest farmland."

But wait a moment, we reasoned.  Those golf courses were all losing money.  They had lost money for a decade.  Our golf course was actually profitable.  (Our borrower had simply been over-leveraged.)

Those foreclosed golf courses were also located in inconvenient, middle-income areas.  The folks living in the surrounding neighborhoods of those foreclosed golf courses were mostly blue-collar folks who didn't make nearly enough money to join a golf club.

Far more importantly, however, the "sales comps" were all sales where the seller had a gun to his head.  Think back to the movie, The Godfather.  That movie producer did NOT want to to cast Jonny Fontaine (Frank Sinatra) in his movie... until he woke up to find the head of his beloved horse under the sheets of his bed.

Folks, you cannot use as a sales comparable a sale where the seller was just 48 hours from foreclosure.  Part of the definition of fair market value is the proviso that ... "neither the buyer nor the seller was under undue pressure." 

Okay, so we can't use foreclosure sales, REO sales, and sales on the cusp of foreclosure as sales comparable's.  These sellers were all under undue pressure.

But what do we do when very few profitable golf courses have sold in the preceding three years?  There were simply no un-pressured sales to use as comp's.

This is when I personally stepped in and started marketing the golf course based on the income approach.  "Buy this Course and Earn a Whopping 9.75% Cap Rate!"  You will recall that a cap rate is just the return on his money that a buyer would earn if he paid all cash for an income property (allowing for about 3% of Effective Gross Income to replace the roof and the HVAC units as they got tired).

Holy moly!  The course sold for $3.2 million within just 10 days of marketing. Prior to that, our idiot real estate broker was telling us that we had to sell this trophy golf course for just $1.6 million.  The real estate broker was a moron to rely entirely on the sales comparison approach to value.

I personally hope the deal falls through because the net profit to our golf club just keeps skyrocketing.  If we had waited just six more months, I am convinced that we could have sold the course for $4.8 million.

The lesson to be learned today is that the sales comparison approach is NOT the only way to value real estate.  People buy income properties for the income they generate.

By the way, I begged the buyer to allow me to buy part of the course based on that paltry $3.2 million purchase price.  I suspect that he laughed at me.  Clever boy.

This may be the most instructive training article that I have written in several years, so I strongly encourage you to study it.  (Note: This is NOT the subject vet clinic.)

Sometimes in the commercial loan business, you have to value a property based strictly on a capitalization rate ("cap rate").

Several years ago, I took on a commercial loan on an owner-occupied veterinary clinic.  The vet had gone through a divorce, and he had been forced to file for bankruptcy three years earlier.  He could therefore not qualify for a SBA loan.

The property was located in a town of over 75,000 people, so he could not qualify for a USDA business and industry loan either.  USDA B&I loans are very similar to SBA loans; but they are designed for rural areas.  Any town with a population of 50,000+ people is not considered sufficiently rural.

The loan had to go to a bank or credit union, so I was forced, absent an appraisal (always let the bank order the appraisal), to somehow create a pro forma operating statement on an owner-occupied veterinary clinic.  Hmmm.  How could I do that without having any idea of the market rent of a vet clinic?  Here is what I came up with, and I must say, it was brilliant.

I knew that the vet had bought the facility for $500,000 two years earlier.  To add in some property appreciation over the past two years, I multiplied $500,000 by 103%, which assumed a 3% annual appreciation rate.  To get the second year's value, after more appreciation, I multiplied the result by 103% again, producing a value after two years of $530,450.

Then I pulled a cap rate of 8.5% out of thin air.  Poof.  Remember, I am trying to get my client a commercial loan here, and any commercial broker (a commercial real estate salesman who specializes in selling commercial-investment real estate) will tell you that my cap rate assumption was probably about right.  I might have used 5.5% for a nice apartment building and 6.5% to 7.5% for a retail or industrial property.

You are reminded that a cap rate is just the return on his money that an investor would earn if he paid all cash for the property, assuming you built in a replacement reserve of around 3% of the Effective Gross Income.  The Effective Gross Income is the number you get after taking off 5% for vacancy and collection loss.

Now please remember where we are going.  We are trying a create a believable pro forma operating statement on an owner-occupied vet clinic, when rental comp's cannot be found.  You could look for a week and not find another vet clinic within 50 miles that was simply rented from some passive investor.  

You will recall that a pro forma operating statement is just an operating budget for the upcoming year, assuming you built in a replacement reserve to eventually replace the roof and the HVAC unit.

Quick Joke:

My wife and I had just finished a meal at one of our local restaurants when I realized I'd left my wallet at home. As the wife headed to the door to retrieve her purse from the car, she told the waitress what had happened, adding, "But don't worry, I'm leaving my husband for collateral." The waitress took one look at me and asked her, "What else you got?"

If you are not working towards building your own loan servicing
portfolio, get out of the business.  The money is in servicing.

Back to the Lesson:

Even though we have absolutely no rental rate comparable's, we can now compute the net operating income ("NOI") on the vet clinic.  We simply multiply the value of the building ($530,450) times the cap rate (8.5%) to arrive at the NOI ($45,088).

Confused?

 To value any commercial-investment
property using the income approach, we
simply divide the NOI by the cap rate.  

For example, if an apartment building had a net operating income of $300,000; and we knew that apartment buildings in the area were selling at 5.5% cap rates, we would simply divide $300,000 by 5.5% to arrive at a value of the apartment building of $5.45 million.

To value a commercial property -

Value = Net Operating Income / Cap Rate

Now let's get back to our veterinary clinic.  We are trying to build a pro forma operating statement, while hampered by the fact that we have no rental comp's.  

To get a net operating income, we simply move the formula around -

NOI = Value of the Property x Cap Rate

NOI = $530,450 x 8.5%

NOI = $45,088

We're getting there!  But your commercial lender will want to see a Gross Income, a 5% Reserve for Vacancy and Collection Loss, some expenses, including a management fee, and a 3% Reserve for Replacement.

The expenses are easy.  We just assume that the property is leased on a triple net basis ("NNN")!  The tenant (our vet) pays the taxes, the insurance, the repairs, the utilities, etc.   Poof.  Suddenly we have no expenses to worry about.  Am I good or what?  Haha!

But your commercial lender will still want to see you taking off 5% for Vacancy & Collection Loss.  He will want to see you taking off 3% for Management and another 3% for Reserves for Replacement.

We know that the NOI is just 94% of the Effective Gross Income, after taking off 3% for Management and 3% for Reserves.  Therefore to get the Effective Gross Income, we simply divide the NOI by 94%.

To get the Gross Income, we start by knowing that the Effective Gross Income is 95% of the Gross Income, because we have to take off 5% for Vacancy and Collection Loss.  Therefore we simply divide the Effective Gross Income by 95%.  Voila!  We've done it.

PRO FORMA OPERATING STATEMENT

Gross Income:                                         $50,364
Less 5% Reserve for Vacancy:                $ 2,398
Effective Gross Income:                          $47,966

Less 3% For Management:                     $ 1,439
Less 3% Replacement Reserves:           $ 1,439

Net Operating Income:                            $45,088

Take pride in your understanding of today's lesson.

Did I lose you?  Remember, I had to create a pro forma operating statement, so the lender could compute the debt service coverage ratio on your commercial loan request.  

The problem was that there were only about twenty veterinary clinics within 50 miles of the subject property, and all of them were owner-occupied.  There were no rental comparable's, so I couldn't just say, "Steve's Vet Clinic is leased for $3.00 sf, so the market rent of the the subject property must be $3.00 sf as well."

By assuming a reasonable and believable cap rate, we were able to work backwards to create a reasonable pro forma operating statement.

By the way, this commercial loan successfully (and easily) closed with a credit union, despite the recent bankruptcy.  Hoorah!

This is the perfect time to talk about the "quality" of income.  Real estate crashes seem to strike about every ten to fourteen years, and it has been thirteen years since the Great Recession.  If we were to have another commercial real estate crash, would you rather own a building leased to Betty's Gift Shop or one leased to Amazon.com?

The quality of income refers to the likelihood that you are going to receive it.  All money is green, whether it comes from the headquarters of the Catholic Church in America or from Boom-Boom's Place, LLC, a chain of gentlemen's clubs in southern Louisiana.

But is it likely that Boom-Boom's Place may have a little trouble making its rent payments or its mortgage loan payments if the economy completely tanks?  Guys are less likely to be drinking five beers a night and spending $30 on tips to the dancers if they are out of work.

Okay, obviously, we would rather be on the receiving end of $7,000 per month from Amazon.com than from Betty's Gift Shop; but in order to win that deal, we have to make some sacrifices.

Amazon.com, Inc. signs a lease for a small industrial building, perhaps used to repair its delivery trucks.  Upon the execution (signing) of the lease, the owners of the little industrial building offers the property for sale.

Now normal industrial buildings in Portland are selling at, say, 6.5% cap rates.  In other words, if an investor paid all cash for a garden-vareity industrial building in Portland, he could expect to earn, after paying all expenses and setting aside a little money every year to eventually replace the roof and the HVAC system in 12 years, a return on his money of around 6.5%.

A cap rate is just the return on your money if you paid all cash for a commercial building.

Wake up, folks!  The money
in this industry is in loan servicing fees!

Before computing that return on your money, always remember that you need to set aside a little money every year to replace the roof and the HVAC system.  This is called the replacement reserve.

Okay, so the seller has a building leased to Amazon.com for $7,000 per month.  Your accountant tells you that you need to set aside $850 per month to eventually replace the roof, repave the parking lot, and replace the HVAC system.  So the investment is scheduled to yield $6,150 per month.

Since industrial buildings in Portland typically sell at a 6.5% cap rate, you compute the value as follows:  Six-thousand-one-hundred-fifty dollars per month times twelve months suggests an annual net operating income ("NOI") of $73,800.

If you divide the annual net operating income (NOI) by the proper cap rate (expressed as a decimal), you get its value.

Okay, so $73,800 divided by .065 (6.5% expressed as decimal) equals a value $1.14 million.  Therefore you submit your offer of $1.14 million.  The selling broker falls out of his chair laughing.  What the heck?

"George," he says, "Betty's Gift Shop might sell for $1.14 million (a 6.5% cap rate), but this is Amazon.com!  The world could be in complete chaos, yet a buyer could absolutely depend on Amazon making its rent payments.  There are investors out there who need the security of predictable payments, and they will pay far extra to buy that stream of predictable payments."

"George, I have offers on this building of $1.5 million, $1.72 million, and finally $1.85 million.  That works out to a 4% cap rate."

When a real estate and stock market crash is coming, it's all about the quality of the income.

Wow.  If you walked into the executive offices of some savings and loan associations in the early 1980's, the wealth and opulence would have amazed you - walls paneled with expensive oak, glistening marble floors imported from Italy, and genuine crystal chandeliers hanging from the ceiling.  On the walls you would often find wildly-expensive oil pantings created by the great masters.

If invited, you might dine in the executive dining room, where highly-paid chefs would treat you to a masterpiece of culinary delight.  The President of the S&L might even fly in on the corporate jet to meet you.  And hence came the famous expression...

When the president gets a jet, sell the stock.

In other words, if the president of a publicly-traded S&L started spending money like a drunken sailor, dump your stock.  The orgy of excess spending all came crashing down just a few years later, when this lavish spending and some reckless underwriting caught up to the S&L's.  But how did we get here?

From the year 1933, which represented the bottom of the Great Depression, until the year 1986, Federal Reserve Regulation Q limited the interest rate that banks and S&L's could pay on time deposits (CD's).

In other words, suppose you owned a bank, and your bank desperately needed more deposits.  The other banks in town were paying just 2.0% on C.D.'s, but you were willing to pay 2.5% interest to your depositors.

Guess what?  You couldn't do it.  Regulation Q limited you to just 2.0%.  Your bank was not legally allowed to offer 2.5%.  In order to compete, banks offered free toasters or free transistor radios in order to attract depositors.

Then in 1986, Federal regulators relaxed Regulation Q.  As long as your bank was healthy, you could offer whatever interest rate you wanted in order to attract new deposits.

Suddenly, wealthy real estate developers were opening their own banks and S&L's.  Hot money was quickly being moved from bank to bank, as certificates of deposit matured.  Whichever bank or S&L in the entire country was offering the highest interest rate would get these fast-moving deposits.  After all, the deposits were insured by the Federal government.  It didn't matter which bank a depositor chose.

But as interest rates on bank certificates of deposit increased, it became increasingly difficult for a bank or an S&L to make a profit.  There was a practical limit as to how high of an interest rate an S&L could charge for a mortgage loan.

To make matters worse, the bleeding heart California Supreme Court, in an infamous decision known as Wallenkamp v. Bank of America, had ruled in 1980 that a due-on-sale clause in a mortgage was unenforceable.  Other states soon followed suit.

Prior to this boneheaded decision, a bank could make a 30-year home mortgage at a fixed rate of, say, 3.5%, knowing that the vast majority of homeowners would move and sell their house every seven years.  When they sold their homes, the mortgage would have to be paid off.  If interest rates crept up to 4.25%, it was not the end of the world for the bank because the loan would almost certainly be paid off in just a few years.

After the Wallenkamp decision, however, banks and S&L's became forced to allow new buyers to assume their low-rate, 30-year mortgages.

As interest rates on both C.D.'s and mortgages marched upwards due to raging inflation, banks and S&L's soon found themselves actually losing money on the older fixed-rate mortgages in their portfolio.  They might be forced by inflation and competition to pay 6% on deposits, while earning just 3.5% on a mortgage loan that potentially could stay on the books for the next 30 more years!

Banks did not suffer as badly as savings and loan associations.  Banks always wrote fewer mortgage loans than S&L's.  Banks, in those days, also priced many of their business loans at 2% over prime.  As the prime rate marched ever upwards, so did the interest rate charged to their borrowers.

But S&L were only allowed by charter at the time to make mortgage loans, not business loans.  These mortgage loans were almost universally fixed rate loans.  The fixed rate on the mortgages in the portfolio of an S&L soon became too low for most S&L's to make a profit.  Remember, the prime rate reached 21.5% in 1981, as inflation approached 16% annually.

The Explosion of Construction Lending:

Savings and loan associations therefore became desperate to earn more income.  They found this additional income in the form of construction loans.  

Construction loans, assuming the project goes well, are very profitable for a bank or an S&L.  The bank gets to earn its two-point loan origination fee (competition has since forced this typical loan origination fee down to just one modernly) on the entire loan amount, but in the early months, the bank has only a tiny fraction of the loan outstanding.   Cha-ching.  This works out to a huge yield for the bank.

In addition, construction loans are short term.  Banks greatly prefer short term loans because they can get their money back and then go into turtle mode if they see a recession coming.  

Therefore, in the early 1980's, commercial construction lending went wild.  The skylines of every football team city in the country were lined with huge construction cranes, as huge office towers and hotel towers climbed towards the heavens.

The Savings and Loan Crisis:

Then the government changed the tax law.  No longer could depreciation losses be used to shelter the incomes of the rich and of high-income earners, like physicians.  They began to dump, and even walk away from, their commercial real estate holdings.  Prices plummeted by 45%.

At the same time, the price of oil also plummeted.  Oil-producing regions like Texas and Colorado saw their incomes shrivel and their office buildings soon emptied.  The era of see-through buildings had arrived.

A see-through building was typically an office tower with no tenants and no tenant improvements.  Because the building was just an empty shell, you could literally look in one window and see the seagulls flying outside of the far windows.  

The S&L's Crisis rolled across the country, starting in the East first, reaching Texas 18- months later, and finally reaching California 18-months after that.  The crisis came to a head and resulted in the failure of 1,043 out of 3,234 savings and loan associations in the United States between 1986 and 1995.

The rest is history.

The date was around 50 years before the birth of Christ.  The Roman Republic had wonderfully prospered under a truly republican form of government for almost 400 years.  At the time, there were no kings, no emperors, no dictators, or no Caesars in Rome.  The Senate alone ruled the city-state.

In 49 B.C., Julius Caesar was then the governor of Gaul.  Gaul consisted about a dozen smaller kingdoms, which combined would eventually become France.  Caesar had conquered each kingdom and province in turn.  As he moved from province to province, he sold the captured people of Gaul into slavery.  Caesar made an immense amount of money in the process.

In terms of relative wealth, Caesar was the Bill Gates of his era.  He was not the single richest man in Rome, but he was definitely one of the top three or four.  

Caesar had also raised and paid for EIGHT of his own legions, and he did so without the Senate's permission.  "Aye, there's the rub."  (Hamlet, Act 3, Scene 1.)  Eight legions were a lot in those days.  The Senate had only given its quasi-permission to raise one legion.  The Senate controlled only 12 or 13 legions, and they were scattered all over the Roman Empire.  The Senators of Rome were genuinely scared.

Two more bits of background before Caesar crosses the Rubicon.  First of all, the Roman judicial system was totally and completely corrupt.  The judges all took bribes, and sometimes they even had the parties bid against each to see who would pay the largest bribe.  Justice in Rome could not be found in the courts.  The ruling of the Judge was already decided before most trials even started.

Now the last bit of background.  Rome had already suffered several bloody civil wars, so the Senate had passed an inviolate law.  Any Roman general who brought a legion across the Rubicon River in northeastern Italy was immediately declared an outlaw and an enemy of the state.  It became the duty of every Roman citizen to kill him.

Okay, so Caesar is in Gaul, putting down the occasional uprising, collecting even more slaves, and getting even richer in the process.  But Caesar had enemies in Rome.  Many rich and powerful political families had their own gang of thugs, including Caesar.  These gangs would all use clubs to crush the skulls of any political enemies caught walking the streets of Rome.  Swords were strictly forbidden.  To carry a sword in the city limits was an automatic death sentence.

As the body count grew, lawsuits were filed against Caesar.  The suits weren't just about money.  Many of these lawsuits were quasi-criminal in nature, and if Caesar was ever brought to trial, he could expect to be murdered in jail on his very first night.

The good news was that Caesar was immune from civil litigation as long as he was the Governor of Gaul.  The bad news was that Caesar's (five year?) term as Governor was about to expire.  The Roman Senate ordered him back to Rome to stand trial. Remember, the trials were all fixed, and the order from the Senate was effectively a death sentence.

So what does a general with EIGHT legions do?  Caesar marched his most loyal legion across the Rubicon (really just a large stream) and headed for Rome.  Oops.  The Senate looked around and realized that the forces they had to face the most brilliant general since Alexander the Great were pathetic.

The Senate and the Roman Army therefore fled Rome to Greece, and the Roman Civil War ensued.  The Senate eventually raised seven legions in Greece to Caesar's four, but in the big showdown - a fierce battle in Greece that pitted Roman versus Roman - Caesar pulled off a brilliant battlefield move.  Together with the fact that his troops absolutely adored him and the fact that his troops were all seasoned veterans, Caesar's forces routed the young, inexperienced troops of the Senate.

The Roman Republic was dead.  Never again in history was the Roman Senate anything more than just a figurehead.  The real power always rested thereafter in whoever was Caesar.

Let me put this differently.  The Roman Senate brought a bull-pucky legal suit against Caesar, and they lost the Republic.

Have you figured out yet why I am writing about Caesar and the Rubicon today?  The undeniably blue State of New York brought criminal charges this week against the Trump Organization, citing a scheme to defraud, conspiracy, grand larceny and falsifying business records. 

Now folks, I am not saying that an army of Trump supporters is going to descend from the hills and overthrow the American Republic.  C'mon, guys, get real.  

But I do believe it is historically ignorant for the State of New York to set the insanely dangerous precedent that any American president who loses power will be instantly exposed to, and assailed with, charges from the states controlled by the opposite party.  Think about President Duarte in the Philippines, who instructed his army, the police, and his own hit squads to instantly shoot 6,000 (20,000?) drug dealers.  Why would I bet that Duarte will declare marshal law and extend his own term?

Let me be clear and not beat around the bush.  Those New York State prosecutors are so historically ignorant that they should not be allowed to have children.  (Don't hold back, George, tell us what you really think.  Hahahaha!)  C'mon, you New York prosecutors.  You are attorneys.  You all studied history.  You should know better than to set such a dangerous precedent.

For God's sake, the single most important thing about America is that political leaders and parties can change power in America peacefully.  If you make an outgoing President or a political party fear for their freedom or their own physical safety when they step down from power, how long will it be before America is no longer a republic?

Imagine the following scenario:  Admiral Smith anticipates a Chinese invasion of Taiwan, and through the use of a distributed defense, where missile launchers are spread out over 50 different islands, ships scattered in the South China Sea, and 60 rusting old trawlers pressed into service as missile ships, we sink the entire invading Chinese fleet.

Admiral Smith retires from the Navy, greatly adored by servicemen from all five  branches of the service.  Don't forget that we now have the Space Force, who surely played a huge role in the First Chinese War.

Admiral Smith runs for President, and he wins in a landslide.  But a great many Americans grow to hate him.  He has raised taxes, and he used the additional income to build more underground missile plants and to build new American shipyards in Mexico and Canada.

The American economy has been on a war footing for too long, and it has suffered.  Inflation stands at 12% annually, and good-paying, non-military jobs are scare.  Millions of Americans come to hate Admiral Smith, even though he keeps warning them that China will soon attack again.

The State of Utah then files criminal charges against Admiral Smith for having only two wives.  C'mon, guys, I am just having some fun here; but my point is that the State of Utah files some bull-pucky charges that carry a life sentence.  Yikes.

So Admiral Smith appeals to the military, who absolutely love him and agrees with all of his warnings and preparations for the next Chinese war.  Congress is "temporarily" closed, as Admiral Smith declares marshal law and extends his own term.  "I have no choice but to protect America from China."

So to the prosecutors in New York, I call you historically ignorant.  You have set an insanely dangerous precedent, and you may have just cost us the American Republic.

"Those who cannot remember the past are condemned to repeat it." -- George Santayana

Some of the cheapest commercial mortgage money in the whole world comes from trusts.  There are trillions and trillions of dollars currently invested in trusts.

For example, a wealthy dad might create a trust for his two minor children, where they receive a monthly income and the payment of their education for twenty-five years, until they reach the age of, say, 30 years old.

But here's the thing.  The trust documents will often say that the trustee is only allowed to invest in bonds with a certain credit rating; e.g., BBB or better.

Click here to view the video lesson.

Therefore, in order to invest in commercial real estate loans, those commercial loans - more precisely, the bonds backed by those commercial loans - must be rated by a bond rating agency, such as Standard & Poor's Global Ratings, Moody's, and Fitch Ratings.

The process of taking around 80 large commercial real estate loans - totaling, say $1.5 billion to $3 billion - and turning them into bonds that can be rated by a bond rating company is called securitization.

The bonds themselves are called commercial mortgage-backed securities ("CMBS").  The CMBS industry is huge, and it helps to provide permanent commercial loans, with rates not much higher than those offered by life insurance companies ("life companies").  Life companies offer the lowest interest rates in commercial real estate finance ("CREF") and get the safest, most desirable commercial loans.

Today's three-minute video lesson attempts to quickly explain the concept of a tranche.    A tranche is a division or portion of a pool or whole.  Think of a tranche as one of the pancakes in a tall stack of flapjacks.

Specifically, a tranche is an issue of bonds derived from a pooling of like obligations (such as securitized mortgage debt) that is differentiated from other issues, especially by maturity, rate of return, or risk.

Confused?  This short video training lesson should help.