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

No sooner had I written a blog post last week about the attractiveness of CMBS loan rates right now, than I got a message for one of my subscribers informing me that conduits are no longer making hotel loans.

By the way, CMBS lenders are still making their large permanent loans on the Four Basic Food Groups – multifamily, office, retail, and industrial – at incredibly low interest rates today.

It makes sense why the conduits have stopped making hotel loans.  Hotel occupancy rates are getting slammed right now by the Coronavirus Crisis.

Conduits make large, cookie-cutter, commercial real estate loans that are quickly aggregated into large pools and securitized into commercial mortgage-backed securities (“CMBS”).

Conduits are not portfolio lenders. They can’t just say, “Well, hotels are getting clobbered right now, but the world is not going to stop needing hotels. Since all of our commercial lending competitors are out of the hotel loan market right now, our bank will sneak in there and make a bunch of juicy loans on some of the very nicest hotels in the country.”

Because conduits are not portfolio lenders, they can’t hold commercial loans on their lines of credit for very long.  They need to sell them off quickly.  They can’t hold these loans for two years, say, until the hotel market recovers.

Conduit is short for commercial real estate mortgage investment conduit, a specialized type of commercial mortgage company that originates loans for the CMBS market.

The thing that is special about conduits is that they get to sell their loans to a special kind of trust, called a pass-through trust, created by Congress, which does not have to pay taxes on its income from these commercial mortgages.

This special pass-through trust assembles a whole bunch (100 to 300) of these large, cookie-cutter, commercial loans into a pool.  Then the trust sells pass-through securities, backed by the stream of payments and payoff’s coming from the first mortgages in this pool.  We call them pass-through securities because only the securities buyer (bond buyer) has to pay taxes on his interest income, not the pass-through trust.

Think of an old-fashioned C-corp.  The C-corp pays taxes on its net income, and then the stock owners pay taxes on their dividends.  C-Loans is a C-corp.  Yikes.  It’s a form on double-taxation.

Congress created authorized commercial mortgage investment pass-through trusts to avoid this double-taxation.  (They had created residential mortgage pass-through trusts a couple of decades earlier.)  This move to avoid double-taxation created the commercial Real Estate Mortgage Investment Conduit industry (“REMIC”) industry.

By the way, a portfolio lender is a lender that makes its loans using its own dough and intends to hold these loans for the entire term.  A bank is an example of a portfolio lender.  A family office is another example of a portfolio lender.

A commercial lender using a line of credit from a bank is not a portfolio lender because the bank that is providing the line of credit is probably going to reevaluate that credit facility annually.  There is no guarantee that the bank will renew it.

Therefore, a commercial lender using a line of credit will need to sell off the commercial loans in his portfolio on a regular basis.  He won’t hold them until maturity.

Lastly, I have used the term, “large commercial loan”, throughout his article.  Conduits seldom make commercial loans of less than $5 million.

Some Thoughts on the Coronavirus Crisis:

You will recall that I made you uncomfortable (and probably bored) a few months ago when I described how the virus would soon become a pandemic and that it would cause another great recession, or possibly even a full-blown depression.

I just wanted to remind you that Chinese small business owners, who employ 60% of the Chinese workforce, have been traumatized.  They are not going to want to take on additional debt.

The Chinese Communist Party can order the Chinese banks to lend, but it can’t order small business owners to borrow.  When banks can’t find willing borrowers, yet they keep raking in monthly payments, the multiplier effect kicks into reverse.  Any monthly payment that is not recycled into a new loan reduces the Chinese money supply by a factor of twenty.

In other words, if a Chinese bank takes in a $1,000 loan payment and doesn’t immediately recycle it into a new loan, a whopping $20,000 gets sucked out of the Chinese money supply.  In the parlance of economists, $20,000 is destroyed.  During the Great Recession, about $4 trillion were destroyed.

The reason why this is important is because even if a cure, or even an effective treatment, for coronavirus is discovered today, the average Chinese small businessmen has already been traumatized.  He is not going to be borrowing even more money from the bank.

China is facing a horrible deflationary vortex, where tight money leads to company failures, which leads to employee layoffs, which leaves fewer workers with money to buy products, which leads to less demand, which leads to more company failures and more layoffs.  Its an ugly feed-forward cycle, a deflationary vortex.

If President Xi died and made me Emperor, I would put a moratorium on the loan payments on all bank consumer loans and bank business loans in the country.  The Chinese Central Bank (“CCB”) can easily replace the dough lost by the country’s banks.  After all, the dough is just digits in some computer.

Now if you hear the Chinese doing such a thing, there may be hope for us all; but absent that, prepare for a deflationary tidal wave coming out of China.  Despite what you might think, we do NOT want China to fall into riots and chaos.  They make the industrial parts and the medicines that our manufacturers need.  They buy a poop-ton of our industrial and agricultural products.  We should not wish them ill.

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

I have a great training article about commercial loans for you today.  How do conduits price their commercial loans?  After all, commercial lenders cannot buy a forward commitment from Fannie Mae or Freddie Mac, like a residential mortgage banker; yet most commercial loans today are fixed rate loans.  How on earth do the commercial loan officers, working for these big-time commercial lenders, know what to quote?

Prices and interest rates across the entire world are declining.  This could be wonderful news for those of us in the commercial loan business.

Before I explain, I want to bring you up to date on a blog article that I wrote last week postulating that a world war with China and Russia may be brewing.  This was a pretty important article, and I urge you to read it first.

The ten largest economies include (1) the United States; (2) China; (3) Japan; (4) Germany; (5) United Kingdom; (6) India; (7) France; (8) Italy; (9) Brazil; and (10) Canada.  I was personally surprised to see that the economies of both Brazil and Canada made the top ten.

Most of these economies are shrinking in population, and this is extremely deflationary.