Topic: Interview and Q&A with an Experienced Banker
March 19, 2020 Meetup Recap
This month we went virtual via UberConference! Mitch and Darson interviewed Larry Wolf, vice president at Hardin County Savings Bank. We planned to record the event, but had some tech issues. Still, we want to share some of what we learned and discussed on Thursday for anyone who was unable to make it. If you have more to add, please contact us via email, text, or social media and we’ll get it added. The DSM Real Estate Investing Meetup is made awesome by all of us contributing! Let’s begin!
Who Is Larry Wolf?
Larry Wolf is the vice president at Hardin County Savings Bank in Eldora, Iowa. He has been a banker for many years and works with many high volume clients in a variety of industries. You might have seen him around Des Moines or mentioned at our previous meetups. He graciously agreed to be interviewed and we gladly seized the opportunity to pick his brain.
How Lending Works
Banks can borrow at a lower rate than consumers can, but it’s not always direct from the feds. There’s often a middle man called a “banker’s bank.”
Here’s an example. Bank A is located in a market that is so hot that the bank has lent out so much money that they cannot lend more based on their own deposits. Bank A can go to a broker (aka banker’s bank) who will lend them money. The broker might find that money from Bank B. Bank B is in a different location where the market is slower and they have money available for lending.
This could be orchestrated through a brokered CD. They can be short term funds or long term funds anywhere from 30 days to 5 years. This often sets the “programs” a lender can offer and is the rationale for why some banks offer higher or lower rates than competitors at any given moment.
What Is “Prime” and How Are Local Banks Affected?
Prime is the borrowing interest rate set by the federal government. The feds can raise or lower rates in anticipation or in reaction to market conditions. So, how does this translate to the bank level?
- The bank borrows funds to make loans based on prime either from the feds directly or through banker’s bank.
- Second and less commonly known, the bank can loan their deposits back to the feds overnight at the federal rate. This generates a return for the bank on their current excess funds.
What changes can an investor expect to see when the feds change prime?
- The lower the fed rate, the higher the bank’s motivation to find alternative sources to produce returns.
- If the rate goes negative, it means that the bank cannot deposit funds with the feds without PAYING. This essentially forces banks to find alternative sources to place their money. Likewise, they can likely borrow (depending on their locked terms) at lower rates to help make their required operating margins possible.
According to Larry, “It’s simple. Rates are tied to the national rate.” Typically, banks will lend based on prime plus some number of points, “rate is prime plus x.”
When a consumer borrows from a non-local bank, that loan is most likely sold to another investor or larger company such as Freddie Mac or Fannie Mae. Selling off to Freddie Mac or Fannie Mae allows the bank to make a loan to consumers at a fixed rate for 30 years. A bank that keeps the loan in-house would have to rely on other customers depositing money for the equivalent of 30 years below that agreed to rate in order to adequately back a 30 year fixed rate loan.
A disadvantage of this system is crappy customer service for the borrower… The loan will likely be sold multiple times. According to Larry, the servicer of any loan can change 10-15 times over the life of the loan! Why’s this matter? Well… in the good times, it doesn’t so much. But, if you ever need to restructure or adjust… being recognized as a person rather than a loan number can have some major benefits.
If you’re looking to build a relationship with your banker, it’s best to find one who services their loans in house. This means that the same bank who did the paperwork on the front end will likely keep the loan in their service for the life of the loan. This is the way Larry’s bank works for most commercial transactions.
This might not seem like a big deal when you are first starting out in the investment business, but it is extremely important to create a solid relationship with a banker. As you do more projects with your banker, you both will become more comfortable working together and things will get smoother and smoother.
COVID-19 and the Market
We would love to report that Larry had all of the answers and a perfect crystal ball to tell us what to do and when, but that would be a total misrepresentation. Admittedly, a lot of our questions were answered with, “We just don’t know yet,” or “It’s too soon to tell,” because that’s the truth! No one knows yet.
Bursting Market Bubbles
There have been market crashes in the past, many of which you are probably familiar with. Below is an oversimplification, but for illustrative purposes… consider the following.
Larry explained that the farm crisis in the 80s was largely due to over-speculation in the value of agricultural land. When the feds intentionally hiked interest rates up, the ability to sell that now-overpriced land immediately decreased. Couple that with an over-forecast of farming performance and values spiraled out of control…
The 2008 crash was, among other things, caused by an oversupply of housing inventory along with adjustable rate mortgage loans, poor lending practices, and relaxed valuation standards. Essentially, we were playing the equivalent of real estate musical chairs. When the music stopped, there were more chairs than people. The empty chairs lost value dramatically, because… well… not many of us need multiple chairs!
Compare that to today’s crisis. The 2020 Covid Pandemic is not like anything we have encountered in recent history. We are being met with a wholly new type of external factor. The effect of this health crisis is causing demand to curb, but we do not presently have a major over supply. According to local MLS data, we are keeping steady with active/pending ratios. However, as this crisis restricts movement, and given the likely factor that major unemployment will occur, coupled with supply chain failures… we do not exactly know the outcome. But there is a truth to the concept that, at least initially, land and asset valuations are not oversaturated and lending practices have NOT become as grossly under-regulated as in 2008.
Application of Relationships within the Scenario
Let’s talk about the bad times. Those are the times when a relationship matters more than a few dollars of savings over the life of a loan. Consider this scenario with the relevant situation we are all in together as a country.
Global Situation: A pandemic hits the entire US shutting down economic trade routes and plunging us into an unforeseeable spiral, the government says “we will halt all evictions” for an unknown period of time, and you have a monthly mortgage payment due.
Scenario #1: You have your loan with a national lender with strict policies and loan due requirements. Your mortgage payment comes due, in the midst of this crisis, and you have not received any rents. Because they are a national lender they lent you 85% of the appraised value, your amortized over 30 years, and you have no reserve requirements built into the loan. During the good times, you had strong monthly cash-flow (because the amortization was so far out). Crisis hits and 50% of your tenants do not make their rental payments. You try to call the lender, but are on a 90 minute hold queue along with everyone else. You decide “Meh… no one else will make the payments either. The government is bound to do something.” In this scenario, you just gave away your certainty to a whim and a prayer. Now you’re likely anxious about what’s going to happen, pinned to the media trying to decipher what your fate will be at the end of times!
Scenario #2: You have your loan with a local lender, who shared his cell phone and keeps the loan in-house. Your lender advised that you should avoid over-leveraging incase there is a down-turn. He also recommends amortizing over 15 years and keeping a reserve fund of at least 60 days. Your cash-flow is a lot less but you are paying down a huge amount of principal every month. The same crisis hits. Your same 50% of tenants do not make their rental payments. You give the lender a call on his cell. He immediately answers and talks through potential scenarios. You realize that “everyone is in this together.” Two days later, he sends a loan modification adjusting the 15 year note out to a 20 year note and doing a 60 day moratorium. Stress level is elevated, but significantly minimized. You have a partner in your corner who knows your model and your business.
Summary: Utilize your banker as a second set of eyes on your project. If you do not have the relationship to honestly present the deal and have a discussion, it’s time to invest in a better relationship. If you cannot convince your banker, there’s probably a reason they are saying “no” that you need to consider. Also, consider lower leverage and accelerated amortization. It’s a lot easier to restructure a project that has equity or cash-flow extensions that can be made. If you go into a deal fully leveraged, there is NO margin for error.
Prime Has Been Adjusted
The federal government has lowered prime in an effort to stimulate the economy. Their goal is to help banks lend more money amidst the effects of COVID-19. During our interview, Larry explained how it works in the following analogy.
Think of the economy as a sponge. The feds just put water on it by lowering interest rates which causes the sponge to swell up. At the same time, COVID-19 and its news coverage is like a heat lamp causing the sponge to dry out. The Feds can lower it again to add more water, but that heat lamp is still sucking out the juice. We have yet to see how it will all play out.
Banks Are Going to Be Cautious
These market conditions are a reminder that bad things do happen. It’s been mostly good, good, good for about the last decade. We don’t know how bad it is going to be yet, so people are taking caution. Loan to value ratios (LTV) have increased in the last 3 years.
When we came out of the 2008 crash, we were looking at 70% LTV. Slowly it rose to 75%, then to 80%. Now it’s likely decreasing again. Mitch adds to this thought by mentioning that the situation might reset everyone into not over-leveraged investing practices. It’s not that fewer consumers want to buy, it’s just that there will be fewer who qualify to buy due to stricter requirements (out of caution). We’re moving away from the 97% LTV and back to the 75-80% range.
“A bank, at its core, takes on risk for profit.” – Larry Wolf
The risk for banks is greater now, so they must do something to protect their profits. This is why they get stricter about LTV. The lower the better. The way Larry sees it, there are three categories of investors now.
Three Categories of Investors
Larry “see[s] a spectrum of philosophies right now.” This situation is creating three categories of investors. (1) The investor with enough cash can take on risk and pay cash for properties for what they believe is a discount. (2) The investor who is already at maximum leverage and can’t afford to lose. (3) The investor that has nothing to lose.
Let’s take a moment to remember that Larry’s investor clients are not representative of all investors. He hand-picks who he works for based on his motto, “plan for the worst and hope for the best.” For the investor who is not overly leveraged and has some cash available, it’s mostly a matter of when do they step back in to buying and selling?
It is here that co-host, Darson, brought up an interesting observation, “Whoa. Back up. Banks are encouraged to loan more, but it sounds like [Larry is] stepping back?” Larry responded by explaining that, in his opinion, the federal government lowered rates in an effort to mitigate a possible crash in the stock market. “They’ll have to do something else,” he continues. The actions that the feds have taken have already been countered by the potential further downturn of the market. He concluded by reiterating that he will continue lending, but he will be much pickier.
As far as a downsizing in the market? Still too early to tell. Larry noted that “the American economy is fueled by disposable income” and if the quarantine is over in two weeks people are really going to want to spend money. If it’s beyond two months, they’ll probably switch into a hoarding mindset and continue to save.
The Rental Market and COVID-19
In a mild housing downturn, rentals usually get stronger. But there’s a catch. If we get into an oversupply (an abundance of rental units or vacant properties), then we start to see price shrinkage. Luckily, as a whole, we are coming into the major migration period. It is this time that we typically start seeing lease renewals pop up which means people are coming and/or going from an area.
So what can we do to protect ourselves, as landlords?
- Be proactive about filling units. Revisit your rental standards and make adjustments to accommodate market conditions. You want to attract high quality tenants now, not later. One month of vacancy is often equivalent to $65-100 in rent reduction.
- Consider incentives for renewing lease terms.
- Consider early payment incentives for existing tenants. Do they have a late fee from a few months ago? Consider waiving that for them if they pay on time (or early) this month. Maybe give a one-time rent reduction of a few dollars for early payment. Provide incentive and add value!
What’s an Investor to Do?
Nobody has a crystal ball. We just don’t know what’s going to happen in the future.
The consensus at the Meetup was to keep your leverage manageable! This is solid advice for all markets. There are times when it pays off to be a bit riskier, but you don’t want to get stuck at the edge of a cliff. During the Meetup, Larry recommended keeping your overall portfolio in the 65-70% range. Jokingly, he added that if he was presented with a 50% deal, that would motivate him to lend, even today!
Will the Banks Help?
If you have a rental property and your tenants are having trouble making rent payments, that financial problem is going to affect your business. Larry recommends contacting your banker sooner rather than later. The more notice you give them, the more willing (and able) they will be to work with you.
That being said, Darson reminded us that all investors should have reserves built into their business plan. Each investor should have at least enough to cover one month of expenses. One month of missed rent should not put you out of business.
But, how will banks help? They can restructure the loans they have made to decrease payments or transition to interest only payments or some other unique solution. Larry did state that at some point, stretching out a loan does not help anyone. He gave the example of a car loan. Refinancing over and over can cause the borrower to be paying way more money than the car is worth.
Protect Yo’ Self
So, what can you do going forward? It is still too soon to know how the housing market is being or will be affected. The following information is what we came up with during the Meetup which could be helpful to investors.
Buy it right. We always want to remind everyone that you make money when you buy it, but you don’t get to collect it until you sell it! This old adage is even more true in a down market. Avoid overpaying and over-leveraging. A good deal that never gets sold, wasn’t a good deal. Keep in mind that the wholesale market could crash. Local sheriff sales have been canceled/deferred. Many flippers get their deals through these channels, so it might be harder to find deals at all. Don’t let a possible deal drought cause poor buying decisions.
Tenants Not Paying
Talk with your lender ASAP! In the next few weeks, you will probably get an idea of which tenants will be unable to pay. Be creative in how you plan to work with them. Some tenants would be more likely to pay if you elect to waive late fees or previous fees as long as they continue to pay on time.
Until Next Time…
That wraps up the March 19 Meetup. We will continue meeting on the third Thursday of every month. The next meetup is on April 16. We will host a conference call using UberConference again. RSVP at Meetup.com. We will be posting updates on Facebook in the DSM Real Estate Investing group.
Disclaimer: This conversation/meetup is for entertainment purposes only. Please consult with Real Estate, Tax, and/or Legal professionals before making any decisions.