What's Going On With Commercial Banks?

Foreign.

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Foreign Good morning, good afternoon, good evening everybody. Welcome this episode of the Note Closer Show. As always, Scott Clarkson. Excited to be here today. Today I want to talk a little bit. You know, probably something you guys have seen in the news. It's all the distress with these different banks and people are asking me, hey, are we going to see a lot of residential notes on these banks that are going out of business or what's the deal with These banks that are failing or struggling or these things that are popping up. And I kind of want to clear a couple things. There's really kind of two. When we think about buying notes, most people constantly think directly to the residential side of real estate. And that's great. That's where a lot of us are spending our time on, where a lot of people are making them. And I had somebody reach out today, hey, I want to buy in la or I want to buy in Minnesota. And I'm like, that's great. But the banks that are making the headlines aren't necessarily your big lenders, like the bank of America is. The Chases, the cities are not big residential mortgage originators. They don't hold a lot of residential debt on their books. They're more on the commercial side of real estate. And I, I saw an article on LinkedIn that explained it better than I've seen anywhere else in very layman's terms about what's going on with the market when it comes to commercial real estate. And while the residential housing market is still strong, we still have a very low distress rate or default rate out there. You're still going to have default. So when you have 80 million homes and you get a 2 to 3% default rate, that's still 2 to, you know, you know, around 1.6 to 2.4. Somewhere around 2 million homes are in default. That's not counting owner finance stuff and other people that are distressed for a variety of reasons and stuff like that, bankruptcies and things. But that's. I'm not going to talk about the residential markets today. I just want to say the commercial market is completely different, especially with what's going on now compared to 2008. Now, we're not going to see a huge, like 15 million homes in default underwater like we saw back in 2000. I do think that we will see an increase because of a couple dominoes falling. And I'll get to that in a minute why that is. But on the commercial real estate aside, what's happened in the past few years that is leading to these delinquencies, leading to these banks that are struggling comes from the fact that this time around, after the Great Recession, where Wall street financed it and Lehman Brothers was the biggest, you know, bank failure out there, big investment banks, stuff like that, you had a lot of regional banks that got into the originating commercial real estate loans. Okay, commercial real estate loans a little bit different than a residential loan. A residential loan. You got banks financing, lenders financing, that it, you know, for a primary residence, 90, 95, 100% plus closing costs or some stuff like that. They're, they're very risky if it's government backed. They've got some government shirts now with the commercial real estate. They don't have that insurance by the government side of things. So this is why in a commercial loan, investors or borrowers, I should say more so borrowers are having to bring 25, 30, 35% down payment of some sort of. So that a bank which most of the commercial debt has been financed the last 10 years has been financed by your medium to larger banks out there. Much more than it was back in 2008, 9 and 10, or before the Great Recession. So you had a lot of these banks that were financing stuff at 65, 70, 75, even 80 cents on the dollar because market was running strong, interest rates were low. That's a great thing. But when interest rates start to change, it really changes the relationship with the bank. And then you throw in Covid, you show, you throw in deficiencies, delinquencies, people not paying their rent, people then not paying their mortgage because they're not getting rent from their tenants. At least a domino effect, especially when you have the Fed start increasing interest rates and it makes things a little bit different. So there's this great article written by Casey Conway. He is the principal and co founder of at Red Shoe Economics. And he had a poster in response to somebody. It's not that complicated where we are at the commercial. Commercial real estate is capital intensive and thrives or dies on debt.

Okay?

Nobody's 100% financing or bringing cash in a commercial real estate space there. It's, it's finance. You got to have good financing terms. You've got to have mortgage on this stuff. When interest rates go up, so do cap rates. Now as an investor, I want to buy on a high cap rate, Tom, but I want to sell on a low cap rate. A higher cap rate basically has an inverse relationship of a stock. You know, it's inverse of a stock mobile used to concert NOI into a value to calculate net operating income. Because basically you take your net operating income divided by the cap rate to figure out the value of a property. And the higher the cap rate, the lower the value. And that means that commercial real estate values drop.

Okay?

Especially when your NOI goes down, your profits are gonna go down. It's definitely go up and that. And, and banks don't like lending on assets declining in value. Now one of the things that people have kind of failed to see and this is both residential and the commercial side is. Oh, they're always like the market's going up, it's gonna keep going up. Values and keep going up. That's great. But what happens when the values start to drop? Well, a bank, commercial bank, that's due to commercial loan. Like I said, they don't want to be really above 70, 75% of the value. Well, if your NOI drops, your cap rate drops and your values drop, guess what? They're no longer at 70 cents on the dollar. They're now at 80, 85 cents on the dollar. Okay. And banks don't like lending on declining assets.

Okay.

In the equation. Add into the equation that expenses are growing two to three times faster. Thin rent growth, cost of goods, cost to repair, cost to build out, cost to rehab and noi. And values decline even more when you start adding those extra expenses to it.

Okay.

It also takes longer for the owner to recoup those rehab expenses or these build out expenses too. Then you look across asset types and you'll start seeing things that get hit even hard like office space. Has it been hit the hardest? And one of the biggest things for that is like what we saw happen with COVID Remote work will do to office building values what E Commerce did to big box retail and malls. That's why you can buy a Literally you are seeing 50% of malls or more across America in disarray, vacant in default. Simon Malls, one of the biggest holders of mall space is really struggling. If I would do anything, I'd short that stock all day long even though it's been hitting hard.

Okay.

And then also you added a little bit of extra magic to it. The Fed actually came in and broke the economy and commercials. It has its values by failing, by failing to understand how the steepest rise in interest rates decimated all assets. With a fixed rate. If you got a fixed rate, you can plant. But if you got a little bit of an increase, like I'll give you an example like a T bond, initial bond, a GSE mortgage or any commercial real estate loan with maturity risk. And what does that mean? Well, if you've got a loan, it's a four year, five year, matures in five years and you've got a rates that are going up and you're trying to refinance that loan. Now your costs are more, they're double, triple an interest rate. You're going to get a 2, 3 year, you know, just simple, you know, 3, 4% interest rate. Well now it's at 6 or 8. That reduces your profitability, which reduces your in net operating. It also makes it harder to get qualified. Okay, so it's really that simple. But it is very hard to fix. You know, as Casey, like I say, congrats Fed, you broke the economy. Now go look at the Texas ratio to see how many banks are at risk of collapse. And I'll talk about the text the Texas ratio in a second. And it's the commercial real estate concentrated banks and the number is in the hundreds of banks that are struggling and facing a risk of collapse. Now what is the Texas ratio? And Texas ratio, if you divine, if you go out and Google, it's pretty simple. The Texas ratio, first of all, it was developed to warn of credit problems at particular banks or banks in particular regions. We call it the Texas ratio because the Texas Savings and Loan scandal back in the 80s during the resolution Trust Corporation in a lot of cases.

Okay.

It's a system to identify credit problems at banks that calculate. That's calculated by dividing a bank's non performing assets by the sum of its tangible common equity and loan loss reserves.

Okay.

And so when you have a ratio of more than 100% or one to one day means they have more non performing assets than what the resources the banks have. It means the bank may need to cover potential losses on those assets, which is not a really great place a bank does not want to be. So that.

Okay.

Let me give you an example here. Yeah. During the 1980s, Texas saw an energy boom. Banks financed a surge. But soon the oil surge died down and banks started to struggle. As a result, Texas saw the greatest number of bank failures from 1986 to 1992 in the nation. That's why it's called the Texas ratio. And so give you a bit of as part of the Texas ratio, non performing assets, including loans that are in default or real estate the bank has had to foreclose on which reos real estate owned is an it's not an income generating asset. Those could become expenses for the bank. On the other side, tangible equity does not include intangible assets that cannot be used to cover losses such as goodwill. Okay, so that's the thing I realized it's, it's the Texas ratio is very useful for investors as well as customers banking. Customers will access the Texas ratio to ensure their money is safe. Making sure that hey, if I put out a dollar in, I'm gonna get dollar back. Oh no, I mean if I put 100 bucks a dollar, I'm gonna get 80 cents back. Because your ratios are way out like negative inflation. You've heard that talked about in the past as well. All right. You know, tax ratio is best utilized when looked when utilized with other analysts of the actual bank. A high ratio doesn't mean the bank will go bankrupt as many banks can operate with high tax ratio as long as there's not like a run of the bank or there's a huge amount of defaults. Now the fact that the Biden administration allowed for banks reduced it reduce the need to keep a lot of deposits in there, that's put things at risk. They haven't gone back. It may have been Trump but back during COVID it may have been Trump that allowed to do it. Maybe not just Biden. They allowed banks to run without a lot of reserves that has not been re instigated where the banks need to go back in and put money back into reserves and stuff because hey, stuff going on. So that's the problem right now. That's why you see a lot of these banks are kind of on that cusp of distress because they have a lot of commercial debt that is clogged in their books. And you have a lot of banks or commercial banks, not your traditional Chase, Wells Fargo, bank of America. I mean there's a, you know, give you an example, there's over 5,000 lending institutions and if you look in Bauer financial or the fdic.gov you can run some reports and see that there's roughly about 1500 lending institutions out there. Banks that qualify themselves, banks that have at least five branches or more. And by five branches or more, this is what we look at for non performing residential debt is that they start having a little bit bigger of a footprint. So they start being a little bit more aggressive in their lending and doing more residential loans versus being very careful about now the same thing goes with commercial loans. And I'll tell you right now as an ex banker, that was the one thing that they wanted to do as a banker, especially for JP Morgan Chase or Bank One before Bank One was acquired by Chase was commercial loans. Commercial loans. Commercial loans because the, the assets are there. The assets are in an increasing market. Great. Well I'll give you an example. Back in 2008 when we saw the hit the fan, Chase didn't do one single commercial loan in the state of Texas for over two years. No line of credit, no commercial purchase. They didn't do anything in Texas. Now are we going to see that again? I don't know. But I'll tell you this, there are a lot of bankers out there and There's a lot of commercial investors and this is something to keep an eye out for too because we've had so many people reach out. You know, I'm an apartment investor, apartment, and I'm buying a commercial property, it's distressed. I'm going to Regent if I rehab it, get the rents up and running and then in three years or four years, we're going to refinance that property, payback off, pay off all our investors and keep the profits on this stuff. That exit strategy is not really viable in a lot of cases. So it'll depend on an asset by asset basis. What's going on with the asset, what's going on, that specific market, where they're at. But I'll tell you that there's some opportunities out there because there's a lot of banks that are going to be calling for investors, especially if the numbers are where they're at, like, oh, we're not going to refinance you because the interest rate is now 2, 3 points higher. You need to bring an additional 10, 15, 20% cash to the table. So don't be surprised if you're part of a syndication in an apartment complex or something like that. If the sponsor starts reaching out to the investors, say hey, we need, we need to do a capital call. We need you to bring some more capital to the table so that we can refinance. Well, if you bring more capital, table, but you're in a lesser valued asset, what's that mean? It means your investment is diluted and your value and investment is less. Your ROI obviously goes down to put more in and getting less out of it. So keep that in mind. Doesn't mean there won't be great opportunities in commercial debt. There is. There's a lot of smaller banks, a lot of regional banks too, looking to divest some of this commercial space. But the couple of the asset classes I would definitely stay away from right now is that office space and that like strip mall. Mall. Retail space for sure is difficult. Unless of course you have a play that you're wanting to run with that. You know, I've seen people take big box stores and convert them to self storage facilities. We've seen some other malls be converted to apartment complexes or other types of, you know, self storage or other things that they could use if the bones of that establishment, the bones of that asset allows for it. Of course, if you've got to re recode or rezone a property, I go through the city to figure out what they do. What's that process for getting a property re rezoned so that it can be used for different, you know, different type of, of assets or different type of use by the city. So it'll all vary definitely, like I said, city by city, bank by bank. It's going to be different. But one of the things you can see if you, you know, one of the lists that we do pull is the Bauer Financial list which is basically just a spreadsheet with all the FDIC reports for like I said, banks over five branches that we, we purchase every quarter. And yes, there are hundreds of banks with a high Texas ratio and that number has gotten higher when you look over quarter after quarter after quarter. And that's necessarily not something you want to see, but it is just what it is. And with every quarter point that the interest rates go up, you get much, you get commercial debt, it gets tightened down and that value starts to decrease. And it can affect more things because if you're trying to refinance, you want to have equity, not have now equity below, you know, the LTV or the combined loan to value. Especially if you can do a seller carryback of some sort of, you're gonna have to be interested. This is where I do believe we'll see a lot of. If you're buying on commercial, it may be best to ask for terms or owner financing in a lot of cases for a period of time. I was actually just working with a student of mine who's out of Minnesota. He's looking at buying an apartment complex. I said well is there debt on it that you can assume it's, it's really great long term debt. Are the rates better on that loan? Is it a longer term than going out and trying to qualify for a new loan or bring all cash to the table? Maybe you can get away with just bringing 10% versus the whole hundred percent. The purchase price. Now it's not the biggest purchase price. I think it's 650, 700, something like that. But he hadn't even considered that. And I said take a look at that because that's, that's an opportunity for you out there. So keep in mind, once again, big thanks for Casey Conway for sharing that description. Just an absolutely great, great. But there's a lot of credit and liquidity that's leaving the market. When you have that happen, asset values fall, banks get tighter and you know, hopefully we don't see a lot of banks go out of business. But if we do, just gotta know where to play. So definitely, definitely important to have cash in the silence so that we're ready to rock and roll when things are available for you. And when everybody's running one way, run the opposite way is what Warren Buffett would say. So go out, take some action. Hopefully this was helpful for you. A quick explanation kind of where things are at. Commercial real estate's different than residential real estate. All right. The sky's not necessarily falling on the residential side. It's. We've had some correction.

Okay.

But it is getting kind of getting nasty and gray clouds out there in the commercial real estate space. So go out, take some action, everybody, and we'll see you off the top. Bye. Sa.