A Simple Question
Low fees and transparency are critical to Warren Buffett, Charlie Munger and Jack Bogle.
Should they be important to you?
Low Fees in Commercial Real Estate Loans Matter
Low fees and transparency - two central themes in Warren Buffet's 2016 Annual Letter to Berkshire Hathaway shareholders. Minimizing fees and creating transparency in commercial real estate are critical given the asset's inherent leverage. CRE fees measured as a percentage of the equity are 2x - 4x greater than they appear relative to the total value of the property.
Warren Buffet, the Impact of Fees and "The Bet"
Mr. Buffet describes "The Bet" on page 21 of this year's Annual Letter to shareholders. Simply put, The Bet pits actively managed funds with high fees against a passively managed, low fee Vanguard S&P 500 index fund over a period of 10 years. Spoiler alert: one must be bold to bet against Mr. Buffett. The 10 year window closes this December.
Jack Bogle founded Vanguard. Vanguard evangelizes low fees and transparency in financial services. Mr. Buffett pays respect to Jack Bogle:
"If a statue is ever erected to honor the person who has done the most for American investors, the hands- down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.
In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me."
Transparency is Critical
Mr. Buffett discusses transparency in a brilliant, non-fiction storyline beginning on page 16. The storyline points out that industry standards (and in this case GAAP) encourage behavior utterly contrary to common sense. Warren Buffett and Charlie Munger refuse to yield to such behavior. It's a good read. Check it out.
Application to Commercial Real Estate Loans
CRE market participants frequently dismiss high fees, antiquated technology and opaque processes.
"Don't worry the Seller pays the fees."
"It's only 2%."
"Yeah, the Lender is paying me too. Sorry I forgot to mention that. Don't worry, I'm working for you. You're my client!"
The Borrower is the source of funds for all fees paid in a commercial real estate acquisition or refinance. Period. God Bless. Amen.
Let's take a quick look at the math of a traditional mortgage banking fee. Traditional mortgage banker's frequently receive far more than 1.00% per loan. Over the life of the loan the total fee can be 150 bps - 200+ bps.
I can hear you now ... "Preposterous! I've never paid a 200 bp mortgage banking fee in my life." Maybe, maybe not. Simply sum production incentives and/or servicing fees received from lenders. These fees are on top of the stated fee in your mortage banking engagement letter.
Back to the math...
Cash Return On Equity = (NOI - Loan Pmt - Fees) / ((1 - LTV%) * Price)
The loan payment on a 6.25% cap rate acquisition financed with a 4.75% (25 yr amortization) loan consumes anywhere from 70% - 90% of NOI @ 65% LTV - 80% LTV. This is before fees.
4.87% Cash ROE. Not So Great.
Consider a $10 million deal on an industrial asset in a nice market purchased with the above parameters (6.25% cap rate with 4.75% financing) at 70% LTV with a 5 year maturity. Cash ROE comes in at 4.87%.
The financing creates a loan constant of 6.84%. Thus, the loan payment consumes 77% of NOI. Equity investors receive a rather modest 4.87% Cash ROE.
In dollar terms, there is $146,000 in cashflow available...before the $105,000 mortgage banking fee (1.00% upfront and 10 bps per annum servicing fee). THAT'S 72% OF YEAR 1 CASH FLOW. 72%!
The standard industry practice is to obfuscate this fact by financing the fee into the loan balance. The practical result is that high fees, no matter who charges them, result in commercial real estate sponsors selling a call option on the initial price appreciation of a project.
Fees and transparency matter, particularly in an asset that is leveraged 2x - 4x capital.
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