Commercial Loans and Fun Blog

So you're thinking about buying a commercial property - maybe a small apartment building or an office building.  

As a general rule, commercial real estate lenders are more conservative than conventional home loans lenders.  Conventional home loans lenders will regularly make purchase money first mortgages that are 80% loan-to-value.  You might say that 80% loan-to-value ("LTV") is the standard LTV for home loans, sort of the "default mode" for such loans.

By the way, a conventional home loan is one where the loan is not guaranteed by the government.  Examples of government-guaranteed home loans include FHA loans and VA loans.  When the government is willing to guarantee the lender against loss, obviously the lender will increase its loan-to-value ratio.

Earlier I used the expression, purchase money first mortgage.  A purchase money first mortgage is one where the loan is used to buy the property, as opposed to a refinance, where the loan proceeds might be used to start a business or pay for your kid's college tuition.

The standard or "default mode" for a purchase money first mortgage to buy an apartment building is a loan of 75% loan-to-value.  If you shop dozens of small banks and credit it unions located close to the property that you are buying, it would not be shocking if one of them - because they happened to be flush with cash - would offer to make you an apartment loan of 80% loan-to-value.

Is a triplex an apartment building?  No.  Multifamily properties have five or more rental units.  Loans on duplexes, triplexes, and four-plexes are actually considered home loans.  Why?  Both Fannie Mae and Freddie Mac will buy loans on one-to-four family dwellings.  As a result, home loans of up to 80% LTV are common on four-plexes.

Okay, but what if you want to buy a small strip center or a small multi-tenant office building to provide income for your retirement?  How large of a downpayment will you have to raise?

In most cases, if you want to buy a commercial-investment property, you will probably have to put 30% down.  If the deal is small, and if you shop 30 or more banks and credit unions located close to the subject property, you just might find one willing to allow you to put just 25% down.

What if the seller is willing to carry back a second mortgage on the property?  Can you put down less money?  Unfortunately not.  Prior the the Great Recession, some banks allowed this; but these banks got crushed in the crash.  Bank regulators will no longer allow second mortgages behind bank first mortgages - neither on purchase money deals, nor later, when there is sometimes TONS of equity.  They won't allow it.    The bank will make you you refinance the entire first mortgage to access that equity.

But wait, as they say in the Ronco commercials, there's more.  If you are trying to buy a commercial-investment property, and the seller is willing to carry back a second mortgage for some of the purchase price, you should apply to Blackburne & Sons.  Unlike banks, we will allow such second mortgages.

Okay, but what if you are trying to buy a commercial or industrial property for your company to occupy and use?  By all means, if your downpayment is an issue, you should apply for an SBA or a USDA loan.

You have probably heard about the SBA loan program.  If your business is older than three years, SBA lenders will lend you up to 90% of the purchase price of a building that you intend to use for your business.

What if your business is less than three years old?  The SBA will probably require that you you put 30% down.

Okay, you have heard of the SBA loan program; but what is this USDA loan that I mentioned above.  The US Department of Agriculture, in order to bring jobs to financially depressed rural areas, has developed a program that is very similar to the SBA loan program.  It's called the USDA Business and Industries loan program.

Click here to apply for a USDA Business and Industries loan.  When the system asks for "Loan Type," simply click on USDA B&I Loan.

Please keep in mind that (1) the Chinese economy is already starting to crumble; (2) the collapse will likely resemble the collapse of the Japanese economy in 1989, leading to the Lost Decade in Japan; (3) President Xi and the Chinese Communist Party ("CCP") will almost certainly be blamed; (4) President Xi will be at great risk of losing power and quite possibly being quietly shot in some cell in a remote prison; and finally, in desperation (5) President Xi will distract the Chinese populace from the collapsing economy and will unite them by invading Taiwan.

Students of history and wave theory can spot humans making
the same boneheaded decisions every generation.

The invasion of Taiwan will require the destruction of the U.S. air bases on Guam, and likely also those in Japan.  Otherwise, the U.S. and its allies will enjoy air superiority.  It is interesting to note that the U.S. military required the participation last week of all 3,000 civilians located near its airbases in Japan in an evacuation drill.

Guam is a U.S. territory, and neither Japan nor the United States are likely to tolerate missile attacks on their sovereign territory.  These missile attacks will probably start World War III, a conventional (non-nuclear) war fought with missiles, jets, and warships.  According the last three war games, the United States and its allies will lose this war.  

We just can't reach the bastards with our conventional weapons.  Our jets can't fly far enough to reach their missile launchers, and the range of their best (and most expensive) missiles is more than twice (three times?) as far.  It will be like a bully in the school yard, holding the forehead of the smaller guy, while the little guy swings at the air.

I try to have fun with this blog, but this is serious stuff.

A buddy of mine asked.  "Can't we just nuke the bastards?"  Between our nuclear triad (intercontinental nuclear missiles, our long-range intercontinental bombers, and our 72 nuclear submarines), we have enough firepower to destroy every town larger than 10,000 people in all of China; but as my Hong Kong buddy recently pointed out, "George, you could kill a billion of us, and we would still have more population than you."  Oh.

But we will never use nuclear weapons, just like we will never use our 2,000 canisters of anthrax or our 20,000 poison gas howitzer rounds.  China has boomers (submarines with nuclear missiles) too, and they are building a whole desert full of intercontinental missile silos.  Almost every human in the United States could die.  At least in a Chinese invasion, maybe our younger children might be allowed to survive.

Interesting note:  While China tested a hypersonic missile last week that flew around the world and then attacked a test target (missed it by a number of miles), someone in our Defense Department pointed out that hypersonic missiles are incredibly expensive.  

Perhaps China has some really cool and dangerous missiles, but maybe they can't afford enough of them.  Remember, these are all conventional missiles.  Each missile might take out an aircraft carrier or several city blocks, but it might take a whole lot of expensive missiles to take out all of our shipyards and missile factories.  Hey, hope springs eternal.

We need to finish developing our mid-air refueling drones to accompany our fighter jets on their 1,000+ mile bombing missions.  I read this week that China has the same problem as the U.S. - not enough refueling jets.

It's kind of cool to watch history play out in slow motion right in front of us, but as I have repeatedly told my kids, history does not always happen to the OTHER guy.  Just think, you and your family could make some history books someday.  Let's just hope you are dipping and kissing some beautiful nurse in a ticker tape parade, rather than...

Remember, I will shortly be sharing with you the exact moment that President Xi will launch his attack.  My earlier prediction that the U.S. and  China would go to war within three years may have been too generous.  With the crash of Evergrande, the war is likely to start a year earlier.  Poop!

Every time you hear in the coming weeks about how China's economy is crumbling, keep in mind that this economic crash only accelerates President Xi's plans to invade Taiwan and start World War III.  Absolutely don't be doing your happy dance when you read that their real estate has fallen by 25%!  

Okay, so when will President Xi start his invasion of Taiwan?  Remember, he has to invade in order to distract his people.  

Another interesting note:  In the past year, President Xi has purged over 1,400 security apparatus officers and policemen.  Does that mean he shot them?  I dunno.  Before World War II, Stalin shot 50,000 officers out of an officer corp of 100,000 - so arguably Xi is just a light weight communist dictator.

Xi would not be purging the secret police if he had no opposition.  Remember, he is trying to run for a third term, and not every communist in China can be comfortable with a President who won't step down.  

In prior blog articles, I hypothesized that the Chinese people would rise up in mass protests and riots once the economic meltdown got really bad.  I read some articles this week that suggest that if Xi is overthrown, it will probably happen from within the Chinese Communist Party.  

C'mon, George, you're killing me here.  When will China invade Taiwan?  

There is a five-month window when the the seas between Taiwan and the Chinese mainland are far too choppy for landing craft.  That five-month period starts in October every year and lasts through the end of February.  March is the first month when an invasion is even physically possible.

But before the Red Chinese can hope to invade Taiwan, they first have to soften up the island nation.  They therefore need to start their super-accurate missile bombardment in October of the preceding year.  They need to take out the shore batteries, the air defense missile batteries, the airfields, the fleets of fighter jets, the beach fortifications, etc.  This missile barrage will likely take months, so perhaps the window for March of 2022 is close to closing.

Therefore I hypothesize that the missile war will start in October of 2022 and the actual invasion will begin in March of 2023.  There is always the chance that the timing will work against Xi.  People could start rioting during the no-go months, and by the time the attack window finally opens, Xi will have already been swept from power.  Hope springs eternal.

Our generals have told Congress that, "The invasion will not start until 2025.  That's the soonest time that China will be ready."

Folks, if we make it to 2025, then Xi will have long since been deposed (and probably shot).  Please pray that Xi gets peacefully deposed.  But just remember what I constantly remind my children:

"History doesn't always happen to the other guy."

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.

What technically is hyperinflation?  Hyperinflation is a term to describe rapid, excessive, and out-of-control general price increases in an economy.  While inflation is a measure of the pace of rising prices for goods and services, hyperinflation is rapidly rising inflation, typically measuring more than 50% per month.

The woman in the picture to the right is actually using German currency to heat her home in 1923.  By the end of 1923, German printing presses were only printing currency on one side of the paper.

Every month my oldest son, George IV, writes a company Investor Letter to Blackburne & Sons' wealthy investors.  I thought you might find this month's Investor Letter particularly interesting:

September 22, 2021

INVESTOR LETTER

George Blackburne, IV

In past investor letters, I presented to you Cathie Wood’s argument that we are actually heading towards a deflationary event (she stops short of calling it a crash). You may recall that in her view, inflation will be temporary.  Once the stimulus funds run out, consumers will tighten their belt before they begrudgingly head back to work.

This belt tightening, coupled with technology improvements, will create a deflationary movement.  On a related note, there was an article on Vox.com, a more left-leaning news site, that was discussing the reasons why people were not going back to work. A whopping 41% of respondents said that they were not returning to work because there was not an opening in their "preferred profession."  I suspect that once the stimulus funds run out, these workers will head back into the work force, regardless if their preferred position is available or not.

In today’s letter, I am going to present to you the view of Michael Burry.  You may recognize the name from the movie “The Big Short,” where he was played by Christian Bale.  Burry was the hedge fund manager of Scion Capital, a fund that correctly “shorted” the subprime mortgage-backed security market and the subsequent crash in 2007.

Contrary to the views of Cathie Wood, Burry is arguing that we are not just headed for an inflationary crash, but this inflationary crash will be on a scale much larger than 2007.  Burry believes that the adoption of Modern Monetary Theory (MMT) by the Fed will have disastrous consequences.  You will recall that MMT states that because our debt is denominated in dollars, the government can, and should, print money until full employment is achieved.  Unlike other theories, MMT does not require backing up this money expansion with raising taxes or cuts in spending.

In some recent tweets, Burry quoted an article describing the economic situation in Weimar Germany during the 1920’s and how remarkably similar those conditions were to our current situation. “Prices in Germany were steady, and both business and the stock market were booming. The exchange rate of the mark against the dollar and other currencies actually rose for a time, and the mark was momentarily the strongest currency in the world”.

Burry then further quotes the article, “Side by side with the wealth were the pockets of poverty.  Greater numbers of people remained on the outside of the easy money, looking in, but unable to enter.  The crime rate soared, and almost any kind of business could make money.  Business failures and bankruptcies became few."

"The boom suspended the normal processes of natural selection by which the nonessential and ineffective otherwise would have been culled out.”  He then finishes his string of tweets with the following: “People always ask me what is going on in the markets.  It is simple.  Greatest Speculative Bubble of All Time in All Things.  By two orders of magnitude.” – Michael Burry June 15, 2021  Whoa.

The money in the mortgage business is in loan servicing fees.
This is going to sound nasty and mean, but if you are not working
daily to build your own servicing portfolio, get out of the business!

Burry further warns that when “dollars might as well be falling from the sky,” companies are inclined to take more risk, which leads to malinvestments (one of my father’s favorite words).  This makes me wonder about the SBA’s new very aggressive lending parameters.  For those of you not aware, the SBA is now willing to work with borrowers with credit scores as low as 620.  I wonder how many of these borrowers, propped up by PPP loans, will default when the well runs dry?

Obviously Burry has a lot of credibility given his past predictions, but are there any numbers we can look at to boost his argument?  Well, as we all know the Debt to GDP ratio is at an all time high.  In addition, M2 Money, which is a tracker for the money supply, has also reached all time highs.  What is really intriguing is the fact that the Purchasing Managers Index (PMI), an index that tracks the overall health of businesses, is higher than pre-pandemic levels.

This begs the question, why is the government printing more money?  Burry believes this is where MMT is coming in to play.  Because we have not reached our targeted unemployment level, the Fed is going to continue to print money.  This will only fuel the speculative bubble and will lead to the eventual collapse.


It should be noted, however, that just this morning Jerome Powell, chairman of the Fed, announced the possibility of raising interest rates in 2022.  Whether or not this is “too little too late" remains to be seen, but it is definitely a step in the right direction.  By raising the rates, it will force companies to be more prudent with their borrowing and should cool the speculation.

Switching gears, I wanted to answer a few investor questions I had received.  Now please remember, we are not financial experts. We get our information from a K-mart magic 8-ball we found in a dumpster at the back of the building, so take our thoughts with a grain of salt.

One investor had asked, "If/when the dollar loses its reserve currency status, would the weak dollar lead to a rise in real estate prices due to foreign investment or just the opposite?"  Well, I gave the magic 8-ball a little shake, and it replied, “Reply hazy. Try again.”

I think the way in which we lose our reserve status would be critical.  If there was a sudden crash, we are taking everyone else with us.  A majority of our foreign investment comes from China, who in turn makes their money from selling America goods and services.  If the American economy tanks, I think it would be unlikely that foreign investors would have enough money to significantly drive-up real estate prices here in the US.  If they did invest in American real estate, they would most likely wait for the market to bottom out before moving in.

But if we slowly lose our status to China over the next two decades or so, then yes, I could see a situation in which foreign investors increase their investments and drive-up real estate prices, especially in places like the Bay Area.

Another investor has asked what do I expect to see in the real estate market in next few years?  I will be honest; I think we are due for a big correction, if not an outright crash.

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.