Lets pretend I’m a terribly sophisticated and experienced property investor. When I invest in property I’m there for the long-term. No fly by night in, out, sell-it-on about for me, oh no. Of course I’m mindful of total returns i.e. rental and capital gains, but really its the regular rent check I’m in it for, which is why when I look at a property valuation I always check to see to what extent it’s simply a multiple of annual rents before I do anything e.g. property X is worth Y and Y = say 10 years rental income.
Heres an example – an office is valued at £100. It has reliable tenants on a long lease paying £6 per annum rent. I think it’s so much of a go-er I borrow £70 from a bank and invest the remaining £30 of my own cash to buy it. The bank is charging me 5% on the debt, so that’s £3.50 a year, which leaves me with the remaining £2.50 to spend on whatever I damn well choose. And hey £2.50 a year when I’ve only invested £30? That’s an 8.3% p.a. return that is. Go me!
Except that’s more than a bit old school, I mean if I borrowed more and invested less (i.e. geared up/used the magical power of leverage), I could make an even bigger return. So instead of £70 I borrow £85 to buy the property (so that’s an 85% loan to value rather than 70%). Same property so same rental income, which means £6 rental income a year to cover interest at 5% or £4.25 p.a., leaving £1.75 for me to spend how I damn well please. And because I’ve only invested £15 that gives me an 11.7% p.a. return. Yahoo! And hey, I’ve still got £15 left to invest so I’ll do the whole thing all over again!
Except you’re thinking, why would anyone be daft enough to lend more money against the same property for the same 5% interest rate? Hasn’t the risk attached to the transaction significantly increased from the lender’s perspective so they should think about charging more to discourage borrowers/get more of a return in case of loss? The risks being (1) the margin between rental income and debt costs is far lower so if say a tenant left the borrower would be in schtuck that bit deeper and that bit quicker, and (2) worst case scenario the bank calls up the security and sells the office to get its money back its more likely to sell it for less than it originally lent at 85% than it is at 70%?
Yup, except for two things. Property lending got so competitive a lot of banks ignored that kind of reality and mispriced (i.e. under-priced) for risk and the idea that property prices were only ever a one way bet (that they would always increase) was a basic assumption underlying much of the British banking industry's business model.
Here though I’ve not explained how to lose serious money. In the run up to the credit crunch (and for a good bit after depending on how stupid a bank’s executives were), so much money was being thrown at property, property values shot up. Take the office example we’ve been using here. After a couple of years it now costs £150 to buy – same property, same rental income of £6 per year. But, hey I’m a sophisticated property investor who made millions in 2004, 2005 and 2006, I can make money here can’t I?
So this time I borrow 85% of the £150 purchase price (£127.50) at 5%, which will cost me £6.37 a year. Feck! This thing only pays £6 a year in rent and that’s less than the cost of the credit I used to buy it, what am I going to do? Borrow more money of course! 85% is for wimps, real property investors don’t get out of bed for loan to values under 90%. Then I can take the additional money I’ve borrowed and use it to service the debt until I eventually sell the office for huge amounts more than I paid for it because property only ever goes up in value!
So OK, I’m no longer investing, instead I’m speculating i.e. taking a punt on there being a sucker willing to buy the office at a later date for more than I paid for it (this mentality applied to most assets asset e.g. companies, oranges, lumps of zinc etc. before the credit crunch and shortly after - oil fer instance). Except, this is obviously only ever a finite option because you can't borrow to repay over the medium-term whatever Carol Vorderman might say in her refinace telly adverts and the supply of suckers is only ever a finite thing, honest. There again if I can find a bank dumb enough to believe me in the short-term, BINGO!
In the medium-term say 3 years plus or so, reality gets in the way of this kind of mince. Take the examples given here
1) Borrowed £70, rental income £6 – who cares what property values are this deal still works. Lost a tenant? Whoop de do, you can get another eventually and there should still be some margin between the cost of credit and rental income.
2) Borrowed £85, rental income £6 – chunk more marginal this because this kind of arrangement allowed investors to buy more and more property and chances are one of them will have come unstuck, but could be worse it could be ...........
3) Borrowed £127.50 in the first instance, rental income £6 – this is the kind of trash that’s going down in flames as I type this, forcing banks to do fire sales of properties (and other assets) where the proceeds are likely to be at least 30 to 40% down on original purchase prices i.e. they’re selling offices bought for £150 for £105 to £84 to try and repay the original £127.50 of debt. This in turn meant they were charging £6.37 for a year or two on a loan that subsequently lost £22.50 to £43.50 (1).
Bingo! So that’s how to lose serious money! Alternatively, just the bank loses because you've done all this via a limited company from which you took mucho big dividends in the run up to the credit crunch and made sure you were always out the office when the bank manager called asking you to sign an asset backed personal guarantee. You might even have charged consultancy fees and built those into the transaction costs.
Of course this might all seem a bit passé right now, I mean we know there was a property bubble and now its burst. Except, property investment being what it is – a relatively slow, cumbersome business – it’s only as we moved from the liquidity crisis into the credit crunch proper and finally the current recession that this kind of lending is being exposed most obviously because more and more tenants are failing.
So whereas for banks 2008 was all about increased funding costs and hacking back to market the value of assets they had bought, the examples given here explain what’s currently happening to bank lending books. There again if I was the kind of idiot banker that had put dross like the third example on the books I’d be awfy keen to emphasise how deals like this are in the past and that we should all be “looking forward” i.e. drawing attention away from my fundamental lack of commercial judgement.
If that didn't work I'd make some comment along the lines of "you know how it was back then, we all had to do stuff like this to meet the targets". Fingers crossed whoever is asking stops right there and ignores the gossip leaking out about how due diligence was regularly ignored if it was commissioned at all and that corners were regularly cut, things no one was ever told to do. There again, as most of the senior managers below the executive boards are still in place, they've got a vested interest in making sure no-one asks those kind of questions as well!
(1) Alternatively the bank doesn't sell the asset. Instead it sits on it hoping values recover in due course. This is a lovely thing to do give or take it means more and more money gets tied up in cack property deals and isn't available to lend to businesses, mortgages etc.