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Timid Bankers Get Slaughtered in Commercial Real Estate Finance

Posted by George Blackburne on Mon, May 27, 2013

If you're a senior executive wth a bank, this article is pretty important to you.  I've been making commercial real estate loans for 33 years now, and I have a surprising observation:

Commercial bankers often get slaughtered in commercial lending because they are so timid.  By the time most commercial bankers work up the courage to enter a lending market, all of the really safe, high-yielding loans are already gone - leaving only the risky deals and the bank's eventual ruin and destruction.

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Let's start in residential lending first, even though this article mainly has to do with commercial mortgage lending.  When Nixon took the U.S. off the gold standard in 1971, he opened the floodgates of inflation.  Homes that the Greatest Generation bought for $15,000 in the 1960's began to appreciate to $40,000 or more.

Smart, entrepreneurial private lenders in California started to make 10% second mortgages (at a time when second mortgages were rare and were considered ridiculously speculative).  These early entrants made a killing.

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By the time commercial bankers finally started making residential second mortgages in earnest, many of the safest deals were gone.  Commercial bankers were left in a bidding war a decade later over the tiny handful of borrowers who had not already tapped the equity in their homes.  By then, real estate appreciation had greatly slowed.  Then, in 1986, a major tax overhaul sent real estate into a seven year tailspin.  California commercial bankers, for example, got slaughtered in residential second mortgages when California real estate tumbled by 40% in 1990 and 1991.

Now let's scroll forward to 1986, the year when Regulation Q was repealed.  Regulation Q was a law that limited the interest rate that banks and thrifts (savings and loan associations) could pay on deposits.  Suddenly commercial bankers could pay whatever they wanted to attract deposits.  It was an era when many wealthy developers bought savings and loans associations (S&L's).

At first these clever developer-banker-entrepreneuers make a killing investing in syndicates to make large commercial loans.  After all, they could charge almost any interest rate they wanted.  Who else - other than a syndicate of S&L's - could fund a $40 million construction loan?  And these early entrants made a killing.

But then mainstream commercial bankers (more precisely S&L executives) got in the act.  They too started investing in syndicates to make huge commercial construction loans.  Eventually the world was full of vacant, glass-and-brass office towers (called "see-through buildings"), and the S&L Crisis was upon us.  Hundreds of S&L's were eventually closed.

Scroll forward to the late 1990's.  Congress has created the tax entity, the REMIC, the Real Estate Mortgage Investment Conduit. Early conduit lenders made an absolute killing.  They made a bunch of superb quality, low-LTV commercial mortgages.  They pooled these super-safe commercial loans and then sold them off to Wall Street investment bankers at immense profits.  The bonds backed by these older, high-rate, low-LTV commercial loans surprisingly held their value, even during the bottom of the Great Recession.

But then dozens of large commercial banks got in the conduit loan business.  Competition got so fierce that interest rates plunged, loan-to-value ratios skyrocketed, and when the Great Recession hit, those commercial bankers stuck with commercial mortgage conduit loans in their portfolios got slaughtered. 

Helloooo?  Anyone spot a trend here?  Most commercial bankers are so timid that by the time they enter a lending field, all of the really safe, profitable loans are gone!  Almost inevitably these late-comers get slaughtered.

Right now the commercial real estate lending market is ripe to be picked.  A commercial bank could come into the market, make some super-safe and dreamy commercial loans, and charge an interest rate that is 1.5% higher than the market, say, 6%.  The smart bank would also insert a large prepayment penalty or a lockout clause.  (If your bank wants to see many such super-safe, dreamy commercial loans, be sure to join C-Loans!)

In a year or two, however, most commercial banks will come herding back into the commercial lending market.  The really cherry deals will already be gone, and the herd will get into a price war over average-quality and below-average-quality commercial loans.  I wouldn't fall off my chair in surprise if the herd ended up bidding interest rates on commercial loans back down to just 3.875% (when they could be getting away with 6% today).

I don't know why I am wasting my time today.  Commercial bankers will probably always be timid and foolish.  They equate "herd movement" with prudence and safety.  They couldn't be more wrong.  (Sons, always remember the slow reaction speed of commercial bankers.  When commercial bankers finally adopt a lending product, its time to get Blackburne & Sons out of that market.) 

Here is the lesson from this article:  There has been no commercial construction since 2008.  The economy is recovering.  Many commercial buildings were so neglected during the Great Recession that they need to be bulldozed.  The prognosis for commercial real estate values is superb.  Just look at what has already happened to residential real estate.

Will commercial bankers have the wisdom to be early entrants back into the commercial mortgage market?  Will they have the wisdom to make 6% loans (with a lock-out clause) in a 4.5% commercial mortgage loan market?  I seriously doubt it.  Most commercial bankers will be too timid about commercial lending to re-enter the market before the best part of the recovery has long passed.

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Topics: timid commercial bankers