But I Want To Stay Debt Free!

Fine – but the big picture is important, so here are a few thoughts to consider:

1. Long-term fixed interest rates are not likely to be as attractive into your retirement (and if you are nearing retirement, your employment income goes away – potentially causing difficulties for you to obtain financing if needed in the future);
2. Mortgaging your to-be-acquired property allows you to maintain additional “just-in-case” liquidity (and can improve your credit score);
3. Over time your investment advisor should be able to comfortably achieve annual returns on your invested capital/retirement funds in excess of the annual interest charges on your mortgage (not to mention the tax benefit of the mortgage interest deduction);
4. With enhanced dividend/interest earnings from investing your liquidity now (as opposed to using it for purchasing a property), your debt-to-income ratios would better support borrowings in the future; and
5. Through a mortgage, you will continue to build real estate equity through principal amortization, and you can always select a lower LTV or faster amortization period (i.e., fixed monthly payments over 10 years instead of 30 years, at an even more attractive interest rate).

The Sudden Fuss About “Debt Yield”

In my earlier years as a lender, I recommended a $15 million acquisition loan that was to be secured by a retail center. The solid credit tenants on long-term leases supported the 7.5% capitalization rate, which was the minimum cash-on-cash rate of return my borrower/buyer was prepared to accept on his investment. Based on the property generating $1,500,000 of net operating income (NOI), the maximum price my borrower was willing to pay was $20,000,000 (NOI ÷ 7.5% Cap Rate).

I recommended the loan based on the conservative cap rate, NOI coverage and 75% loan-to-value ratio. After approving the deal, my credit officer said: “As a commercial lender, we should achieve a Debt Yield of at least 10%, and focus less on Cap Rate”.

Debt Yield is the rate of return on the loan (a lender’s expected return upon foreclosure). It is the same calculation as a Cap Rate (NOI ÷ Purchase Price), except the denominator is the loan amount instead of the Purchase Price. In this example, the Debt Yield is 10% ($1,500,000 NOI ÷ $15,000,000 loan). It ensures: (i) a safe LTV ratio, and, (ii) that the NOI should adequately cover debt service on the loan, provided the interest rate is comfortably less than the Cap Rate.

The Point Is This: The concept of Debt Yield has been around forever, but it is forgotten at the top of every economic cycle and resurrected at the bottom. Here we go again – the banks have finally remembered what they had forgotten.

Dick Cantner (SBDC) Interview with Michael Kanuka

I am extremely grateful for the support and guidance I have received from the Small Business Development Center (“SBDC”) at Indian River State College, in Vero Beach, Florida.

Below is an interview that I did with Mr. Dick Cantner of the SBDC:

Dick Cantner Interview with Michael Kanuka from Zumarra Digital Agency on Vimeo.

And One More Thing . . .

I’d like to re-visit an issue I alluded to in one of my previous posts.  It has to do with a large residential lender, in classic rhetoric, proclaiming it was time to beef-up staff in anticipation of a significant housing recovery.

Well, their timing was good.  Home prices in the U.S., including distressed sales, increased 12.1% in April 2013 compared to April 2012, according to CoreLogic’s Home Price Index.  This was the biggest year-over-year gain since February 2006.  Give credit where credit is due.

This time, however, permit me to ask a couple of rhetorical questions:

1. With an abysmal U.S. public debt picture ($16.8 trillion including intragovernmental obligations), is this momentum somewhat artificial or shortlived?

[Reading a little further into CoreLogic’s report, home prices remain 22.4% below their peak (Florida’s prices are still down by more than 40%, and Nevada by 47% – these percentage examples are not insignificant)]

2. Were staff increase announcements made solely in preparation for a recovery, or perhaps to offset previous announcements that they were exiting the wholesale lending business?

[Wholesale lenders are fed loans exclusively by the mortgage brokerage community.  Lenders exiting this kind of business really have no choice but to find a way to source lending business on their own – therefore they MUST hire]

Yes – things have picked up, but I see little evidence of other banks aggressively increasing staff right now.  I hope I’m wrong, but I still say we have a ways to go.  Be prudent.  Be cautious.

Take Your Time

USA Today recently published an article on the “continued housing recovery”, written by a journalist from the Des Moines Register.

The excitement started when Wells Fargo Home Mortgage announced they were building a complex in Des Moines for 1,800 employees. Wells has increased headcount by 18% over the past year because, as their senior economist stated: “…more people are interested in selling their house to buy larger ones.” The optimism was apparently fueled by the Fed’s commitment to keep interest rates low, which one Iowan banker in the article said has given people more confidence because “…everyone agrees we won’t see the unemployment rate coming down anytime soon.”

Pardon?! Sounds like illogical conjecture to me. People don’t build confidence and buy larger homes when they are out of a job. News of the unemployment rate dipping below 8% was welcomed, but the unemployment rate has been less than 6% on average over the past 30 years. Yes, loan delinquencies are at their lowest level in four years – but such delinquencies are still over 5% of banks’ portfolios (versus under 2% well before the housing crisis).

Don’t rush to buy a bigger house and lock in a bunch of debt right now just because rates are low. With the QE stimulus ending and people still out of jobs (while banks continue to unload their foreclosed product), and with taxes going up and the federal debt continuing to rise… there is still time before the other shoe drops.

Developing to a 6% Cap?

Sounds crazy doesn’t it?

It wasn’t that long ago when a 10% cap rate was the norm. If you couldn’t achieve a 10% unlevered NOI return on investment, it didn’t make sense to pursue an acquisition. But remember, that was for a cash-flowing stable income property asset. Not only are industry professionals today interested in acquisitions well below that old 10% threshold, there are veterans (even after having been through at least two real estate cycles) who are rolling-up their sleeves to make a development deal work at that low 6% level – without “blinking an eye” to the associated development, interest rate and market risks.

Well, as crazy as that sounds, the old principle of making sure a 2%+ spread exists between the cap rate and interest rate indeed holds true today under a 6% cap rate threshold. And, it doesn’t appear that commercial borrowing rates are positioned to sky-rocket (who would have thought that U.S. dollar LIBOR would reduce to 0.20%). But the more prudent way to underwrite these deals is by focusing on unlevered and levered IRR’s, using conservative assumptions. The latter measurement is down from the old 20%+ days, but something less than 15% today is still risky. If you can make it work at that level (ensuring a more reasonable return on cost margin), you would be well-advised to build and sell quickly so that you yield a reasonable developer’s profit – that is, before LIBOR starts moving north or your tenant leaves.

Start blinking your eyes.

Leadership Humility

Dan Quiggle

I recently attended a NAIOP/ULI Joint Program and Trade Show that featured Dan Quiggle, President & CEO of America’s Choice Title Company, as a guest speaker. Having worked in Ronald Reagan’s post-presidential office, Dan’s message was focused on leadership – primarily based on what he had learned from one of the most respected U.S. presidents in history.

Dan did a great job, and was clearly motivating in his delivery. In my opinion, the key take-away for the audience was to remember Reagan’s four leadership attributes: loyalty, attitude of gratitude, humor and humility. While there was no particular order of importance, the most time was spent discussing humility – which I think was quite appropriate.

Humility is the oftentimes neglected quality of being humble. Aside from the modesty part, humility also involves being respectful to others and admitting when you are wrong. Granted, as a leader you don’t necessarily want to have the reputation of constantly apologizing, but leading by humility garners the most respect from your employees, colleagues and clients, as well as your family and friends – guaranteed.

With the upcoming election, don’t go away thinking that this article is slanted towards a Republican vote (not that that would be a bad thing!). But the world would be a better place if we all, Republicans and Democrats, Chairmen and Managing Directors, Borrowers and Lenders, and Real Estate Brokers and Mortgage Brokers, followed these obvious leadership qualities – especially humility.

Pretty Simple

Why would anyone ever consider using a mortgage broker?! I polled several borrower and lender clients recently to get their candid thoughts on this question. As a mortgage broker myself, naturally this could be somewhat self-serving, but it was also relatively risky because it could backfire if they were to answer: “Well, I hadn’t considered this recently, and so perhaps you raise a good point that I shouldn’t be using your services at all!”

But the feedback was simple and consistent. Borrower clients indicated that their main reason for using a mortgage broker was because they were either unwilling or unable to take the time to source the best loan pricing, terms and conditions from too many lenders in the market. Lender clients, on the other hand, indicated that a solid borrower landing on their desk with little marketing effort allowed more time to manage their loan portfolio.

Of course neither side could resist adding why they would elect not to use a mortgage broker in the future! Borrowers almost unanimously complained that their “former” mortgage broker was unresponsive and therefore unreliable (such as being regularly tardy with returning phone calls). And lenders admitted that they cringe when their caller ID displays the number to a mortgage broker who regularly pushes loans that are way outside their risk acceptance criteria or who sends them inaccurate information.

Aside from using a mortgage broker who is professional, experienced and trustworthy, the only other response I made (which of course was self-serving) was that a good mortgage broker should offer independent advice and an unrestricted selection of capital sources and loan products to borrowers; whereas to lenders, a mortgage broker should be able to strengthen the client relationship so that the business conducted is long term and lucrative. Pretty simple.

The Importance of Reputation

It is old news that the mortgage brokerage industry suffered a large reputational set-back as a result of the 2007-2008 U.S. subprime mortgage/housing crisis, occurring subsequent to the 2005 U.S. housing bubble. And, it is generally accepted that, although lenders irresponsibly originated large numbers of high risk sub-prime mortgages in anticipation of continued home value appreciation, mortgage brokers were also blamed for endorsing poorly or fraudulently underwritten loans (which, in many cases, were based on artificially high property values).

Not surprisingly, the mortgage brokerage industry was detrimentally affected from the housing crisis insofar as borrowers’ appetites to engage mortgage brokers significantly declined. Since that time, however, the U.S. government has tightened the rules and regulations over licensing/reporting requirements, accountability, and information transparency. The industry image has improved, but there is definitely a lot more room for progress to be made.

But regardless of the reputation of the mortgage brokerage industry, there are still trillions of dollars of loans that are either maturing or require restructuring attention. And, there will always be situations where a homebuyer or real estate investor will benefit from the services of a seasoned, trustworthy mortgage broker to source the most optimal loan available.

While many real estate owners/borrowers have now taken a more proactive approach to addressing their financing needs, there will always be those who are:

• generally unwilling or unable to take the time to source or manage their own loan,
• more comfortable outsourcing their financing needs for economic or efficiency reasons,
• unhappy with their lender, mortgage broker or the terms of their loan, or
• unaware that their lender or mortgage broker could be providing better advice or terms.

In addition, there will always be a significant number of capital sources/lenders who:

• are relatively unknown to real estate owners/borrowers,
• have credit programs that may appear to be unclear, inflexible or too restrictive,
• have risk management policies and/or time constraints that prevent them from thoroughly analyzing more complex lending terms or amendment requests, or
• are presently more focused on the non-performing loans within their portfolios, as opposed to having an ongoing dedicated program of sourcing borrowers for new loan placement.

In conclusion, the mortgage brokerage industry must make “reputation” their number one priority to re-gain the confidence of the borrowing public and therefore remedy the “disconnect” between unsatisfied borrower needs versus the need for lenders to grow and optimize their credit programs. Since the prevailing view is that greedy, apathetic and relatively unregulated mortgage brokers were among the biggest contributors to the U.S. housing crisis, it is up to the mortgage brokerage community to address this issue – and the effort should be lead by the most experienced, reliable, diligent mortgage brokers by demonstrating the kind of integrity that both borrowers and lenders expect and deserve to receive.