Let's look at true commercial properties for this blog post. [Caution-- math ahead and involved in understanding this post].
How did these loans get into trouble so fast? Let's take a 10,000 square foot office building as an example. The developer finds a parcel of Hwy 158 land at $800,000, circa 2005. Assume construction costs of the building at $125 s.f. which with our building codes and permit costs represents conservative pricing. We now have a total cost of $2,050,000. The borrower gets half of the property under pre-leases before he visits the bank at $25 a s.f. The appraiser retained by the lender confirms the pre-leases, compares the rents with comparable properties and determines the entire building should be able to lease out at $25 square foot, and given current availability and rental pace, he also projects the building will be fully leased 12 months after completion. The bank is happy with the pre-leases and projections. A look at the possible tenants reveals well known local and national companies. The developers have outside businesses and their financials indicate over the past four years, they could contribute significantly to the project if rents faltered for a period.
OK, so what do we have? A $2,050,000 construction project, including lot purchase. $250,000 in gross rents, assuming 10,000 s.f. @ $25/s.f. The borrower puts 20% down, leaving a loan of $1,640,000. Typically, a bank during the boom would be loaning at 7% or so, and community banks would usually amortize those payments over 20 years. This gives us payments of $154,000 per year against gross rents of $250,000. But, more math is involved. There will be expenses, management fees, taxes, insurance, perhaps some vacancies. Most banks would take those gross rents and reduce them by at least 20%, leaving us 200,000 in "net operating income".
Running those numbers we have $200,000 in net rents against $154,000 in payments, for an after expense coverage ratio of 1.3 (200,000/154,000). Most banks want coverage to exceed 1.25, so this loan meets that minimum criteria. To be extra careful, the bank would also average in the personal income of the guarantors--let's say there are three of them--a physician, a Realtor, and a retired lawyer with substantial dividend income. Their post-personal debt income increases the coverage ratio even more to the bank's liking, perhaps to 1.6.
The building is completed, and it leases up as predicted. A large law firm, a real estate sales company, and an engineering firm take up 5,000 s.f. The remainder is leased by a small insurance agency, an architect, an office for a landscaper, and perhaps a title insurance company.
Three years later, we're in a real estate crash. Even though the bank was happy based upon the pre-lease agreements, rental projects and appraisal, our one-dimensional economy creates a major problem. Every single tenant is somehow tied to the real estate market. The attorney closes loans, the real estate comapny sells the houses, the engineer lays out the subdivisions and makes sure houses comply with building codes, the architect designs the buildings, the insurer writes the property insurance, the title company insures the attorney's work and the landscaper sods the yard for the new home. And the developers personal income? The Realtor's income is down by 2/3, the retiree's dividend income was destroyed in the stock market crash, and only the physician is left standing, unable to shore up the project on his own.
By 2008, many of these tenants are gone, en masse, or if surviving, are doing so with gross annual revenues 30-70% lower than what they had averaged each of the prior six years. This pattern is repeated all over the county and soon vacant offices are everywhere.
Rents have now declined to $18 s.f. Our $250,000 in gross rents is reduced to a mere $180,000, assuming the owner can lease the entire building in this environment. After 2o% expenses, our net revenues are $144,000. But our annual debt payments are still $154,000/yr. Even fully leased, we are $10,000 short in our ability to repay. If we are only 75% leased, more likely in the current environment, we're netting $108,000 against $154,000 in payments. Uh-oh.
Congratulations! We just made a $2 million bad loan; even though our building was entirely leased, appraised at cost or slightly more, and the owner put in 20% ($400,000) of his own cash.
And if some self-satisfied reader is telling himself that "anyone could have seen a worldwide crash rivaling the Great Depression" coming to the fore in 2007, I have a building to sell you for $2,050,000!
At this point, one might ask, what is the bank to do? Suppose it forecloses? What is the value of the building?
The appraiser will look at the rents in the market and the vacancies. More than likely, if the building is 25% vacant at $18 s.f, the appraiser is likely to settle on $15 s.f. as a truer reflection of the income potential. He will then take the $150,000 in projected rents and reduce them to a net income of $120,000. Next, he will compare this revenue stream with alternative investments and come up with what we call a capitalization (or "cap") rate. Let's say T-bills represent a safe investment at 3.5% and junk bonds return 11% in the current market. The appraiser looks at the potential tenants and now determines they will be composed of mostly small, "mom and pop" businesses. He picks a cap rate closer to junk bonds than T-bills, say 9%.
Next, the appraiser takes the net rents and divides them by the cap rate:
Thus, the same building that appraised at over $2 million in 2005, providing the bank an 80% loan to value is now worth $1.3 million. If the bank is still owed close to $2 million, its loan to value is now over 150%, and if it wants to sell the building, it will take a write down of $700,000 on this one loan. If the bank has two more loans in the same geographic area in the same trouble, we're looking at $2.1 million in losses. Now look at all the banks in the area and all the empty buildings and projects. The local total is potentially staggering. But, many of these banks are located all over the state, and are experiencing similar losses in those regions--Raleigh, Willmington, New Bern, Bertie County, Currituck. Some of those banks are national in scope, and invested in commercial and residential loans in areas suffering even worse than Dare County--Florida, California, Nevada, and coastal South Carolina. As the media has been warning, the wave of potential commercial loan failures could easily rival what we are witnessing on the residential loan side.
Just to make you sleep even less soundly, given the rate shopping malls are failing nationally, especially in mid-sized cities---you might not want to know that insurance companies are often the primary lenders in this sector. Better not count on that cash value, annuity or even the death benefit.....