What does your bank know that you don’t?

Shh! There is a big secret in the banking community.

Do you know what it is?

As a private lender in Colorado I’m constantly networking with bankers. About six months ago I started seeing an interesting trend: Many banks were starting to be a little more conservative on their underwriting. In essence, banks were slowly tightening their standards.

Why is this important?

Banks tend to follow the cyclical nature of the economy with more lending at the beginning of a cycle and less later in the cycle. If we look at the last recession, toward the tail end of the cycle we started to see banks tighten their criteria. As we became fully engrossed in the downturn, many banks increased underwriting standards exponentially to preserve capital and ride through the cycle. 

What I saw six months ago is beginning to show up in economic research. According to a recent Federal Reserve Report, many banks are starting to tighten lending standards on commercial loans. This occurred because “Most domestic banks that reportedly tightened either standards or terms on C&I loans over the past three months cited as an important reason a less favorable or more uncertain economic outlook.”

Furthermore, Jim Rogers, the famous investor and Republican supporter who predicted the last recession, recently said, “There was a 100 percent probability that the U.S. economy would be in a downturn within one year.”

I’m not convinced we are 12 months out, but based on historical metrics a recession/correction is due and will happen in the next 36 months or so. As a lender, we are also seeing signs indicating we are on the “tail” of the current cycle.

How do I know? 

Our loan submissions from “investors” (I use investors in quotes, since many took a two hour class from a salesman who likely has never made money in real estate and now think they are real estate pros) are up substantially and many investors are convinced that the markets will keep humming along.  Furthermore there are a ton of new entrants coming into the markets driving prices up and continuing the euphoria.

Unfortunately based on what is occurring in banking and what we are seeing in our loan submissions, there is no doubt that we are due for a slowdown or correction. It feels like we have a party like 2007 happening all over again!

Although nobody can predict with accuracy the severity of the coming slow down, there are four steps that everyone involved in real estate should begin taking to ensure you are ready for the next cycle

What should you do today to prepare? 

I’m not talking about stocking up food to get ready for the apocalypse, but steps everyone involved in real estate should take today to ensure financial success through the next downturn. I joke that I’m still “walking a bit funny” after getting beat up in the last cycle! Although, not a pleasant experience, it was a life-altering learning experience.

Having personally been through many bubbles including the last real estate bubble that imploded in ‘08 here are some key takeaways. In the last cycle, we were in the lending business (fortunately we still are) and thought we had positioned ourselves for any downturn. Boy, were we wrong. What did we learn from the last cycle that will prepare us for the next one?

Four steps everyone should take today:

1. Begin deleveraging: Leverage is great when the markets are going up. You can make substantial profits when everything is good. The same holds true when the markets go down: your losses are magnified. Now is the time to reduce leverage. We are now 100 percent deleveraged holding all of our loans in cash so we don’t have the “drama” of having to deal with banks, lines, securities, etc…
2. Make sure you have plenty of cash: Notice I said cash not liquidity. In the last cycle, we had tons of liquidity on our lines, which was more than enough to help us through the last crisis.  Unfortunately, many of the lines became useless during the crash as banks pulled back which became a big issue for liquidity.  This is why cash is king.
3.  Watch your risk profile:  We are at the end of the cycle so now is not the time to be starting new projects with long life cycles like a new development.  Now is the time to start winding these downs so you have capital to ride through the next cycle
4. Limit fixed overhead: At this point it is important to make sure your operation is very lean so that you are flexible in the next cycle. When possible shy away from heavy fixed overhead and focus on variable overhead that you can quickly adjust to the changing market conditions. For example, instead of bulking up staff, outsource non critical functions so that you can scale your business at a moment’s notice.

Regardless of whether the next cycle is today or two years from now, we are somewhere near the tail end of the current cycle. Everyone in real estate needs to begin preparing their business to ride through the next cycle with minimal damage. The four steps above are a good place to start based on what we learned from the last recession.