Last week I blogged on the problems associated with LIBOR.  It is abundantly clear that something needs to be done to replace the LIBOR index as a measure of market interest rates.

I pointed out that $350 trillion in financial instruments worldwide are currently tied to LIBOR.  Regardless of which index the authorities end up using to replace LIBOR, the switchover is going to be tricky.  I can see in my mind’s eye some greedy attorney affixing a bib and rubbing his hands together in glee.  Yum.

The index that will be replacing LIBOR, at least here in the U.S., is the secured overnight financing rate (SOFR).  The secured overnight financing rate is a benchmark interest rate for dollar-denominated derivatives and loans.  The Federal Reserve Bank of New York began publishing the secured overnight financing rate (SOFR) in April 2018 as part of an effort to replace LIBOR.

The daily secured overnight financing rate (SOFR) is based on actual transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets.

Photo by Andrea Piacquadio from Pexels

Benchmark rates, such as the secured overnight financing rate (SOFR), are essential in the trading of derivatives—particularly interest-rate swaps, which corporations and other parties use to manage interest-rate risk and to speculate on changes in borrowing costs.

Interest-rate swaps are agreements in which the parties exchange fixed-rate interest payments for floating-rate interest payments. In a “vanilla” swap, one party agrees to pay a fixed interest rate, and, in exchange, the receiving party agrees to pay a floating interest rate based on the secured overnight financing rate (SOFR)—the rate may be higher or lower than SOFR, based on the party’s credit rating and interest-rate conditions.

In my earlier blog article, I pointed out that LIBOR had become the rate at which banks do not lend to each other because most banks are up to their gills in liquidity.  LIBOR had become nothing more than a guesstimate.  SOFR is therefore preferable to LIBOR since it is based on data from observable transactions.

Unlike LIBOR, there’s extensive trading in the Treasury repo market—roughly 1,500 times that of interbank loans as of 2018—theoretically making it a more accurate indicator of borrowing costs.

Interest rate swaps on more than $80 trillion in notional debt switched to the SOFR in October 2020.  This transition is expected to increase long-term liquidity, but it also may result in substantial short-term trading volatility in derivatives.

While SOFR is becoming the benchmark rate for dollar-denominated derivatives and loans, other countries have sought their own alternative rates, such as SONIA and EONIA.

Time will tell whether SOFR is a suitable replacement for LIBOR.  The difference between the two indices was that LIBOR was based on unsecured loans between banks, whereas SOFR was the rate that banks would loan to each other, but only if such loans were backed by rock-solid collateral.

What is going to happen if a Chinese destroyer trades missiles with an American destroyer?  Talk about “living in a powder keg and giving off sparks.”  Such an event could easily trigger World War III.

Suddenly the investment world goes into a risk-off mode.  Corporate bonds and stocks would likely plummet, while Treasuries and gold would likely soar.  Because SOFR is based on well-secured, inter-bank loans, SOFR might not increase that much.

At the same time, the demand for non-US-government debt will almost certainly plummet.  Yields on investment grade bonds could soar to over 20% in a matter of 48 hours.

What damage will be done to the U.S. financial system because SOFR materially understates real interest rates in the system?  Remember, over $80 trillion in financial instruments are already tied to SOFR.  I dunno; but it can’t be good.

My own company, Blackburne & Sons, will always be in the market – even during war time – to make commercial real estate loans.

That being said, the Company is moving more into the syndication business.  We are putting together syndicates to buy income-producing properties for all cash.  In other words, there will be zero debt.  That is where everyone should be if war does break out – trophy properties that are owned free and clear.

By George Blackburne

I am looking for an expert witness in a commercial real estate lending case.  You will be paid an expert witness fee for your time, and qualifying as an expert looks great on your resume or your website.  Here are the details.

Lesson From Business School:

Have you ever wondered why Elon Musk is so hell-bent on building new battery giga- factories all over the world so quickly?

The reason why is because that manufacturers have learned that the more experience they garner in building widgets, the lower their cost of building each widget.

As they build widget after widget, they learn a little trick here and a shortcut there.  Pretty soon these little tricks and shortcuts add up to some real cost savings.  This leads us to The 10% Rule.

The 10% Rule:

Every time a manufacturer doubles the number of widgets that he has ever constructed, his cost to manufacture each widget falls by 10%.  In some cases, his cost per widget falls by 15%.

It is important to appreciate the word, “ever.”  If Elon Musk had manufactured one-hundred thousand electric auto batteries in the entire life of Tesla, at a cost of $1,000 per battery pack, by the time Tesla had manufactured TWO-hundred thousand batteries, the company could reasonably expect to be able to manufacture each battery pack for just $900 each.

The Japanese taught us this lesson.  In the late 1980’s, the Japanese were eating our lunch in manufacturing.  Their cars were cheaper, and their quality was outstanding.  Japanese chip makers were rising to rival Intel, Advanced Micro Devices, and Texas Instruments.

Their bread-and-butter D-Ram computer chips were as good as ours, and they were selling them at less than their cost.  “Dumping!” cried Texas Instruments, in a complaint and lawsuit before the Federal Trade Commission.  “They are bidding against us on big computer chip orders, and they are quoting prices that are lower than their cost.  They are dumping D-Ram chips at less than their cost, just to steal market share!”

Oops.  By the time the case reached trial, however, the Japanese were able to prove that they had actually made a handsome profit on that big order.  Even though their cost per chip was $100 at the time they bid on that big order, and they bid $99 per chip on that big order, the order was so large that by the time they delivered the chips, their cost had fallen to just $90 per chip.

They Japanese literally “schooled” us, and that is why this manufacturing lesson is now taught in most U.S. business schools.

So whenever Tony Stark… oops, I mean Elon Musk… opens another huge battery giga-factory somewhere in the world, just nod your head and say, “You go, Elon!  Pull even further ahead in lowering your costs.”Did you know that Elon Musk actually did a cameo in one of the Ironman movies?   Haha!  Anyone else out there think that Gwyneth Paltrow, playing Pepper Potts, looked absolutely outstanding in that white outfit?

By George Blackburne

Some more green shoots are visible as the bridge lenders are starting originations also.  The warehouse lending market (big banks lending to debt funds) has started up again, with more cautious leverage.  The warehouse lenders will also monitor loan collateral more closely.

The difference between a commercial mortgage banker and a commercial mortgage banker is that commercial mortgage bankers service many of the loans that they originate, normally for life companies.

The money in commercial real estate finance (“CREF”) is in loan servicing fees.  As I often say, “It’s the loan servicing fees, silly.”   An easy way to remember this is that mortgage bankers are rich, and mortgage brokers are poor.  Want to start earning huge loan servicing fees?

So where do debt funds get their dough their large commercial bridge loans.  We are talking here about bridge loans from $5 million to $100 million.

The general rule is that the sponsors of a debt fund will put up several million dollars of their own dough.  Then they will go out to wealthy individuals that they know, using a private offering, to raise, say $200 million.  They will make, say, $160 million in bridge loans.

Then they will go to a commercial bank and pledge the first mortgages in their portfolio for a $200 million to $250 million line of credit, giving them $400 million to $450 million in lending capital.

As the debt fund makes a profit, some of the earnings are retained as equity, giving the debt fund the ability to borrow even more.

But where do the sponsors of the debt fund go to raise their original $200 million?  Who invests equity into a debt fund?  The answer is mostly wealthy investors, family offices, hedge funds, and opportunity funds.

But what is a hedge fund?  A hedge fund is a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.  Investopedia defines a hedge fund as an aggressively managed portfolio of investments that uses leveraged, long, short and derivative positions.

There are two cool things about a hedge fund.  First of all, these public offerings do NOT have to be registered with the SEC.  Registration is a phenomenally expensive process, required before a company can go public, that involves extensive audits going back several years and immense legal documents.  The process can take almost two years, and the up-front cost is well in excess of $1 million  There are also ongoing legal costs of another $1 million per year.  Yikes.

Now remember, hedge funds do NOT have to be registered.  Why?  Because every investor in a hedge fund needs to an accredited investor, i.e., have a net worth, exclusive of his personal residence, of at least $1 million.  The SEC assumes that accredited investors are either smart enough to understand the risk or can afford to pay an advisor.

The second cool thing about a hedge fund is that a hedge fund can publicly advertise for more investors.  They just need to make sure that every investor is accredited.  This freedom to advertise is a huge deal.

So what is an opportunity fund?  An opportunity fund invests in companies, sectors or investment themes depending on where the fund manager anticipates growth opportunities.  In plain English, the manager invests wherever the opportunities lie.

Important note:  Opportunity funds often buy shares of stock in companies, known as equities.  In contrast, most hedge funds invest primarily in debt instruments.

Another difference between a hedge fund and an opportunity fund is that hedge funds investments are not publicly-traded investment instruments.  Opportunity funds, in contrast, are public offerings, offered to the general investing public.  In other words, you don’t have to be accredited to invest in an opportunity fund.  Interests in opportunity funds are typically offered by insurance plans, mutual funds, and other investment firms.

Some opportunity funds focus on real estate itself, REIT’s, and real estate debt instruments, such as mortgages, debt funds, mezzanine debt, and preferred equity.

Another concept to grasp is the concept of one fund investing in another fund.  A hedge fund might invest in a debt fund.  An opportunity fund might invest in a debt fund.  Therefore most debt funds are a fund of funds.

Now where the debt fund makes its dough is that it can often borrow for as little 3.5% to 4.0% and then make loans at 6% to 9%, plus loan fees.

Clearly debt funds are leveraged, and if the bank holding its credit line gets freaked out and calls its line of credit, the debt fund could be forced into liquidation.  The recent report by George Smith Partners that the warehouse lending market is loosening up is great news for debt funds and the availability of large commercial bridge loans.Commercial Mortgage Rates Today:

Here are today’s commercial mortgage interest rates on permanent loans from banks, SBA 7a loans, CMBS permanent loans from conduits, and commercial construction loans.

Be sure to bookmark our new Commercial Loan Resource Center, where you will always find the latest interest rates on commercial loans; a portal where you can apply to 750 different commercial lenders in just four minutes; four HUGE databanks of commercial real estate lenders; a Glossary of Commercial Loan Terms, including such advanced terms as defeasance, CTL Financing, this strange new Debt Yield Ratio (which is different from the Debt Service Coverage Ratio), mezzanine loans, preferred equity, and hundreds of other advanced terms; and a wonderful Frequently Asked Questions section, which is designed to train real estate investors and professionals in the advanced subject areas of commercial real estate finance (“CREF”).

By George Blackburne

The time to buy is when there’s blood in the streets.
— Baron Rothchild, 1815, Member of the Rothchild banking family.

There is an interesting story about this quote. Baron Nathan Rothchild was one of five sons of Mayer Amschel Rothchild.  Mayer was the founder of the famous and incredibly wealthy Rothchold banking family.  They made Sam Walton’s kids (Wal-Mart) look middle class.

Each of Mayer Rothchild’s five sons headed up a huge merchant bank in a different country.  Nathan Rothchild headed up the Rothchild Bank in Britain.

One way the Rothchild’s made big money was by syndicating huge bond offerings for their respective national governments.  There have even been suggestions (probably untrue) that the Rothchild’s encouraged war between countries so that each son could earn huge bond syndication fees selling war bonds.  George IV is in California, and Tom is here with me in Indiana.  Maybe I should encourage a big snowball fight between the states, and then have The Boys sell ice makers to each side.  Haha!

Okay, so the year was 1815.  Napoleon had just escaped from the Island of Elba, and the French king kept sending army after army to snuff out Napoleon’s little rebellion.  Napoleon had started out with just 30 members of his old Imperial Guard, but as soon as any French force would march on Napoleon, the troops would let out a great cheer, turn around, and join Napoleon’s side.  “Would you fire on your Emperor?” he once asked Marshall Ney.  Finally Napoleon sent a message to the restored Bourbon king, “There is no longer any need to send more armies after me.  I have all the troops I need.”  Haha!

The restored Bourbon king fled, and for the next 100 days, Napoleon mobilized all of France.  He reassembled the Grande Armeee, an army of 100,000 men.  The British, the Prussians, the Austrians, and the Russian were totally freaked out.  They had just fought Napoleon for almost twenty years, and they had finally defeated him.  Why won’t this little sucker just die?!

The aristocracy of Europe was gathered in Belgium to party, dance, and divide up the spoils.  Beautiful women, in fancy gowns, danced with their handsome officers to a wonderful orchestra – until a messenger staggered into the ballroom.  “Napoleon has stolen a march on us.  He has defeated the British at Quatre Bras.  Our army is in full retreat.”  Women screamed.  Some passed out.  Officers scurried everywhere.  The Duke of Wellington, who had never been defeated in battle, famously commented, “I have been humbugged.”

Wellington marshaled his beaten, but unbroken, troops, and emplaced them on the reverse slope of a row of hills overlooking the little town of Waterloo.  Placed there, Napoleon could not accurately aim his famous artillery at them because his gunners couldn’t see the British troops.  They had to fire blind.  The next day, as the Prussians rushed to help Wellington, Napoleon sent infantry division after infantry division marching up those hills.  Each time, the British drove them back.

I really admire Wellington because, even though he was personally a cold fish, he took wonderful care of this troops.  He had them lay down to present the smallest possible target to Napoleon’s endless artillery cannonade.  The French cavalry tried charging the British infantry, but the incredibly brave Redcoats quickly formed into squares and presented the French cavalry with a bristling wall of bayonets.  Horses will not commit suicide by hurling themselves onto bayonet points, so six different cavalry attacks came to naught.

But each time the Redcoats formed square, they became a perfect target for Napoleon’s artillery.  Thousands of brave British boys were blown to pieces, and as the Redcoats formed square each time, the squares became smaller and smaller.  Finally, the British were ready to be broken.

Vive L’Empereur,” shouted Napoleon’s never-beaten Imperial Guard, as they marched up that apparently deserted hillside.  When they were almost to the very top, with victory just steps away, Wellington shouted, “Stand up!”  The exhausted and decimated British survivors rose up like ghosts out of the mist and formed their famous “thin red line.”

Napoleon’s columns were twelve men across and hundreds deep.  The dense formation was designed to punch through any enemy line, but only a few Frenchmen could fire their weapons from this formation.  Wellington’s thin red line had only two men to a file, and every man could fire.  They wrapped themselves around the head of the French column and fired volley after volley into it.  The fresh French troops were stopped cold.  “Fix bayonets!” shouted the few surviving British officers, who had bravely stood in place as their troops had lain down.  “Charge!”

The Imperial Guard broke and ran.  After the battle, Wellington made his laconic but famous comment, “It was a close-run thing.”  Four days later, Napoleon surrendered for good.

Nathan Rothchild had been hard at work as well.  His pre-assigned agent jumped onto a fast mail packet the instant the Battle of Waterloo was over, so Nathan had a jump-start on the markets.  At the time, Consols – the British equivalent of Treasury bonds – were struggling because of the British loss at the Battle of Quatre Bras the day before.  Who wants to own the debt of a country that is about to be overrun by Frenchmen?

Taking advantage of his prior knowledge, Rothchoild started to sell Consols short in huge quantities.  “Oh, my God. Rothchild knows.  Rothchild knows (that we lost at Waterloo).  Sell my consols at any price!” shouted hundreds of traders. …  A terrible run on Consols began.

Until Rothchild suddenly changed position and bought up enormous quantities of Consols for pennies on the dollar.

I am not telling you guys to run out and buy stocks because there is blood in the streets.  In three weeks, I predict that the new, hot story in the final press might very well be about how orders from China, the world’s second largest market, are down by 60%.  This may initiate the second down leg in the stock market, which I fear will bring us about 20% lower than our recent lows.

No, I wrote this article for for my private investors, urging them to snap up our hard money first trust deeds.

“Right now just about every bank in the country – almost all 4,000 of them – is out of the commercial mortgage market.  While commercial loan demand has plummeted, we are seeing some very, very attractive deals.”

“Folks, you have to be smart.  Until this crisis, 4,000 commercial banks and another 5,000 credit unions were competing against us in the small balance commercial loan market.  Poof!  They were suddenly and completely gone.  For the next few months, we have the market largely to ourselves.”

Commercial Mortgage Rates Today:

Here are today’s commercial mortgage interest rates on permanent loans from banks, SBA 7a loans, CMBS permanent loans from conduits, and commercial construction loans.

Be sure to bookmark our new Commercial Loan Resource Center, where you will always find the latest interest rates on commercial loans; a portal where you can apply to 750 different commercial lenders in just four minutes; four HUGE databanks of commercial real estate lenders; a Glossary of Commercial Loan Terms, including such advanced terms as defeasance, CTL Financing, this strange new Debt Yield Ratio (which is different from the Debt Service Coverage Ratio), mezzanine loans, preferred equity, and hundreds of other advanced terms; and a wonderful Frequently Asked Questions section, which is designed to train real estate investors and professionals in the advanced subject areas of commercial real estate finance (“CREF”).

Beer Drinking With George Tonight

Tonight (May 4th) at 5:00 p.m. Eastern Time, I am going to hold a Zoom BS session to just chat, share, and gossip about the amazing happenings in commercial real estate finance.

There is no cost to attend, but I would really like it if each of you would hold up a beer, a wine, or a mixed drink to show you truly grasp the spirit of the occasion.  This chat is supposed to be, first of all, fun; but I suspect we will all learn some interesting things as well.

There is no fixed agenda.  This is not a training class.  I’ll make a few observations about how to survive and prosper in a weird market like this, but after that, the floor is open to anyone to chat about anything related to commercial real estate finance.

To get into the meeting, please write to me, George Blackburne III (the old man), at george@blackburne.com for your Zoom instructions.

I literally get 1,350 emails every single day, seven days per week, so it is please VERY important that your subject line read, “Beer Drinking With George.”

We have 31 people signed up for tonight, and I am going to cut it off at 35.  If you don’t get an invitation, I’m sorry, but you missed the cutoff.  You’ll just have to get drunk on your own.  Darn!

I am using the free version of Zoom, so they will cut me off after only 40 minutes.  I urge those of you who have signed up not to be late.  It would be great if some of you could please bring either some hot commercial lenders to recommend or some related observations to share.  Thanks!

By George Blackburne

The Coronavirus Crisis is now the fourth commercial real estate crash that I have experienced in my forty years of running our family commercial mortgage company, Blackburne & Sons.  They seem to happen about once every twelve years.  Each time commercial real estate fell by exactly 45%.

To those of you who are commercial loan brokers, you should keep working!  There is some serious money to be made during these crashes.  The old, savvy real estate investors know that the best time to invest is when blood is running in the street.

The first commercial real estate crash began in 1986, when President Reagan changed the income tax laws to eliminate the tax shelters previously provided by commercial real estate.

Prior to 1986, a surgeon earning, say, $500,000 per year could shelter, say, $150,000 of his income from taxation by buying highly-leveraged apartment buildings or commercial properties.  The depreciation from these rental properties provided a paper loss – often without too much of a negative cash flow.  These paper losses could be used to reduce the amount of the physician’s taxable income.

When rich guys could no longer use depreciation to shelter their earned income – bam – the value of commercial real estate suddenly plunged like a falling rock.  By the time the crash was over, commercial real estate values had fallen by a whopping 45%.  Please remember that number – 45%.

Savings and Loan Associations (“S&L’s) were heavily invested in first mortgages on commercial properties.  By 1992, one-third of them had failed.  The Resolution Trust Corporation (“RTC”) came in, closed up 3,234 of these S&L’s, and then sold off their foreclosed apartment buildings and office buildings at fire-sale prices.

The RTC offered these buildings at just 50% of an already-depressed fair market value, but the purchase had to be for all cash.  Since 95% of banks in the country were out of the commercial real estate loan market, hard money brokers had an absolute field day.  So did the commercial loan brokers who stayed in the market, originating commercial loans for them.  (Please read that last sentence again.)

In October of 2002, the NASDAQ crashed by 78%, when most of the big dot-com stocks melted down.  Commercial real estate crashed by 45% during the Dot-Com Meltdown.  Once again, there is that magical number:  45%.

Once again, almost all of the banks pulled out of the commercial lending market in 2002, and they stayed out for more than four years.  Banks are nothing but a bunch of frightened herd animals.  Once the bottom (nadir) of the real estate cycle had been found, banks should have been making commercial loans like crazy.

During every one of the commercial real estate crashes in my lifetime, commercial real estate fell by 45%.  After hitting a bottom about two-and-half years into each crisis, commercial real estate recovered to new highs within three years.

But I was thrilled that the banks were a bunch of scarety-cats.  Surviving hard money shops (“Aye, there’s the rub,”), like Blackburne & Sons, made a killing after the Dot-Com Meltdown.  We were the only guys at an all-girls school dance.  Our best commercial loan brokers, who brought us all of our deals, made a killing too.

During the Great Recession, commercial real estate once again fell by 45%.  There is that number, 45%, again.  Just as during the previous crises, the banks immediately dropped out of the commercial loan market, and they stayed out of the market for far too long.

Hundreds and hundreds of hard money mortgage companies also closed up shop during the Great Recession, leaving Blackburne & Sons, and just a handful of others, as the last men standing.  Once again, as the only guys at the dance, we all found lots of dance partners.  We made a ton of superb quality loans.  The commercial loan brokers who brought us these deals made a fortune.

Why did so many competing hard money shops close their doors?  Answer:  Because most of them were structured as funds.  As soon as the crises hit, all of their investors lined up to withdraw their investments.  Previously, these mortgage funds made 85% of their money by making new commercial loans and earning new loan fees.  With no new money flowing into their funds, these hard money shops had no dough with which to make new loans and to earn new loan fees with which to make make payroll.

The situation is even worse today for hard money shops.  Ninety-five percent of them are structured as mortgage funds – as opposed to just 55% of them before the Great Recession.  Your favorite hard money commercial lender?  I’d be surprised if it ever made a commercial loan again.

Do you own a hard money commercial mortgage fund.  Don’t be pissed at me for telling the truth.  You’re screwed, but you can still save your company.  Announce to your investors immediately that you are now charging 390 basis points (3.9%) for loan servicing fees and property management fees.

The single best thing you can do for your hard money investors is to stay in business –  calling for late payments, force-placing fire insurance, exercising your assignment of rents, getting receivers appointed, moving properties out of Chapter 11, hiring property security companies, cleaning up the properties, winterizing the properties, renovating the properties, renting the properties, and selling the properties.

Yeah, your private investors will be pissed at you for awhile.  Remember, however, that most of then are invested in several different hard money mortgage funds.  When their other hard money shops close up entirely, their whole attitude will change.  The portfolios of these competing mortgage funds will get devastated by vandals, breaking pipes, and even worse, by greedy attorneys and their fees.  Your investors will bless you for raising their loan servicing fees and property management fees, thereby staying in business.

Anyway, now back to the needs of our commercial loan brokers.  Blackburne & Sons doesn’t use a mortgage fund.  We syndicate every new commercial loan that we make – maybe 30 investors or so per deal.

Now the sexy thing about being a syndicator is that wealthy private investors always have dough to invest.  It’s merely a matter a price (interest rate).  Therefore Blackburne & Sons intends to stay in the market, making commercial real estate loans, every single day of the Coronavirus Crisis – just like we did during the S&L Crisis, the Dot-Com Meltdown, and the Great Recession.

If you are a commercial loan broker, your eyes should be seeing dollar signs right now.  The banks are now out-of-the-market, and so are 95% of the commercial hard money mortgage funds.  Commercial loan brokers by the tens of thousands have probably resolved to find another occupation.

Because of the Coronavirus Crisis, commercial real estate is likely to once again fall by 45%.  All of the banks will soon be out of the market.  They will no longer be competing against you.  You have broken into the clear.  The businessmen near you who own commercial real estate surely need money, and you know one of the few commercial lenders still making loans.   Go feast!

Contact every business owner you know who owns commercial real estate.  Do you need cash?  Seriously, who doesn’t need cash right now?

By George Blackburne

Conduit loans, also known as CMBS loans, enjoy a fixed rate for a whopping ten years.  Unlike a fixed-rate commercial loan from a bank, there is no rate readjustment after five years.  The rate is fixed for the entire ten years.

And with ten-year Treasuries at just 0.79%, there has never been a better time in history to get ten-year, fixed-rate conduit loan.

Conduit loans are priced at some negotiated spread over the higher of ten-year Treasuries or corresponding interest rate swaps.  Here is where you go to find ten-year Treasuries.  Here is where you go to find today’s interest rate swaps (as known as the swap rate).  Here is another site that provides interest rate swaps.

Today (3/8/20), ten-year Treasuries are at 0.79%, and ten-year interest rate swaps are at 0.81%.  Therefore we will use the higher of the two indices – interest rate swaps.

Okay, but what is the spread or margin over the index?  Conduits are pricing their office, retail, and industrial commercial permanent loans at 140 to 290 basis points over the index.

Therefore, we are talking about conduit commercial loans priced at between 2.21% to 3.71%.  Wow!  So who gets the 2.21% rate, and who has to pay 3.71%?  It depends on the loan size, the risk, the debt yield ratio and the tenancy.

The larger the deal, the smaller the spread.  The safer the deal, the lower the spread.  For example, if your property is located on Madison Avenue in New York City, you will enjoy a lower spread than a deal located on a nice retail street in Salt Lake City.  Madison Avenue is a more proven location.

There are some properties, however, that sell for such incredibly low cap rates – for example, Madison Avenue in New York City – that the debt yield can be too low.  This is a bad thing.  Sometimes the debt yield ratio on that Salt Lake City property can be more attractive to a CMBS investor.

Do not confuse the debt yield ratio with the debt service coverage ratio.  Interest rates are so low that it is easy for most commercial properties to offer a 1.25 or higher debt service coverage ratio today.  The ratio is almost irrelevant when it comes to conduit-size deals ($5MM and larger).

The quality of your tenants also determines your spread over the index.  Quality refers to strength of your tenants.  If you have a shopping center anchored by Target or Krogers, you will enjoy a tighter spread than a shopping center anchored by a mom and pop grocery story.

CMBS loans are made by commercial real estate mortgage investment conduits “REMIC’s”, known as conduits.  There are specialized commercial mortgage companies that originate large, cookie-cutter commercial permanent (long term first mortgage) loans for eventual securitization.  In layman’s terms, a conduit loan is a very plain-vanilla first mortgage on one of the four basic food groups – multifamily, office, retail, and industrial properties.

Is your deal kinky?  Does it need a long story to explain it.  If so, its probably not a conduit-quality deal.

But it is important to note that your property does NOT need to be almost brand new and very beautiful.  Life company lenders demand such properties, but most conduits would be perfectly happy to make $8 million permanent loans on forty-year-old neighborhood shopping centers or on occupied, downtown, office buildings.

Every commercial lender prefers to make loans on multifamily properties, so the spreads on multifamily deals are about 10 bps. tighter.  You will not be shocked to learn that hospitality spreads are fifty basis points higher than standard conduit deals.

What about loan-to-value ratios?  You will seldom get a conduit lender to go higher than 65% LTV on a hotel.  The loan-to-value ratios on the four basic food groups are typically between 70% to 75%.  The higher the LTV and the lower the debt yield, the higher the spread (and eventually the higher the interest rate) that the borrower will pay.

Lastly, conduit lenders do NOT lock in their rates at application.  Most of them will, however, lock in their spreads, while the conduit commercial loan is in processing.  That being said, there will be a floor of 5 bps. to 10 bps. below the interest rate quoted at application.  In other words, if interest rates go up during application, the borrower will have to pay a higher rate.  If interest rates fall, the borrower might enjoy a slightly lower rate.

Investors, I know you are all freaked out that you might die from this coronavirus (its out to kill all of us “old-gomers”); but you can apply for a conduit loan from the safely of the virus bubble in your home.  Focus.  If you can close a conduit commercial loan during this crisis, your cash flow, and that of your heirs, will be fantastic!  Git ‘er done. Ten-year Treasuries may never be lower.

By George Blackburne

George Smith Partners recently released a tombstone about a commercial loan closing that used a financial term of which I had never heard:

“George Smith Partners arranged $23,750,000 in bridge financing for the refinance of a 229-key, full-service hotel located in Downtown Minneapolis, Minnesota…  The Property, built in 1986, underwent a PIP in 2017.”

What in heavens is a PIP?

A PIP is a Property Improvement Plan required by a brand or franchise – usually a hotel franchise, like Marriott or Hilton – to maintain or improve standards.  Often the property owner needs to obtain a secondary loan or refinance the property.

A property improvement plan (PIP) is required to bring a hotel in compliance with brand standards.  According to HVS, an effective PIP should help owners gain market share, increase guest satisfaction, drive revenue performance, and enhance profitability.  Elements like lighting, faucets, and fixtures are foundational for brand standards, but now energy-efficient equipment upgrades are entering the equation.

One hotel franchisor recently said that her company is pushing hard to incorporate sustainability measures into the conversion process. There are things that the franchise is recommending in order for the franchisee to run an efficient building.

For instance, if a boiler system has a 30-year life expectancy, but it’s only 20-years-old, the franchisee might consider changing it out early because there is no down time, new systems are 30 percent more energy efficient, and there is a good ROI attached.  “We’re looking at mechanical systems, chillers, boilers, and things that are not very sexy,” she says. “It’s really important in looking at how much it’s going to cost to operate that piece of property.”

Property Improvement Plans (PIP’s) are not cheap.  PIP costs can vary greatly with different brands, hotel sizes, and property locations.  One of the most popular PIP’s, Holiday Inn’s Formula Blue, usually costs between $10,000 and $25,000 per room.  Since the average Holiday Inn Express location has around 75 rooms, that adds up to between $750,000 and $1.875 million in total costs.  Hampton Inn’s Forever Young Initiative is another popular PIP, which experts estimate will cost between $15,000 and $40,000 per room.

Yikes.  That’s real money. SBA loans are often, but not always, utilized to finance a PIP.  It is important to understand the types of improvements a prospective hotel owner can make using SBA funds.  Experienced hotel owners often focus on the following areas:

• Renovations to exterior facades – including signage, roofing, and colors
• Room and lobby updates such as lighting and fixtures
• New amenities such as indoor/outdoor pools and fitness areas
• Expand or improve parking
• Replacing mechanical items that are close to end of their useful life – such as the roof or heating system.

Instead of obtaining secondary financing, many property owners choose instead to refinance the entire property.  Because ten-year Treasuries are so low, this is the best time in history to refinance your property with a CMBS loan.

Article By George Blackburne

When a bank makes a commercial construction loan, it is certainly not going to take all of the risk.  A bank will usually require that the developer cover at least 20% to 30% of the total project cost – land cost, hard costs, soft costs, and a contingency reserve equal to 5% of the hard and soft costs.

Usually this takes the form of the developer contributing the land free and clear of any liens, plus having paid much, if not all, of the engineering and architectural fees.

Therefore I was shocked to read a tombstone sent out by my friends at George Smith Partners, one of the oldest commercial mortgage banking companies in the country.  You will recall that a tombstone is a closing announcement designed to show the types of commercial loans that a particular lender makes.

The tombstone boasted of the closing of a $4 million non-recourse land loan in Beverly Hills, at 8% interest for one year.  This land loan was made at 90% loan-to-cost (LTC)!  Ninety percent on a land loan???  I know that Colorado oregano is now legal in California, but 90% LTC on land is an insane amount of leverage.  (In this particular case, the cost was the same as the fair market value.)

So I wrote to my buddy, Bryan Schaffer (a very good man), and asked, “Bryan, I don’t understand.  What is the exit strategy?  Any construction lender is going to expect the developer to contribute the land free and clear, and it might require even more developer’s contribution.”

Before I share with you Bryan’s answer, I need to explain that, prior to the Great Recession, banks were allowed to give developers credit for the appreciation in the value of their land.  For example, suppose a developer purchased some land for $1 million, and three years later, because he bought shrewdly, the land now appraises for $3 million.

Back then, the bank was allowed to value that land at $3 million for equity purposes.  Therefore, if the developer only owed $500,000 on this $3 million piece of land, the bank would say that the developer contributed $2.5 million in equity towards the proposed construction loan.

But then the Great Recession hit, and construction lenders took huge losses.  To curb what Federal regulators deemed as reckless commercial construction lending, banks were only allowed to value land at the developer’s actual cost – in this case, just $1 million.  This has greatly restricted commercial construction lending over the past decade.

We are now ready to reveal Bryan’s answer to the question, “A land loan of 90% loan-to-value?  What the heck have you been smoking?”  Haha!

“George, It is very hard to get the full appreciated value of the land.  On this deal, if you just did a construction loan, most lenders would only give the developer his basis (actual cost), which was $1.4 million.”

“With a $4MM land loan and an appraisal at $4.4 million, the bank will give us at least a $4 million value for land – and most likely the full $4.4 million value.  At some banks, if he deposits the $4 million (from the loan proceeds), they will loan him the entire $4 million against it at a very low rate, which he will use to pay off his land loan.  He will get the full $4 million to $4.4 million credit (for the value of the land) and will also show $4 million of liquid assets, but it will be in a restricted account.”

“So the hard money loan cost him $200K to $300K, but in exchange he does not have to bring in fresh cash of $2-3 million and likely also looks better for future loans because he has the $4 million in a restricted account.  It is a little bit of a financial game, and it is only good for someone that does not have the cash.  Hope that helps, Bryan.”

Did you get lost?  It helps to understand that banks only want to lend to developers with lots of cash on hand.  Our developer will take this $4 million in land loan proceeds and stick it into the account of the bank which will make the new construction loan.  It’s a restricted account, so the dough can only be used to construct the proposed 12-unit apartment building.

Because the land has a whopping $4 million loan against it, the bank can’t just value the land at the developer’s cost of $1.4 million.  It makes no sense, so the bank is forced to value it at least at $4 million.  And since the bank is already breaking the Fed’s rule about valuing the land at the developer’s actual cost, they will probably cave in and value the land at its $4.4 million appraised value.

So the land loan costs the developer $200,000 to $300,000 in loan fees and interest – but it reduces by $2 million to $3 million the amount of equity the developer has to contribute to the property.

As Bryan explained, its kind of a shell game (1) to make the developer look liquid and rich; and (2) to get around the Fed’s rule that bank construction lenders must value the land at the developer’s actual cost.  I suspect that there are a lot of parties winking at each other.  Haha!

By George Blackburne