I am going to start a bank someday. No really, it is on my bucket list. Not because I have this crazy love of banking or dealing with regulators (in fact, dealing with most bureaucrats drives me nuts), but because there is something in me that is drawn to business sectors where so many of the participants are poorly run businesses. If you are an Altus Shareholder reading this, don’t worry. This is not an imminent undertaking – my focus is still on running Altus – but the more I deal with the banking world, and the more I learn about the banking world, the bigger the opportunity I see.
I can hear the many bankers reading this Altus Insight howling in objection. Yes, I know it is a really hard business, and no, I am not talking about your bank. I am talking about all those other banks. I won’t mention any of them by name here. It is bad juju to call out specific performers in a forum such as this, but as a borrower and banking client, and as a business with lots of highly sought after connections by banks (our investors), we work with lots and lots of banks. In almost all cases I am shocked at how bad they run their businesses.
A good friend of mine was in the banking business for many years (and despite my complaints, I still have many friends in the industry) whose favorite banking quote was “All banks are profitable, good banks are just more profitable.” According to Wikipedia, there are currently 4,096 commercial banks in the United States. In the most recent quarter (through June 2023), according to the FDIC, 97.1% of banks were profitable. The FDIC does not report annual numbers, but looking through the data for the four quarters of 2022, at least 96% of banks were profitable every quarter. Meanwhile, using the cool filtering tool at finviz.com, we can find that only 3,143 of 4,812 public companies were profitable over the past four quarters (65.3%). And that number is pulled higher by all the profitable public banks (758 public banks) skewing the profitability number higher. 96% versus 65%…yep, banks are profitable. Even Silicon Valley Bank and First Republic Bank, in being taken over by the FDIC, were not shut down because of a lack of profitability. SVB’s 2022 profit was $1.5 Billion (yes, with a B).
All banks are profitable, good banks are just more profitable than bad banks. It is extremely difficult to start a bank. Once you have an operating bank, the government inundates you with expensive regulatory compliance requirements, meaning a bank has to be decently large to afford to be a bank. The regulation creates substantial barriers to entry. In angel investing terms this is called a defensible moat. There are reasons for all the regulation, but one of the drawbacks (in addition to more expensive cost of funds) is that industries with restricted competition have reduced innovation and incentive to improve. Don’t believe me? How fun is your utility company to deal with?
Where does all that bank profit come from? Like any good business, there are several revenue streams. But at the end of the day, banks live and die through their interest rate spreads (side note: this, or rather a lack of this, is what ultimately did in SVB and First Republic). Borrow money at one rate (from depositor) and lend it at a different rate (to borrowers) and pocket the difference. Add in fractional banking and the magical growth of lendable dollars, and Boom! Profitability. This interest rate differential accounts for well over 50% of the revenue of most traditional commercial banks, and most of that is attributable to real estate lending. Yes, I know, it is far more complicated in real life, but this is plenty illustrative for our purposes.
I am not the only person with active bank interactions that feels this way. Many of our investment company contemporaries feel the same way, and the poor quality of service in the lending world is a common topic of conversation. I get it, banking is a complicated business, but the issues are not technical or overly complicated to solve. Are they difficult to solve? Maybe, but not because they are complicated. The difficulty comes from inertia and culture.
All the examples in the following sections are real true-life examples that help illustrate where banks come up short, but shouldn’t:
- Lack of understanding of risk: Banks by nature are risk averse, so it seems like they should understand the risk they are trying to avoid. Instead, we are often left shaking our heads by the questions asked (or in many cases not asked) and the loan terms they present. Quite often banks will offer to lend at higher leverage with better rates for properties that are 100% optimized than those that aren’t, even if the properties that aren’t fully optimized are still operating well. Remember, valuations and DSCR (Debt Service Coverage Ratio) are tied to NOI (Net Operating Income), so by definition, all other things being the same, a lower occupancy already results in a reduced loan amount. For example: on one hand is an apartment building that is 98% leased. On the other hand is an identical apartment property, except it is 92% leased. If a bank is lending to leverage and DSCR constraints, it makes sense that the loan amount would be higher for the property with the higher occupancy – it has a higher NOI. But instead, the loan terms themselves are often different – a lower relative LTV is provided to the second property. So, the bank is lending more money, both in absolute and at a higher loan-to-value on a property that is fully optimized (meaning the only way performance can go is down) than to a property that is just as stabilized but has room for improvement in operations. In the second scenario the collateral can improve. In the first it cannot, but the lender still extends on the first.
Another example is around recourse requirements. As borrowers, we don’t like recourse. Not so much because of the recourse itself (though that is part of it), but because it restricts our ability to borrow on other projects (other lenders don’t like seeing it). Lenders tell us in the case of a foreclosure they will always go after the secured collateral first. Several states have a single action rule, meaning if they go after the collateral, they CAN’T then pursue the guarantee. So, the guarantee is worthless to the bank but of high cost to the borrower. As borrowers we are often willing to pay a higher interest rate (which means higher bank profitability) to not have the recourse as a contingent liability impacting our ability to run our business. And yet, the banks are so stuck on the guarantee, which is worthless to them, that they pass on the higher profit we would be willing to provide. Of note, I realize this is not the case in all situations and locations. But it is the case in many situations; and this is a great illustration of a lack of understanding of risk on the part of those lenders.
- Lack of understanding of real estate: With so much traditional bank lending focused on real estate, the lack of understanding in real estate fundamentals is mind blowing. Don’t get me wrong, banks THINK they are real estate experts, but then say things or ask questions that blow their cover. I could list dozens of examples here. One such example is a loan our sister company Altus Capital placed for a client a couple of years ago. Several years previous, the owner had converted a hotel into deed restricted low-income housing, now needing to pay off the original financing. The property was commonly 100% occupied, with a waiting list to boot. Located in one of the least affordable and most housing constricted markets in the country, the loan request was around 25% of replacement cost and was well below 60% LTV. The DSCR was well over 2, fully amortized. Remember, this was at a time when lenders were tripping over themselves to loan on apartments, often lending 80% LTV (or more) and at DSCRs as low as 1.2 on interest only payments. We got the loan placed, but only because we knew people inside one of the banks and were able to sit down with them to walk through the deal step by step to show them why the risk was so low. We spoke with a dozen banks. There were a variety of reasons they didn’t like the loan, but all of which came down to a risk they saw (i.e. the tenants couldn’t qualify on their own income for the units), which was a part of the very reason the loan was such low risk in the first place. Had they understood real estate more fully, this loan would have had banks fighting over it. The lender that did the loan ultimately understood the real estate, and upon further explanation, they were excited to have it in their portfolio.
- Client service, and especially potential client service, is often at a complete disconnect from what the client wants/needs: I am not sure most banks can even tell you who their client is. A depositor is certainly a client, and taking good care of a depositor keeps deposits at the bank. Some banks (First Republic) do (or did) a great job of this. Others (Chase) do a terrible job. Some banks do a better job with individual depositors while others cater to businesses. That is all well and good. But borrowers are also a client of the bank, and if a bank is in the business of buying the use of money (borrowing from depositors, the Federal Reserve, etc.) and selling the use of that money (lending to borrowers), then the depositors are the suppliers, and the borrower is the consumer. Taking care of your consumers is hugely important in nearly all businesses.
- Lack of integrity in terms or process: Several times in the past twelve months we have had banks bail on loans deep into the process, after term sheets were negotiated, and even after approval from their loan committees. Different excuses each time, never about the project or the borrower, but in all cases having cost us a substantial amount of time and money. The bank controls its money. It can do whatever it wants with it. As a borrower we respect that. But if for some reason there is a change in the ability to lend (oops, the bank’s multifamily allocation is already full and they missed it), they should at the very least be honest and admit the mistake, the issue, etc.
- Lack of dependability/transparency: I believe this is often not intentional. Upper management generally does a poor job of making sure the loan officers themselves understand what the bank is looking to loan against and at what terms. An example from last month happens more often than it should. A borrower had a build-to-suit construction loan ready to go for a credit tenant from a bank they had done several loans with in the past. Just before closing the lender pulled the loan and said they would only do it at a lower loan amount. There was no explanation as to why, just that this was their way or the highway. Banks may have millions in cash sitting around (they are banks after all), but borrowers – especially well-run active borrowers – are efficient with their cash allocations. Pulling a bunch of extra cash into a project may be possible, but it causes issues elsewhere in their business. We took their loan to another lender and explained the situation and the loan specifics that were required. The second bank assured us they could hit the terms and provided a term sheet. The loan went to loan committee for approval…and came back at a lower loan amount. The justification was that the bank had a requirement to include operating costs in their analysis, even if it was a NNN loan. If this were indeed true (see the first bullet above), how in the world does the loan officer and the underwriter not already know this? Further, if this had been a purchase transaction, these banks’ actions easily could have put the borrower’s deposit at risk, which would have become non-refundable. When we pointed out that it was a NNN loan and all operating costs were borne by the tenant, we received a response saying it was in case of HVAC failure, landscaping dying, and other such items. We then pointed out via phone and email that those items were not operating costs, but rather capital expenditures and were also under warranty by the contractor. We never heard from the bank again.
- Banks don’t understand their loan docs: Ask your friendly banker what a 50% recourse burndown means. I have never found one that can accurately explain it to me. Not one. Even when we ask their attorneys, their attorneys often can’t describe it. We commonly receive loan docs with requirements like GAAP accounting. Very, very few borrowers use GAAP accounting, so all are in technical default if they sign the loan docs. The list goes on (and on). The best scenario for us is custom loan docs, which is always the borrower’s cost, and yet for some reason banks often push back on that.
- Timing: Real estate purchases are per contract, and those contracts have strict timelines. While appraisal turnarounds are outside of a bank’s control, everything else in the approval, documentation, and closing process is within their control. Being laissez-faire about missing deliverables while the borrower (client) is hanging in the wind is a slap in the face to the borrower, and often times creates substantial monetary risk.
- Unwillingness to face the heat: When banks renege on terms or commitments, those changes are done by bank executives (or in larger banks, sometimes middle managers). They are not done by the loan officer. But regardless of how damaging the impact of backing out on a commitment might be to the borrower (client), the higher-level banker will rarely (very, very rarely) communicate the decision with the borrower directly. Instead, they hide behind the junior bankers and let them take the heat and deal with the destroyed relationships. From Altus’s perspective, this is a terrible way to run a business and build customer or employee loyalty.
- By their very actions, they often increase the likelihood of what they are trying to avoid: In the Great Recession I owned several loans behind senior bank debt. Many of the borrowers were impacted by the recession and had trouble paying the lender, especially when refinancing out of balloon payments (a repeat of which is quickly approaching now in the real estate market – but for different reasons). The banks, not wanting to foreclose, put together various extension packages hoping to kick the can down the road, but in many cases, the extension terms were so punitive that instead of making the situations better, the outcome ended up being worse for the borrower and the lender (and unfortunately me as well as the junior debt holder).
- Fearful when others are fearful: Twenty-four months ago, we secured a five-year mini perm on an industrial construction loan fixed at 3.5%. The same lender will now lend at 8% on a fully stabilized small bay deal, but with much more intensive underwriting and less generous leverage (tied to DSCR). The lender was excited to make a 300 basis point loan to deposit rate spread, and now is reluctant at a 450 basis point spread, despite the loan structure having far less risk (stabilized versus construction).
- General Bizarreness: Several years ago, I received a term sheet from a publicly traded bank that required me to deposit an amount equivalent to the loan amount into their bank, and into an account that they would control. I would earn 1% on my deposit, and they would lend me the same amount at 6%. Need I say more?
I could go on (and on). The opportunity for improvement is huge; and doesn’t require turning a bank into a fintech company (though that may also be an opportunity). As one of my first mentors Keith Cunningham often said, having a successful business is easy. Find out what they (your customer/client) want, go and get it, and give it to them. Way too few banks do any part of this. When the economy is strong it doesn’t matter as much that banks are bad. Now that banks are fearful, inefficient, and treating clients poorly, it is a big deal. That inability to get out of their own way is going to exacerbate the impending interest rate increase distress. As fearful banks slam the lending door shut, the effects will reverberate through the economy. If Main Street can’t borrow (and it usually borrows from banks), many Main Street businesses can’t thrive, or maybe even survive. At the end of this, and I believe not too far in the future, there lies a recession.
This isn’t to say there aren’t great banks already out there. We work with wonderful banks in Texas, Arkansas, Mississippi, Oklahoma, and California. But they are a small percentage in the broad world of banking. That leaves a massive amount of market share and volume available to anyone that can do it even slightly better.
I am going to start a bank someday. No really…
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at email@example.com.