At the end of the year, my youngest son will be completing his MBA. Of course, I was quick to remind him what B.S. stands for (you know…bull stuff) and that an M.S. is more of the same and of course a P.H.D is piled higher and deeper. Whether students are finishing their post graduate work or beginning middle school, back to school season is here. Although they may grimace when they hear “back to school” they won’t regret pursuing a higher education as they compete for well-paying jobs in the future. Today’s millennials are the most educated generation in American history. Student debt though can be a burden but the cost of not going is higher. An average 50-year-old with a college degree will earn about $46,500 more annually than an average person with just a high school degree according to Brookings Institute. In short, higher education leads to higher income, leading to higher likelihood of home ownership which in turn drives our overall economy.
As an aside, while still on the topic of education, you have heard of “helicopter parents” (those that hover about doing everything for their children). My wife (who does college counseling) tells me that now we have “lawn mower parents.” These are the parents who mow down anything in their child’s way that would be uncomfortable for them to experience.
First, let me tell you that things are doing well, business is good (no I am not tired of winning yet). But, I do always worry about what will cause things to change and when will it happen. When real estate outperforms for too long – when appreciation returns far exceed net income (rent) growth and when short-term returns are far better than long-term returns it usually means that the market is overpriced, and it will correct.
While I can’t tell you how happy I am to see unemployment at all-time lows and GDP growing and inflation low and consumer confidence high, I am trying to look for cracks in the foundation. As mentioned above I worry about student debt, but I am far more concerned about automotive debt and pension obligations.
First, new car sales are flattening because of rising prices. However, used car sales have risen. Overall sales are down 6%. But why are sub-prime auto loan delinquencies at a 22-year high? There is over 1.1 trillion in auto debt outstanding. In 2007/2008 Greenspan started raising rates after years of low rates. Soon after, subprime loans started blowing up and it trickled over into chaos.
Problem #2 – There are big unfunded pension obligations because of the way that the Federal pension laws were written. When pensions were first started, employers balked at having to make mandatory payments to a pension fund, because they might have a bad year or years and wouldn’t be able to make the payment. So that’s when it was written into law that payments didn’t have to be made, with the UNREALISTIC expectation that employers would then make up any shortfall when times were good. There was no limit on how big the shortfall could be, there was no repercussions for it, AND it didn’t have to be posted to a balance sheet as a recorded liability. So…guess what happened. About 99% of all pensions in the U.S. have big unfunded obligations. There is a big push to have those unfunded liabilities recorded on the balance sheet, but it’s going to have a huge impact on financial statements and could even force some corporations and municipalities in BK.
On that subject, you have legacy retailers like Sears who have more retirees in their pension plan (+/- 100,000) than they do employees (+/-85,000). When you see Sears sell off it’s crown jewels like Craftsman and Stanley Black & Decker for 900 million you have to realize they must contribute about $250 million of that to its pension plans.
So back to education for a minute. More specifically, Debt Service Coverage Ratio (DSCR). We often hear what kind of loan to value (LTV) can I get or what percentage down do I need down? When in fact most all lenders are looking at DSCR.
DSCR = Net Operating Income/Debt Service (full loan payment that may be interest-only or amortizing). Basically, it is the amount of income (plus cushion) you have to pay the loan.
Of course, the obvious use of this ratio is monitoring the risk of potential default. A low DSCR (close to 1.0x) means the property’s net income is barley sufficient to cover loan payments.
But it’s important to note that DSCR isn’t purely a performance monitoring metric. It’s a measure that will affect the underwriting of your loan and can determine how well a borrower is able to finance their asset.
When acquiring a property, a low cap rate and a high DSCR requirement can shrink your loan proceeds. I think this is best shown in examples. Loan quotes shown here are for illustrative purposes only.
Example
You’re buying a stabilized retail asset in San Diego, where such properties trade at very low cap rates.
If Purchase Price $10,000,000 and NOI = $425,000 then Cap Rate = 4.25
You’re able to get two competitive loan quotes for the deal, and you’re most concerned about maximizing leverage. At first thought, you’re excited about a loan from Big Bank #1, because you know they can go up to 80% LTV while staying non-recourse.
But in San Diego, that’s not the case.
| Lender | Rate | Term | Min DSCR | Amortization |
| Goliath National Bank | 4.5% fixed | 7 years | 1.1x | 30 years |
| Big Bank #1 | 4.5% fixed | 7 years | 1.2x | 30 years |
In order to cover a 1.2x DSCR with Big Bank #1, the max proceeds they can reach would be around $4\5.6 million, an LTV of 56%, a far cry from the max 80% you hear about. Given the $425K NOI, the property would need to trade at a much higher cap rate to reach 80% leverage.
The other lender, Goliath National Bank, would be higher leverage (up to ~62.5% LTV), purely based on their lower standard for debt service coverage.
There are a few strategies for managing your DSCR risk.
- Buy value-add – if you can “increase the cap rate” on a property you own, and then refinance, the equity you’ve built up on the property should help you reach higher loan proceeds.
- Buy at higher cap rates – this may mean hunting for properties in markets that are more advantageous for buyers’ Higher risk, higher reward, higher cap rates.
- Use lower leverage- more equity is required, but you’re building in a larger margin of safety from a default.
- Find the right lender – in San Diego County, to achieve higher leverage you need to use a bank or credit union that understands the local market, and tailors their lending programs appropriately.
Hopefully, this month’s letter was very educational and not to full of B.S. I hope you enjoy the story…and continue your education…
Manure: An interesting fact
In the 16th and 17th centuries, everything for export had to be transported by ship. It was also before the invention of commercial fertilizers, so large shipments of manure were quite common.
It was shipped dry, because in dry form it weighed a lot less than when wet, but once water (at sea) hit it, not only did it become heavier, but the process of fermentation began again, of which a by-product is methane gas. As the stuff was stored below decks in bundles you can see what could (and did) happen. Methane began to build up below decks and the first time someone came below at night with a lantern, BOOOOM!
Several ships were destroyed in this manner before it was determined just what was happening.
After that, the bundles of manure were always stamped with the instruction, “Stow high in transit” on them, which meant for the sailors to stow it high enough off the lower decks so that any water that came into the hold would not touch this “volatile” cargo and start the production of methane.
Thus, evolved the term…the acronym for “Stow High In Transit.” (You can figure it out.) It was stamped on all the bundles. So, it’s really not a swear word which has come down through the centuries and is in use to this very day.
I did not know the true history of this word.
I always thought it was a golfing term.
