Latest / Real Investor Radio Podcast / Episode 2 | The Banks & What Happened To Rates

Transcript

Episode 2 | The Banks & What Happened To Rates · Real Investor Radio Podcast

• Craig 00:00 You're listening to Real Investor Radio with Craig Fuhr and Jack BeVier, where we cover advanced real estate investing topics to help you stay ahead of the curve in your real estate investing business. Alright, so let's just go ahead and jump right into the content today. And I want to give, sort of lay the predicate of where we are today, and then we're gonna go back in history to take a look at sort of how we got here. All right, Jack? Yeah. So March 12th, 2023, we have the first of the large bank failures, Silicon Valley Bank. Directly after that, there was Signature Bank, credit Suisse, one of the largest banks and, and, and oldest in the world, March 15th, failed and was bought up by U SS B. And then of course, most recently, first Republic Bank on May 12th. And when you put them all together, these bank failures were every bit as large as the failures of 2008 in terms of assets that were purchased backed up by the Fed. So these weren't, not insignificant, but, so let's talk about that, Jack. How did we get to this place with these large regional banks failing? What's going on here? Jack 01:11 Yeah. So to understand the nature of the crisis, we have to rewind to understand, you know, how, how did we get to the trigger point? The trigger point for the Silicon Valley failure was a sale of mortgage-backed securities failures. They needed to raise cash. We'll talk about why they needed to raise cash, but ultimately, at the end of the day, they needed to raise cash. And they sold some securities, some mortgage backed securities that were on their balance sheet. They sold 'em at a loss that kind of teed everybody clue everybody in. So there were significant embedded losses on their balance sheet. And then that idea led to a run on the bank. But to understand kind of how we get to that point, we have to rewind several years. So the, the mortgage-backed securities that they own in the first place, why were they buying mortgage-backed securities in the first place? Is I think a, a good place to start. Craig 02:05 Why were the regional banks purchasing up mortgage-backed securities? Jack 02:09 Yeah. And, and other securities. So they had, there was a, a, you know, a lot of money printing that happened post covid a lot. So a lot of cheap money on bank balance sheets. They made a ton of money with P P P loans, deposit rates were at an all time low because, and deposit levels were at an all time high. So deposit rates were at an all time low. So banks became this set of institutions that had a tremendous amount of very cheap liabilities. Something that, you know, it's important to think about it that way. When we go deposit money into the local bank, the money that's sitting there, it's not sitting in an escrow account. It's a liability on that bank's balance sheet. And they, and there's a cost to that. If it's your checking account, it's nothing. If it's your savings account, maybe it's a, it was maybe half a point to a point. Sure. CD rates, you know, vary based o over time. But those are all the bank liabilities. Right. Craig 03:01 Grandmom goes and takes her life savings, 150 grand, 200 grand, walks into Silicon Valley Bank and says, I wanna put this in a savings account. She's gonna get 1%. That sa that 150 grand of grandmom's money is a liability on the bank accounts balance Jack 03:19 Sheet. Yeah. On the bank's balance sheet. Yeah, exactly. And in the case of Silicon Valley Bank, it was, Hey, this venture capital firm just raised $50 million of, of, you know, of a series C financing. And it's, and that $50 million is sitting in the bank's bank account as a liability. And it's very cheap for them. So they have an incentive to go deploy that capital. 'cause they can make money on it. If they go right, the spread, they go make loans, or if they go invest in other things with that $50 million, they are able to keep the spread. You know, they go invest. And in this case, they go invest in mortgage backed securities at 3%. At the time they're collecting three points on $50 million and they're paying that venture capital firm, you know, 25 basis points. They're spreading that difference. And it's a lot of money. So at the end of the day, the temptation for the temptation for bank boards or for CFOs to, you know, c CEOs, you know, c-suite teams to deploy that capital. The greed behind that, frankly, like was, was the driving decision behind, behind doing so Now I'm gonna finance nerd out here real quick. The original sin though was that they were borrowing short, so they were borrowing de deposits, which are callable at any time, right? Yeah. Craig 04:40 Grandmom can walk in and get her money anytime she Jack 04:42 Wants. Right? So they, they have the risk that grandma comes in the next day, in this case the venture capital firm with Silicon Valley Bank Sure. And request their money the next day. But they, what they were using that, those deposits for were to go buy long duration loans, you know, mortgage backed securities that they expected to stay on their balance sheet for five years, or Craig 05:04 Government bonds at Jack 05:05 Yeah. Craig 05:06 You know, Jack 05:07 Absolutely. Some whatever duration. Sure. There you go. And in finance 1 0 1, you, you learn that that is an original sin. That is the reason for the s n l crisis in the eighties. Like we did see this one before. This was not a new set of circumstances. Borrowing short and investing long is called asset liability duration mismatch. And it is finance 1 0 1 for Don't do this. It may kill you. Craig 05:31 For those of you listening right now, I want you to get out number two per and put a, put a note in the margin Jack just laid te tell give me that one more time. What do, what do we, what is the, what is that called again? Jack 05:42 It's, it's asset liability duration mismatch. The idea is that the assets on your balance sheet, how you, how long you expect them to stay outstanding Yep. Should match your liabilities. The, your borrowings. So like, if you invest in five year loans, you should borrow money that will all that won't expire before five years because you may get called at three and then you'll be, you'll, you'll be forced to sell the stuff your assets before maturity. So if you line up the duration, then you never take any interest rate risk. Right. So borrowing on two days notice and investing for five years is like 1 0 1. Don't do it. And, but you know, frankly, the greed of this situation with such so much cheap money led the, you know, the, the c-suites of, of these various banks to gamble and they lost. Yeah. Which is why the equity holders ultimately got, got wiped out. Craig 06:40 Well, let's take a step back so we know where we are today and we're gonna take a step back and sort of look at history from, from where we've been since say like 2000, 2004. And then we're gonna bring it back to the current day and sort of how it affects our audience, right? How today's market affects the audience and what we can sort of expect moving forward. But let's take that step back in time here. So man, we were talking right before we hit the record button here about, you know, if you would've come to me in 2000 and, you know, 15 years ago, 2000 6, 5, 4, whatever, and say Wall Street Craig is going to be in the game of residential real estate investing, you would've looked at me like I had three heads and said I was crazy. They would never get into that game. So tell us how, what, what led us to that moment where, where Wall Street was like, Hmm. I think we're gonna jump in. Jack 07:38 Yeah. So to your point in, in 2007 when I started with Dominion, I was working at an office street in New York, purely institutional capital. And I had met Fred and he was doing this buying houses. And there was like, I was like, well, who, you know, who are the institutional players who are doing this? Because clearly this is real estate. There must be some institutional involvement. He is like, there's none. Like it's, it's a bunch of guys. Craig 08:02 It was the biggest, it was one of the, I think one of the greatest mom and pop businesses. Jack 08:07 Oh, amazing. Craig 08:08 Completely fragmented. Yeah. No major players, Jack 08:12 Great yields, Craig 08:13 Great incredible yields. Jack 08:14 You would get these because they were single family houses you would get, you could buy at the time, you could buy, you know, an 11 cap house in the shadow of a seven and a half cap apartment building. And I'm like, it's the same location, it's the same tenant. Like surely the operational difficulties can be overcome with 400 basis points of spread. And so I, when, when I, you know, figured this out when I met Fred and, and he was pitching me on like what the business model was, I was like, this makes no sense. Like this is phenomenal. Like this, this feels like, you know, superior risk adjusted return. Yeah. Now, clearly today, fast forward today and there's a lot of institutional involvement in even tertiary markets. Yep. And all of that happened in the wake of the great recession right. In, in Craig 09:02 2008 occurs. Right. There's just a ton of carnage, a lot of assets that are valued for pennies on the dollar. Yeah. Jack 09:10 Well be being taken back and, but not until 2010 and really 11 and 12, were they taken in by the banks who were then forced sellers and, and on mass. Right. And who were then forced sellers who were then forced to put them on the market. And that led to, and at the same time, and the only place to get money at the time was the banks who were selling the assets, who had no interest in deploying capital into the stuff that they're just trying to get off their balance sheet. Right. So it was like, it was, it was equity only. Yeah. And so the, the, the assets cleared at an equity only price. You just, you couldn't get debt by and large. We still got some debt from certain banks, but like by and large, like you couldn't get debt on these assets. So they, the, the values dropped to a point where the equity would buy it on the unlevered return by itself. And those were phenomenal prices. Right. So Craig 10:04 In the early two thousands, really, you know, for decades prior to that, if you wanted to have a small business, if you wanted to go purchase investment real estate, you'd walk down to your local bank that had probably had two or three branches in your state or in your county, and you'd ask for a loan and the bank would basically become a partner in your business. Yeah. You know, you're gonna get a quick loan. It's probably not gonna be the cheapest loan ever. But it was cheap enough and it was easy. I got a call after flipping hundreds of houses here in Baltimore and successfully repaying every one of those loans sometime around 2007 from our small local bank here. And I won't name them, but you know, who they were began with an s ended with an E. Right. And so this tiny little bank that had been in business for I think over a hundred years, two branches called me up and said, as much as we love you, and you've been a great customer, Craig, we're out of business. We're not going to under, we're not going to write any more of that paper. And that effectively started a long, and I don't think it's, it's even come to an end yet, sort of dissolution and disappearance of these small community banks, which have been so critical to this success and growth of many of small towns and counties and even cities across America. So maybe we can just speak to that quickly and sort of the evolution of how Wall Street then entered the business in, in that 2012 timeframe. Jack 11:35 Yeah. So there's, there's really this, these two parallel paths. The commercial banking industries involvement in residential real estate and Wall Street's involvement in residential real estate, which really didn't start, like the starting point on Wall Street's involvement is really in the 2011 2012 Yes. Timeframe. Before that it was all commercial banks. And so, you know, the commercial banks took a lot of hits in the great recession. 'cause they had a lot of residential real estate exposure. A lot, particularly a lot for land builders, or I'm sorry, home builders and land developers and a lot of single family folks too. Of course. And then, so they're the forced seller at the same time as they were the, the only financier of the asset class, which, you know, led to a big decrease in those prices. And there was such, such a disconnect in the market. The prices got so good that, that, and there was enough volumes for the first time ever that where there was actually a volume of single family real estate. Like the I if you, when, you know, when I, when I told my buddies what I was going, when I was going to go do in Baltimore buying single family houses, buy Craig 12:39 Ones these doozies. Yeah. Jack 12:40 They were like, well, how do you, how do you make any money? And I'm like, well, there are 12 caps. And they're like, oh, that's cool, but like, you can't deploy any real capital though 'cause you're deploying capital like 80 grand at a time. And I'm like, yeah, yeah, yeah. But you know, it's a 12 cap. So like, we'll figure it out. Like, you know, we can do, we can do a bunch of them. Right. But, you know, wall Street just wasn't interested 'cause you couldn't, there wasn't enough inventory to really deploy large amounts of capital until 2011 when, and really 2012 when you saw the, what became public REITs. But at the time, you know, the, the, the private equity groups, you know, invitation being the most, probably the most famous and one of the earliest, most aggressive actors Yeah. A Blackstone's company through Invitation Homes, were now standing with us at the courthouse steps in, in Atlanta and buying houses on mass Craig 13:28 In 2012. You show up to Atlanta because you wanted to, prices Jack 13:32 Were great. Yeah, Craig 13:33 Yeah, yeah. You saw the great spreads and a decent amount of inventory, I would assume. Yeah. So you take a whole bunch of cashiers checks down to the courthouse steps and you start bidding on houses. And notice standing right next to you now Jack 13:45 Yeah. Is some suit from New York who'd also flown down that day. Craig 13:49 You're like, what the heck? Who's this guy? Yeah. Jack 13:51 And they're buying houses very aggressively. They've got a long-term thesis that this stuff is undervalued. They were a hundred percent correct. And they start deploying large amounts of capital into the space. And so as the equity, as the, as the Wall Street equity was deployed into single family real estate, really fra you know, frankly, because the, like the yields were too good to be true. They figured this stuff must be going up. But once, once the equity Wall Street equity was deployed into single family real estate, well the Wall Street Equity called their Wall Street debt buddies over at Deutsche Bank in this case and said, Hey, we need you to figure out how to finance this stuff. And they figured it out, right? 'cause there were fees to be made. And so that was the first time that Wall Street debt got in, you know, figured out the single family real estate space that was the beginning of, of really, of the industry. From that point forward, you had other private equity firms in real estate in, in wall, you know, institutional capital buying properties, which led to them doing their own securitizations, which is how Wall Street generally raises debt Craig 14:54 Slow down there. A big Jack is off to the races. He's very excited. So it's two parallel paths we're talking about here. I wanna paint a picture real quick story, if I could, Jack, of what it looked like back there in that sort of 2011, 12 timeframe, I was actually buying houses in Phoenix, Arizona, which was one of the hardest hits market in the country. These houses were built in that 2000 3, 4 5 timeframe. So they were essentially new. They're in these large tracks. And what we were seeing when we got to, to, to the Phoenix area was you would have a Dr. Horton, an N V R, you know, whatever, the builder was in these massive tracks, and you'd ride into a neighborhood and you would just see the mains coming up, the, the main stacks coming up out of the ground. Yeah. Jack 15:41 Pipe farms Craig 15:41 At pipe farms. And then there would be one completed house. Yeah. We would buy that one that probably sold for three 50 new, we were getting it for 80 grand at the courthouse steps. Right. And so these, this is the spreads that the Wall Street companies were seeing at the time. We would buy it for 80 grand, do a little patch and paint, sell it in a weekend for a buck 75. Right. And there were thousands and thousands of these properties available. So when you talk about the volume that was now readily available for these large companies to deploy this massive capital and equity, that was step one. But the industry has matured greatly in the last 10 years. Right. They're not just, you know, so, so now we've got two parallel paths. We've got an equity path and a debt path. So speak to that. Jack 16:27 Yeah. So the, so the institutional debt path, you know, the next step for them was single borrower securitizations. So like progress residential American homes for rent would do their own securitization, which is based, it's just raising debt. It's just, you know, instead of going to a local bank and asking for a loan because they're asking to raise $300 million and no one wants to do that $300 million slug, they parse it up, you know, they, they, they, they document it so that they can sell it in pieces and they sell it, but at the end of the day, it's just raising debt. And so they raised debt so they could continue to buy more houses. And the institutions went on a, you know, a, a long protracted buying spree. There were ended up being some other institutional debt providers who then said, Hey, I wanna provide debt to, to Main Street. And so in, in the, the early conferences, the 2014 1516 conferences, they were dominated by, it was, it was another Blackstone company called B two R Finance, a Cerberus owned company called First Key, and then colony owned company called, which became Corevest. And Corevest ended up being kind of like the last man standing in that. But Corevest and, and they, and Corevest continues to exist today though. Now they're owned by a mortgage reit. They were focused on lending to Main Street borrowers. Craig 17:49 Explain that Jack 17:50 For the first time, Craig 17:51 Which was huge. Yeah. Jack 17:53 Big, big kind of like tide shift in the industry because Craig 17:56 Prior to that, you would either walk into your community bank and get a, a loan walk down to your friend's family in fools who would lend you the money to go buy a house or two. Right. Or you would come to a hard money lender like Dominion was, or, and still is, frankly. But you guys basically had your own fund of money put together, for lack of a better word, until a company like Corevest comes in and says, no, we want to, we want to lend to you dominion. Is that correct? Well, let's, Jack 18:23 Let's draw the distinction between kind of, between short-term capital and long-term capital. Yeah. So what I was, the, the core corevest was interested for the first time in lending long-term capital to real estate investors, which is the first time that they're really competing with the banks for that, for, for providing long-term financing. There were now banks would also provide short-term, you know, bridge financing for the service level wasn't as good as your hard money lender, which is why generally folks would pay higher rates for, to, to work with a hard money lender. Let's leave the bridge space aside for a second and just focus on the, the long-term side that Corevest B two R first key entrance in the market was the first time that Wall Street money was going to lend to Main Street investors and compete with the local banks. Sure. And then their goal was then to go do a securitization. Craig 19:13 And so what does that loan product look like? It was a 30 year type thing, or Jack 19:17 Not 10 years. It was either a five or 10 year loan fixed rate yield maintenance. So like you couldn't, you really couldn't prepay, it was extraordinarily expensive to pre, you know, to, to prepay the loan. So they wanted, you know, they wanted to lend you money at 7% and lock that in for 10 years Sure. Or lock that in for five years in a lot of cases. And so it was an option. And if you couldn't go to your local bank, say, say you were a small fund and no one wanted to sign a personal guarantee, and all the banks required a personal guarantee. So you, you say you wanted a non-recourse option, COREVEST was where you went for that. Oh. 'cause they were kind of the only place to go. So when, when, when B two R and First Key fell out, or, you know, got out of the market, COREVEST became kind of the only game in town for a couple years with a nonrecourse option. And then the next kind of iteration of that long-term financing that happened was that a couple enterprising companies, Veris was probably one of the, the main companies that, that kicked this off created a product that was based off of the debt service coverage ratio. The underwriting was based off of the debt service coverage ratio of, of the, of the real estate. Craig 20:27 What year are we talking here? I Jack 20:28 Think this is 17, 18. Craig 20:30 Okay. Jack 20:31 And so, you know, early innings they thought they, they're like, this is a huge underserved market. You know, we, we can compete with the banks. If we could get Wall Street used to, if we can get the, the, the bond buyers used to buying this product, we can drive rates down and grab market share. And they did that, they did the heavy lifting of familiarizing the rating agencies with how this product behaved, the nature of the market, et cetera. And they got wider and wider adoption for what is now loan as D S C R loans. Craig 21:02 So let's just kind of drill in right there on this D S C R loan product that really was quite revolutionary. I mean, we, we were just talking and we were talking about sort of what's available to the investor with a portfolio. He's hang, he's a landlord, he's hanging onto this stuff for a while. He's gonna walk into his local bank still today and probably get a five or 10 year loan product. Jack 21:28 Right. Craig 21:29 Wall Street comes along and now they want to compete with the banks and they come out with this D S C R debt service coverage ratio loan product and, you know, explain what it is and why it has really revolutionized sort of the, the industry for the, for the average investor. Jack 21:48 Yeah. Yeah. So as you said, the, the bank's typical loan product and still is either a five or a 10 year loan with typically five years of fixed rate and then an adjustment. Yep. Maybe during aggressive period of time, you might've gotten your bank to do a 10 year fixed rate loan. Definitely very hard to come by now then you had, I'll use Corevest as the example Corevest using kind of a commercial mortgage backed security approach to the industry where they were doing 10 year loans and they were, and with basically don't prepay them. So you, you took a lot of interest rate risk as the borrower, or you gave up a lot of flexibility as the borrower to work with them. But then when Veris started using, they, they kind of changed the approach and they used much more of a, a Wall Street but residential mortgage-backed security approach where they said, Hey, we're doing loans and getting 'em securitized that are not qualified mortgages. Jack 22:42 Right. Not Fannie Freddie eligible were, you know, at, at the time you could do a bank statement loan or you know, for, for whatever, or, or for whatever reason, you wouldn't, you couldn't qualify for the Fannie Freddie product. Sure. There was still a product for you. It was a little bit more expensive, but there was some aspect to it that Veris would get their heads around to make sure it was still a good loan and, and then issue that loan and then go securitize that in the secondary market and they would educate the bond buyers on why this was still a good loan. Right. So Veris had the vision to that is Craig 23:15 A lot of heavy lifting by the way. Jack 23:16 It's a lot of heavy lifting God's work. And so Vera had the vision to apply that idea to investment real estate for, for landlords and introduce this competing product, which was ultimately being funded by, through the residential mortgage-backed securitization pipes that already existed. But they added, they just added a new product and they said, Hey, it's, it's a D S C R loan because it's underwriting is based off of the debt service coverage ratio of the rent that's coming from the property, the house, and the ratio of that rent relative to the principal interest tax and insurance payment that this loan is gonna require. And so they set up some other various guidelines to keep from trying to game that system and try to, you know, try to just make sure the paper was actually good. A lot of Craig 24:06 Boxes to check, Jack 24:07 A lot of boxes to check. But at the end of the day, those boxes did not include, show me your tax return didn't include, show me your full r e o schedule, gimme and calculate your debt to income ratio. So for a self-employed borrower, which is a lot of real estate investors, it was a much easier, and to the bar from the borrower's pers perspective, logical underwrite than even going to their local bank who was going to ask them for two years of tax returns and financial statements and Rio's schedule. And you know, we'll work on that for a couple weeks and then I'll take you to loan committee and then I'll come back to you for a couple other things. And maybe 90 days later you get your phone loan funded if you've got a diligent loan officer Craig 24:51 Yes. Nothing like the loan committee that meets once a month and you call them one day after they've met, met, now you gotta wait another month. Yeah. And then to me, one of the hurdles that I see here with this, with these these big Wall Street companies is they've got a massive amount of capital deploy, but they don't have boots on the ground. Right. Who became the boots on the ground. Jack 25:10 Right. So, so the boots on the ground for the local, for the commercial banking industry was always your loan officer. Right, right. Local guy, local loan officer. Been in the, been in the community for decades. You went Craig 25:19 Down to the zip code, which ones were hot and which ones were Jack 25:21 Not. Exactly. That's, you know, that provided a service level. That service level got less and less as banks were consolidated in the wake of Dodd-Frank. Yep. In the wake of the great recession. And so that service level has generally, as a trend gotten worse over the past 10 years. But it's still, but there, but there was an in-place distribution network. Right. The commercial banks do have an in-place distribution network, even though it's getting worse over time. Sure. As you pointed out, wall Street really didn't have a distribution network. And so with the, the, the C M B S product, that corevest product, they were trying to create it organically. They were going out to real estate investors themselves. Craig 26:01 I remember that Jack 26:01 Since they were only going after folks who could do a 10 year fixed rate loan and not prepay the thing, they wanted non-recourse. There were only so many, there were, you know, probably hundreds, maybe a couple thousand potential borrowers. But they thought that, hey, we can deploy a lot of capital this way and it's the logical next step in the maturation of the industry. Sure. And they did that when D S C R product came out, really in 2018, the rates weren't quite as good, but there was no distribution network. And so they went to Veris and, and I'm gonna just, there were other people as well, I'm just using them as my example. Right? Sure. Like, you know, they, they, they're getting all my props for this, for this evolution, but they, they went to, Craig 26:43 That's Jack actually saying he's envious of the work that they've Jack 26:46 Done. A dude ki like Yeah. And I just, I know a bunch of people over there and they're killers. They're absolute killers. Craig 26:50 Absolute bad asses. Jack 26:52 So the, they went to where mortgage backed sec where, where mortgages had always been originated, which is the, the mortgage broker space. Sure. So for 2018 and 2019, the vast majority of loans that got originated that were D S C R loans got originated through mortgage brokers, conventional mortgage brokers. This was just another product in the quiver when you called your mortgage broker and you were like, Hey, I'm self-employed, do you happen Craig 27:16 To do commercial loans as well? Right, right. Yeah. Jack 27:19 Yeah. And they'd say like, Hey, I need a mortgage on my house. And they'd be like, oh, you're a real estate investor. I, you know what, I have a a new product for that. Right. And so Craig 27:25 Very opportunistic. Yeah. Jack 27:27 Some stuff got written Craig 27:28 Right. And organic. Yeah. Jack 27:29 Yeah. So, so some, some paper got written but it was not like, but we didn't really hear a ton about it. And at the time it was early on and so it was more expensive than what you could get at a local bank. Oh, Craig 27:40 That's right. Yeah. You mentioned that Jack 27:42 If you had a banking relationship, it didn't make sense to take that loan because you could go to your local bank and get money at 150 basis points cheaper. Got it. 200 basis points cheaper. So, you know, why would I go do that? It's painful, but I'll deal with for 200 basis points, I'll deal with the pain in 2020. In the wake of covid, that was a game changer for, for the D S C R product because everyone got scared. The fed dropped the rate, feds dropped rates to zero, started printing cash, putting a, put a lot of cash into the economy, which really drove the, drove all of the interest rates down. Right. And so with that new lower benchmark interest rate, you know, index the, all of a sudden in late 2020, the d Ss c R product was now actually more, was actually cheaper. It was actually cheaper than your local bank for the first time. Craig 28:36 It significantly or significant enough. Right. Jack 28:38 It was the same rate, but the D S E R product was offering you a 30 year fixed rate. Yeah. And your bank was still offering you that 10 year loan with a five year, with only five years of fixed rate with Craig 28:49 Decreasing service levels. And now you've got Right guys like, you know, your company and others who are just poised and ready to service these, these borrowers with this new 30 year product that is priced more competitively than the local bank. Jack 29:04 Yeah, exactly. Unheard of. Yeah. And, and so once that became the product, right, 'cause it was cheaper, all of a sudden it wasn't just being offered by mortgage brokers to whatever random real estate investor might call them. Then at that point, the distribution network got expanded to the, the private lender network. Like all the, all the small private lenders and hard money lenders and, and big private lenders and hard money lenders who are talking to real estate investors every single day selling them bridge loans, offering them, you know, this was just the complimentary product. I can offer you short-term money, I can offer you long-term money, but I'm selling to the same investor. And so it made, it just made too much sense to be able to offer a d ss c r loan to somebody who was taking a bridge loan. Craig 29:49 And it's a massive market. Jack 29:50 Yeah. And it's a mu Yeah. And it's a much bigger market than bridge. Craig 29:54 Can you talk about sort of how the business exploded at that time for you? Jack 29:59 Yeah, sure. So we, we recognized that as, as soon as those rates got even close, and then they actually became more, you know, even became cheaper that, that we were like, this is just where the industry is going. I can offer the same rates, better terms and my service level. And I'm competing with that, with the banker, with, with the the 55 year old banker who's getting pressure to deploy lots of capital. Like he can't that bank, that banker is having a hard time making a $250,000 loan economically at all. Much less deliberate service level. Whereas this is my core customer. We got into the, we already distinguished ourself in the bridge business as being speed and service. And so now I can offer long-term money at better rates and better terms, and also still deliver that speed and service. Like this was, this was a no-brainer. Jack 30:48 Yeah. So we, we, we pushed all in on that, hired a lot of people and originated a and have been originating a a lot of that paper. And so, and I think that that is frankly kind of the way that the industry has gone. The DSS there you may today, well, sorry, you may 90 days ago have been able to go to your local bank and get a, actually, you know what, lemme back up there real quick please. So in the middle of 2022 was an interesting point in time because the securitization market got very expensive because of all the, all the, the volatility in the capital markets in 2022. And so in the middle of 2022 D S C R loans be were very expensive. They were seven 8% or they were 8%. Eight 8% plus. And so that didn't Craig 31:37 From what, from, from what was at the lowest Jack 31:39 From as low as four. I mean we were down to, we were, we were writing paper at four consistently. Craig 31:44 Okay, so you're writing paper at four what year? 22, 20 21. Jack 31:48 Middle of 20, 21. And then less Craig 31:50 Than two years it was, you know, with, with the market changing the way it did up year, Jack 31:54 It was a year and a a year later is up 400 basis points. And so, you know, that's not, not very interesting financing, you know, you're inve the real estate prices haven't come down. So you're still buying that same like six and a half cap piece of rental property. And now instead of financing at four, which makes total sense, you're now gonna finance it at eight. Right. So volume's dropped considerably. Craig 32:15 Yeah. I I think you and I had lunch right around that time and you're like, the phones have stopped ringing. Yeah. Jack 32:19 It was like, I mean Yeah. If you needed the loan, sure we got it. Sure. But, but at that point we started calling for, for our real core real estate business, we, we started calling our banks back. 'cause in middle of 2022, they still have cheap deposits. And that's, we wanna circle back here 'cause this is, this is an episode about banks and the banks still had cheap deposits in the middle of 2022. So if you got a term sheet from them in the middle of 2022, it was good. It was all of a sudden, once again, two now is once again 200 basis points cheaper. Sure. And so you went back to bank in the, in the second half of 2022, maybe the first couple months of 2023. But what has changed now though, so, so, but the Fed has been increasing interest rates on banks for, you know, going on a year now. You Craig 33:07 Called it the big sledgehammer. Jack 33:09 Yeah. The Fed. The Fed has a big sledgehammer. Right. It, it can do two things to affect monetary policy. It's, it's, it's trying to drive down inflation and maximize employment. And it has only two tools to do this. And they're both kind of sledgehammers. One is it can buy securities. So it did that in the wake of the great recession, buying mortgage-backed securities called, it's called quantitative easing for just quantitative easing. And the other is that it can increase the, the interest rate that it charges banks. Now here's what I consider to be a misunderstood idea in that context. So the Fed starts increasing rates a year ago at this point, right? Yep, yep. Well, actually more than a year ago at this point. But if the banks aren't borrowing the fed's money, well then nothing really had happens. 'cause I can tell you that it, you know, my interest rates have gone up to to to 15% Craig. But if you're like, well, I'm not borrowing it anyway, so's no thanks. That's, that's nice. Who Craig 34:01 Caress it has no effect on me. Yeah. Jack 34:03 So it had, so the fed's, fed's increase in, increases interest rates, made a lot of headlines, but didn't really hit Main Street for months and months and months and months. And it only, yeah, Craig 34:13 It was like we would hear every night on the news about, you know, Powell just raised another three quarters of a point. It's really gonna have a massive effect. And while it does have some effect, I don't think the average American really was like, oh yeah, I see where that's hitting me. Right. The wallet right this second. Yeah. And, and, and so investor sentiment was sort of the same exact thing, right? Yeah, Jack 34:32 Exactly. And, and the reason was because we were all still flush with cash consumers businesses in middle in 2022. We all still had cash to burn and so we weren't borrowing. Sure. So we didn't, you know, we weren't borrowing that expensive money, so we didn't, it didn't affect our behavior, didn't modify our behavior in any Craig 34:49 Way. It was only hurting the banks. Jack 34:51 Yeah. Yeah. It was only hurting the banks, but the banks weren't. That's the thing though, is the banks weren't, the banks still had our money. Right. Because let's circle back to that deposits idea. Our deposits are the bank's liabilities. And so while the banks have our liabilities on their balance sheet, balance sheet, and they're cheap, the bank doesn't need the fed's money. Now what, in the third and fourth, in the third quarter, you started to see you, you noticeably started to see deposit levels which were trending down kind of really accelerate and get to a and get to a point where banks were like, Hey, hey, like these deposits are, there's a lot of deposit outflows. Like people are not, you know, our, our li you know, our cheap liabilities are disappearing. And let's also circle back to that, that asset liability concept, the bank. Jack 35:42 So it's, it's cheap liabilities are disappearing. It made a bunch of loans that must stay outstanding. They're not callable. Right. They are staying outstanding. And so a bank, the, the, the regulators, one of the key reg issues that the, the bank regulators, the O C C and the F D I C monitor at bank level should monitor at bank levels is the, the loan to deposit ratio. So if you make a ton of loans and you don't have very many deposits, well that's a weak bank. Whereas if you have a ton of deposits and you've put a little bit of some of that money on the street or relatively less money that on, on that money on the street, well that's a very stable bank. May not be a very profitable bank, might may not be as profitable of a bank, but it's very stable. So from a regulatory point of view, they care about stability among, among, above all. And so as deposits are decreasing, the banks are getting nervous because they're like, Hey, our loan to deposit ratios are getting too high. Craig 36:42 We need to go borrow some money. Jack 36:44 Yeah. We need to, we need to go either raise deposits or borrow some money Craig 36:49 Now at a much higher rate from the Fed, Jack 36:51 But now at a much higher rate, which affects their profitability. Craig 36:54 So then we started talking about how the tide was turning with Wall Street now becoming, they were less competitive on a D S C R loan than a bank. Right. And now the tide starts turning, right? Jack 37:07 So when, when you've got, you know, the regulator coming in, the threat of the regulator coming in because your loan to deposit ratio too high is, is an existential threat, right? So there's two things that you can do to affect your loan to deposit ratio. You can either decrease the numerator, decrease loans, or you can increase the denominator, increase deposits. And so the way that you increase deposits is you start paying, you offer more for them, right? You pay more, right? And so in the fourth quarter and in the fourth quarter last year, and it really accelerated in the first quarter this year, you saw banks off going from CD rates of 1.5%, 2% to four and a half, five plus. Sure. And that put pressure on every, all, all the other banks to keep up pace because they were starting to see deposit outflows. Jack 37:59 So in addition to, you have like the, the overall macro economy with deposit outflows, right? Decreasing money supply. You now have competition within the banks to grab as much of what's left as you can. And they're paying more to do that to kind of a musical chairs issue, right? Sure. So that they're not the last man standing or they are the last man standing. So when you have those, that increase in deposit rates, that means that you, the loans that you do make, you have to charge more for 'em. And so because you know, you can't borrow money at 5% and lend it at five and a half and you know, and pay for overhead, that doesn't make any sense. Got it. So all of a sudden, in the past, in the past, you know, six months, especially in the past two to three months, we've seen bank term sheets move materially. They want to decrease the number of loans, they wanna affect the numerator. So they've gotten tighter on credited guidelines that That's right. Because they wanna decrease the amount of loans and if they're gonna make a loan, they're gonna charge, they're wanna make good money on it. So they're going to, they, so they've increased the cost of it. Craig 39:05 There's a great story that I point out to everybody. Again, you can read all of our show notes@realinvestorradio.com slash notes. The notes for today's episode will be in that Google box, whatever we choose here. But the, it was an American banker story, Jack, that, that was entitled mid-size banks tighten up on commercial Credit. And that's exactly what you're explaining right now. I think I just heard you said they're basically not making as many loans, but they need to make more money on them. Yeah, Jack 39:40 Exactly. Right. Craig 39:41 They've, they've tightened the criteria more boxes for, for each borrower to check, which makes, you know, which makes, you know, the standard investor, let's face it, that just, it just feels like I gotta jump through more hoops to get this loan that's now gonna cost me more money. Yeah, exactly. Is essentially what you're saying. Jack 39:58 Yeah. So there was this, so now there's been this slingshot, right? Like last, last summer to maybe the first quarter banks were once in, again, an attractive place for main street investors to borrow money. But now because of this increase in deposits and tightening of boxes by, by bank loan committees, once again, D S C R is, is back in, you know, is, is now the, I would say the same cost, but better terms and way Craig 40:22 Better service and way Jack 40:23 Better service. So from a predictability point of view of like, hey, how do I fund my business on a going forward basis? We're we're, we're doing a lot of that product for, for those reasons, you know, so I'm watching these trends be because, you know, because they affect our, our volumes that I'm trying to plan our business. So that's the trend that we're currently seeing. I wanted to circle back on, you know, as real estate investors ourselves, we've worked with banks for 20 years and they've, you know, that that's how we built our whole rental portfolio. Like we built the vast majority of our rental portfolio before the D S C R product ever existed. Sure. And it's still one of the major sources of capital for small business in America. Right. And so one of the points that I wanted to make on today's podcast is that I'm concerned about the role that commer the, the commercial banking industry is gonna have in Main street single family real estate on a going forward basis. Yes. Craig 41:24 Sort of the trend, the long-term trends here. Yeah. Jack 41:25 The long-term trends, particularly because, so, you know, particularly because at at a point this, this moment in time, the banking industry also has this looming commercial real estate credit issue office basically. Craig 41:40 Sure. So just for folks who not really caught up on where the market is there in, in some major markets around the country, la, Chicago, Austin, you know, they're experiencing extremely high vacancy rates in commercial real estate right now. So in some of these, in some of these places, 25 to 40% vacant right now, which no one's talking about. So go ahead. I apologize. Jack 42:04 Yeah, no. And, and so banks and banks have the underlying paper, you know, by and large, you know, banks have funded a lot of office buildings over the years and so there's a significant concern that are there embedded losses that, that have not been realized and have the banks appropriately reserved for that or there losses yet yet to take on that? So from a main street real estate investors' point of view, investing in single family houses, it's just insult to injury. Yeah. Craig 42:30 You're just, you you wanna say, well that doesn't concern me when in fact it actually does. Jack 42:35 Yeah, exactly. It it does because if you care about your bank, well then you care about this because your bank cares about that and you're gonna get, you know, and rolled up in it. Yeah. And it, and it's gonna, it's gonna flow downhill. And so the, the terms that you're gonna get from your bank are gonna be, I think, less competitive and for a material period of time, like they've got a looming c r e crisis that they have not yet figured out how to quantify. You've still got a very hawkish fed who's increasing interest rates and wants to make sure, Powell wants to make sure that he, his legacy is not that inflation crept back up. So he's probably gonna leave rates high for longer than he needs to. Sure. That's our estimation anyway. And so I don't see this working. I guess my point is, I don't see this working itself out in the next 12 months. I don't think that banks are gonna be, once again competitive, once again a, a really interesting resource for Main Street real estate investors to fund their business. Well, Craig 43:28 Why do I care, Jack? I mean I've, I've got Wall Street to back me up, you know, who cares? I, it, it's, it's another, it's, instead of going to Home Depot, I go to Lowe's. Right. So, you know what, what's the concern? Yeah. Jack 43:39 The, the concern there is that we've gone from single sourcing to the banks to now potentially single sourcing to to main or to Wall Street. And so Wall Street, we ride the curve of, in the D S C R product run is priced generally off of the five year swap rate, the five year treasury. And so that all of a sudden matters, right? Like I never cared, I never watched 10 years ago I did not watch the five year treasury, Craig 44:05 The five year note. Like Yeah. Jack 44:06 Just, it didn't affect my business. Right. Today it affects our, it affects pricing of D S C R loans on a daily basis right now. Craig 44:13 Is that right? Jack 44:13 Yeah. So like it all of a sudden that matters. How Craig 44:16 Is it so specifically tied? Jack 44:18 Because the bond buyers expect that the loans will pay off on average five years. Ah, they're, they, they think that they're buying a five-year asset. I see. Because given historical prepayment speeds, that's how long it's taken. Also on a lot of the product though, you can get different prepayment penalties. The one that we do the most of is a 5, 4, 3, 2, 1 prepayment penalty structure. You can, you can get pay a little bit higher interest rate and get a 3, 2, 1. But, so given the 5, 4, 3, 2, 1 prepayment structure, the expectation is that the loan's gonna out be outstanding for five years. Yeah. Craig 44:51 I think, I think from like a, you know, sort of a philosophical and, and you know, love of, of the industry standpoint, I I look at sort of the immunization of, of the local bank and even the regional bank at this point as something of that that is a cause of concern. So, so tell me what the other hurdles to the, to the average investor like, like myself or or so many people that we know, why do we care that we're seeing less business going to these community banks and more business going to the, to the Wall Street lender? What's, what are some of the other hurdles that we should be worried about? Jack 45:32 I think that from a, we're gonna be fit more into programs, right? Yeah. Like the, the securitizations are standardized in some way. Exceptions are things that the bond buyers have to think about. And so the people who the, the, the, the comp, the companies that are buying the, this paper and then doing a securitization with them are trying to minimize exceptions. So I think that we are gonna be forced more and more into particular boxes. Yeah. Now, and to the extent that we want exceptions, we're gonna pay for 'em. Craig 46:05 Is the concern there that it's a loan product that sort of covers the country rather than that smaller bank who understands the market so much better. And so you have to fit into the local box. I don't have to fit into the box that governs the entire country. Right? Yeah, that's Jack 46:21 A fair point. There are also regions that benefit from that, right? Sure, sure, sure. Like pricing is not different on a regional basis. Right. So maybe it should be, but at the moment pricing is not different on a regional basis. You know, the, the, the, the, the stronger markets that have better demographics are not being priced Craig 46:37 Accordingly. Yeah. Jack 46:38 Accordingly. So there, there's certainly regions of the company country where one part of the country is subsidizing another part of the country. Oh sure. Yeah. So to speak. But in, but in general, loss rates have been very low on the product as a whole. So until we see like a, a significant a material change in, in loss rates, then maybe then the, the underwriters will start making tweaks and saying, Hey, if you're in this particular region, we're gonna charge you an extra 50 basis points. Just 'cause Speaker: 3 47:08 I wanna talk about the, the, the one other hurdle that, that I see Jack, is that the loan product is tied, as you said to the, the rents versus we've been in the rent markets, it's been shooting up like, like a, you know, a rocket. What happens if all of a sudden we've got a revaluation in rents on these loans? Jack 47:28 Yeah. I mean, you'd get less proceeds. The thing is they, that's not a difference though. Like the bank, the banks also underwrite D S C R. So like that, that's not different from one product versus another. Speaker: 3 47:38 A lot of the business shifts over to Wall Street. You're seeing that what happens if they decide to get outta the business because the, it's just not valuable anymore. Jack 47:48 Yeah. Just why would they, you know, why would it not be valuable as long as the paper's good. Craig 47:52 Alright Jack, so maybe we can finish up with just talking about just bringing this thing full circle right. To the present, talk about how it's going to affect the average audience member of the show. Let's talk about sort of, you know, where we are in the banking crisis and how we might be seeing, you know, some additional consolidation, maybe some decreased service levels from the banking sector. Jack 48:15 Yeah, exactly. So I'm concerned that because of this banking crisis that we just witnessed, we there, it generally is the case that regulators, once there's a banking crisis, they want to tighten everything up. Right? They wanna put the screws on over, maybe over-regulate a little bit. Sure. Which tends to increase the costs of regulation and makes it harder to be a small bank because you've got similar cost of regulation amortized across a smaller balance sheet. Right, right, right. So it that that is the, that idea was led to, or you know, was what happened with Dodd-Frank. Dodd-Frank was increased regulation coming outta the great recession and it led to a 10 year wave of, of bank consolidation and frankly and m a Yeah. And yeah, through m and a and, and led to a, what we'd witnessed was a, an already a decrease in the service level from, from local banks and, and you know, fewer local banks. You know, they became regional banks, then one regional bank bought another regional bank and all of a sudden the, you know, we did, we did loans with 16 banks over the years. They are at two bank, all that paper is now at two banks. Those Craig 49:24 3,500 community banks right across the country have either been bought up or have gone outta business since 2008. Jack 49:33 Yeah. And there's 5,000 that remain and there are some, you know, very credible predictions that it'll be 2,500 in 10 years from now. Yeah. Craig 49:42 But 90% of all deposits are within like 20 banks right now. Yeah, exactly. Right. Where it used to be the exact opposite where the, the bulk of the deposits were in these local banks. Yeah, Jack 49:52 Exactly. Craig 49:53 Who, so Jack 49:53 Go ahead and those local banks are the ones who would return your phone call as a main street real estate investor. Right. Call up JP Morgan Chase and tell 'em you want a $200,000 loan. Like there's you, you won't even get a return phone call. Right. Craig 50:02 They can't do it. Jack 50:03 So that's hyperbolic, you know, statement. Of course. But like, but the idea is that if we, we will probably see another round of, of consolidation in the banking industry that will probably lead, you know, towards larger balance sheets and that will probably lead to a continued decrease in the service level that Main Street real estate investors can expect from their local loan officer who's also probably aging up at the same time. Sure, sure. And, you know, thinking about retiring in the next five 10 Craig 50:32 Out on the golf course as we speak. Jack 50:34 So I only see the industry continuing to trend towards, towards that kind of like institutionalization for better or worse, right. A stronger connection between Wall Street and Main Street investing. And I think that's something that, that is, that it started happening 10 years ago. It's continuing to happen. It's, I think it's only gonna increase over the next 10 years. It's something that as a result, main Street real estate investors need to be thinking about and be educated on those topics because the connection between those, you know, the, the connection between what happens on the front page of the Wall Street Journal and what happens in our main street real estate investing, investing business is tighter than, than it ever has been. Craig 51:17 One last thing that I wanna touch on before we end the episode is the opportunities that you see right now for, help me Out Private lending, is there going to be this wave again of going back out to friends, family, and fools as my old mentor used to say to fund our businesses? Jack 51:41 Yeah, I think that's absolutely the case. The private lending pri, you know, private lender CRE and creative financing strategies. Craig 51:49 There you go. Jack 51:50 Yeah. I think are also like those, those two things are gonna be an important tool and an important arrows in the quiver to have Craig 51:58 Seller financing. Yeah. Jack 52:00 Creative finance financing. Yeah. Pr private money with, with negotiated terms so that you, and frankly I think it's an, it, it's a prudent piece of any real estate investor's balance sheet given otherwise you are, you know, the main, the Wall Street tail is gonna be wagon, the main street dog. And this is one of the only things that you can probably do to try to mitigate that in some way, right? That you have some like uncorrelated money. You know, Craig 52:26 In an upcoming episode we're gonna be talking about should I securitize or not? Yeah. Jack 52:32 And Craig 52:33 For, for the average investor. Yeah. The, Jack 52:35 The idea of doing a securitization is, it's, it's extreme can be in, in certain markets, an extremely attractive cost to capital and give you a competitive advantage. It's one of the main reasons that institutional real estate investors were able to buy as much real estate as they did. Right. They weren't dumb. They just had better money than us. Craig 52:52 Yeah. Why, why can they pay 110% of asking price? Right. Are are they just that dumb jack? Jack 52:59 Right? No, they, they, they, they weren't, they never were. They're making money all along, but understanding how that securitization market works really kind of demystifies a lot of those things that are happening. So we did a securitization about 18 months ago. It's was tremendous for our business. And at some point in the future, I'm sure we'll do, we'll do another one, but I'd look forward to kind of just kind of demystifying that process. It's not crazy brain surgery. It does require a certain amount, enough scale to do it, but it's definitely something that Main Street investors should be educated on. You know, you should know, know what it, you know, when it's an appropriate tool. Craig 53:33 Let's tie it up for a bow with the audience. What do you give them? Give 'em something to think about, things to keep their eyes open for over the next six to 12 months. Jack 53:44 Yeah. I, I think that right now it's, you know, as we mentioned in the first episode, happy to be here right now after how kind of concerning and, and low volume the end of 2022 was. Yeah. But I do not, we are certainly not out of the woods yet. We, and these macro economic ideas are affecting, affecting our main street real estate business more than more than they ever have. And so kind of keeping an eye on what's happening there and incorporating those ideas into your, your business planning is more, more important now that it has been Craig 54:19 Absolutely. Folks, you cannot keep your eyes closed to all that's going on around us. These big macro issues affect us right down to the street level. And that's what we're trying to get across here with this podcast episode. Jack, it's awesome. Thank you. Pleasure. Again, I wanna thank everybody for checking us out. Your comments are always welcome. Please, please comment. It only helps us in designing content for you. Let us know what you'd like us to talk about. If you have any questions, feel free to ask. We'd be glad to answer. But we look forward to seeing you on episode three. This is Craig Fuhr and Jack BeVier signing out from Real Investor Radio. Thanks for listening. Bye-bye. (Generated by Podcast Show Notes at podcastshownotes.ai)