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236 The Lender’s Dilemma 211 2. If the borrower experiences a period of inflation unanticipated by the lender (especially if the loan is granted at a fixed rate of interest), he will reap leveraged equity growth as the appreciation of the entire property value is credited to his equity. Of course, these benefits come at the expense of risk because leverage magnifies both profits and losses. The choice of how much debt to use often discloses a difference of opinion between borrowers and lenders about inflation expectations. When borrowers view inflation expectations differently than lenders, they place a different value on the property. This results, given fixed net operating income (noi), in borrower capitalization rates differing from lender capitalization rates. Some rearranging of the identities for ltv, dcr, and value will convince you that market value may be represented as either of the two identities in Equation (9-1) cri ¼ marketvalue ¼ 12 constant dcr ltv ð9-1Þ where ‘‘constant’’ is the ratio of monthly installment payments required on the loan to the loan balance (also the factor from Elwood Table #6, the payment to amortize $1). Setting the two expressions for market value (mv) equal to each other and solving for capitalization rate (cr) produces Equation (9-2). cr¼ 12 constant dcr ltv ð9-2Þ Although lenders have some discretion in the setting of interest rates, due to competition and the influence of the Federal Reserve Bank, the lender’s discretion is across such a narrow range that it may be ignored for our purposes. Thus, using an amortization period of 360 months and exogenously determined interest rates, we assume that the choice of constant is essentially out of the control of the parties to the loan contract. (This is not to preclude the borrower from electing a shorter amortization term to retire debt faster, something he can do without agreeing to a shorter loan provided prepayment is allowed.) We pointed out in Chapter 3 that, if one does not model individual cash flows separately as part of an economic forecast, DCF analysis adds nothing of value to capitalization rate. Indeed, a primary benefit of using DCF analysis is to be able to vary cash flows as part of arriving at value. The lender that fixes both the ltv and the dcr is, in effect, dictating that the buyer use outdated 236 212 Private Real Estate Investment capitalization rate methodology. Two important consequences follow: 1. It forces the buyer to use an inferior valuation tool. 2. It requires the buyer to accept the lender’s inflation expectations. THE LENDER’S PERSPECTIVE To illustrate we will analyze a sale of a property that has been arranged at a price of $1,000,000. The property has $100,000 of net operating income, thus the buyer’s capitalization rate is 10%. The buyer requires an 80% loan to complete the transaction. Assume that 30-year loans are available at 8% interest. The monthly loan constant is .00733765. The lender’s underwriting policy provides that the loan may not exceed 80% of appraised value and net income must exceed debt service by 50%. (These are admittedly stringent standards to make our point.) Using the right side of Equation (9-1), we find that the lender’s value of $946,413 is $53,587 below the buyer’s, a shortfall of about 5%. The lender places a higher capitalization rate of 10.566% on the property, and the loan approved of $757,131 satisfies both the ltv and the dcr requirement, but is insufficient for the buyer’s needs. This is because the lender employs a valuation technique that depends on annual NOI, the constant, and both a fixed predetermined dcr and ltv. THE BORROWER’S PERSPECTIVE The buyer’s approach to value is different. By agreeing to pay $1,000,000 for the property and to borrow $800,000 at market rates and terms, the borrower is saying that the equity is worth $200,000 to him. Thus, he has examined the present and anticipated cash flows in light of his chosen discount rate and, after considering payments on an $800,000 loan, makes the following calculation using Equation (3-9) from Chapter 3. 200,000 ¼ n¼1 ð atcfdÞn þ ð atertÞt The connection between the difference in the parties’ opinion of value and the differences in their inflation expectations is found in their differing opinions of g in Equation (3-12) of Chapter 3. 236 The Lender’s Dilemma 213 Regardless, the lender’s capitalization rate, produced by his fixed ltv and dcr, is higher than the buyer’s. The lender believes that the buyer has overvalued the property. Assuming both are rational and in possession of the same information set regarding the current business climate, who is correct? Only time will answer this question. In order for the parties to agree to disagree and continue in the loan transaction, something has to give. The lender may either: 1. Decline the loan. If there are other, less restrictive, lenders in the market who can attract this loan, the borrower goes elsewhere. 2. Relax one, either ltv or dcr, of his underwriting standards in order to acquire this loan. If this is a desirable loan to a qualified borrower, the second alternative is preferable. Over time, the quality of the lender’s portfolio is influenced by the quality of borrowers he attracts. Better qualified borrowers use modern valuation techniques that attempt to forecast changing income over time. The converse, if one believes that lower quality buyers use outmoded valuation techniques, is that over time the lender who fixes both the ltv and the dcr suffers from adverse selection as his loan underwriting standards attract weaker borrowers. Thus, in order to use a mortgage equity appraisal method for lending decisions that aligns with the borrower’s use of DCF analysis for purchasing decisions, either ltv or dcr must be allowed to vary. What remains are the questions of whether the borrower is better qualified to make a forecast or if his forecasts are better than the lender’s. There is also the matter of which loan standard to allow to vary. It is to those critical questions that we turn next. IRRATIONAL EXUBERANCE AND THE MADNESS OF CROWDS Let’s step back a moment and consider the lender’s concern that the buyer is overpaying. Suppose that for a period of time buyers gradually abandon the use of better analysis tools in favor of short cuts. This sort of behavior is met with lender restraint, a sort of benign paternalism. The manifestation of that restraint is in the lender’s choice of underwriting tool. Acquisition standards and criteria for Tier I and Tier III properties differ as much as the participants in these two markets. The level of due diligence, analysis techniques, appraisal standards, and negotiating prowess all increase with a move from the one-to-four unit Tier I property to institutional grade 236 214 Private Real Estate Investment Due Diligence Level 5 FIGURE 9-1 100 # Units Due diligence in the Tier I and Tier III markets. Due Diligence Level 5 100 # Units FIGURE 9-2 Tier II constantly increasing due diligence by size. property. Hence, due diligence might be a function of property size. If we restrict our argument to these extremes, a graph of this claim looks like Figure 9-1. The focus of this book is on the Tier II property in the middle. One wonders if the move in sophistication is continuous across all sized properties. Thus, retaining the tier concept but concentrating on Tier II, we ask if due diligence increases continuously with size? If so, Tier I represents a minimum level of due diligence and Tier III represents the maximum. If we claim that due diligence quality islinear in size, one would expect an increase in due diligence across Tier II as property size increases, as shown in Figure 9-2. 236 The Lender’s Dilemma 215 Figure 9-2 illustrates a ‘‘static’’ model, a snapshot of reality at any given moment. Whatever we believe about how investors approach the acquisition process, it is likely that such a process changes over time. Thus, it is a dynamic process. The acquisition standards of 1994 are probably not the same as those of 2004. Acquisition standards themselves should be viewed as cyclical, responding to changes in the surrounding environment. Investors in a hurry resort to rules of thumb (ROT) to quickly evaluate whether a property is worth a closer look. The use of a rule of thumb for acquisition is a different matter. It represents a reduced level of due diligence over more sophisticated methods such as DCF techniques. The Tier I market rarely uses DCF, more often using the rule of thumb known as gross rent multiplier (GRM). At the lowest size of Tier I, the single-family rental, value is perhaps, say, 100 times its monthly rent. Some apply that to duplexes, triplexes, and four-plexes. Somewhere along the line monthly GRM is abandoned in favor of annual GRM. This is hardly a rise in sophistication because the annual GRM is just the monthly GRM divided by 12. Few, if any, Tier III acquisitions are made on the basis of GRM. The question is: At what size property do GRMs drop out completely in favor of DCF and other sophisticated methods? Is it 20 units, 50 units, or 90 units? Also, wherever the drop-out point, does the drop-out point change at different times in different markets? Perhaps most important, why does it change? In very strong seller’s markets an often asked, but seldom answered question is: When will it end? Or, where is the top? One way to approach that question is to ask when do the simple rules of thumb measures that shouldn’t be relied upon for decision making creep into the larger acquisitions populated by what should be the more sophisticated investors? A 20-unit building, made up of 2-bedroom units renting for $1,000 per month, that sold for $100,000 per unit, is purchased at the 100 times gross monthly income rule that once applied to houses. What that says is that the housing consumer is paying the same in rent-to-benefit terms for an apartment as he once paid to rent a house. Apartments don’t have yards, and apartment renters have to share walls with people who may not be good neighbors. The question of ‘‘How high is up?’’ becomes more urgent when house economics, ratios, and standards begin to drive investment decisions. An interesting empirical question might ask if there is a relationship between the top of the market and a time when rules of thumb dominate appraisal and acquisition standards at the larger property levels? Figure 9-3 illustrates such an idea. The essence of the rules of thumb is to impound future events implicitly into one simple measure, a kind of short cut. By contrast, the central value of forward projection methods is to allow the analyst to explicitly consider the effect of changing future events on the expected outcome. Departing from ... - tailieumienphi.vn