June 2023
Many clients wonder why someone (who is qualified to borrow from a bank) would use a private lender when the interest rate is lower at banks. Sometimes, the time it takes to secure a loan from a bank is the same or more than the time it takes to build a new real estate project. Scott says many clients prioritize certainty of execution and timeliness, and if the loan is short term, the difference in interest rates does not matter much.
Chris and Scott also discuss the current real estate market. Scott says rents are starting to plateau and even decrease in some areas, while operating costs and insurance premiums are increasing exponentially. Rising costs and the inability to raise rents sufficiently to offset expenses are putting real estate owners at risk, especially those with upcoming loan maturities. Because of the banking crisis, many regional and even larger banks have pulled back, creating a capital shortage. Therefore, private lenders may benefit as they can provide loans to quality sponsors that may not have access to traditional financing.
As for Scott’s team at Artes Capital, they are aiming to increase yield for investors while decreasing risk. Scott says Artes is placing more emphasis on identifying higher-quality sponsors to partner with and is mitigating risk by strengthening their loan loss reserve, which provides a financial buffer should they incur losses due to defaulting borrowers.
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Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, joined by fund manager of Artes Capital, Scott Taylor. Scott, thanks for joining us.
Yeah, glad to be here.
So, Scott, you've been in private real estate lending for a little over seven years. And in the real estate lending market for about 20 years. Tell us a little bit about Artes Capital and then we want to talk a little bit about what's going on in real estate opportunities, stresses. But tell us a little bit about our Artes Capital.
Sure. So being a real estate lender for almost 20 years started on the banking side and spent about 11 years with Wells Fargo managing a very large portfolio there. And even at Wells, this huge red tape organization, it was always about customer service, taking care of clients, knowing relationships. When I got involved in the private lending world about seven years ago, very similar strategy.
It wasn't about just transactional business, it was about finding relationships that you could do multiple deals with. And a couple of years ago, when my partners and I launched Artes, that was really the the key component to what our business strategy was, was relationship driven. People pay you back, properties don't. We are a recourse lender, not a non-recourse lender.
So it was all driven by people. And here we are in this very interesting, you know, real estate environment today. And I think if you talk to any lender today, they're all saying people first, not properties. Where two years ago, there was a lot of asset lenders, they didn't necessarily care about the sponsor. And so one of our kind of key components to our lending strategy is serving us extremely well right now, and we hope it continues over whatever headwinds come in the future.
One of the biggest questions we get asked by clients when we're talking to them about our excitement around this strategy and why we like to allocate a portion of some of these portfolios to it, is why would somebody use a private lender like yourself? Can you just, I know you've got some really good talking points on that.
Yeah, it's actually something that I questioned myself when I was at Wells, you know, back in 2015, 2016 when I was at Wells, I could lend out at, let's say, 4% with very minimal fees and the private lending kind of industry at that time. Let's just say the average loan was nine and two. So they're paying 11% a year where I'm around 4 to 5.
And I just never understood, like, why would anyone why would any quality sponsor with a good piece of real estate...
Quality sponsor meaning like real estate developer or. Yeah, or somebody.
Or investor.
Somebody who's in a real estate business.
Somebody that can go to a bank. Yeah. And get a loan. Right. There's definitely people that can't go to a bank. The bank does not want to lend to them. Regardless, credit issues, no cash flow, no assets, whatever it is. But why would somebody who is qualified, why would they pay 11% versus four? And when I started digging into the private lending world, what I realized is 75% of the folks that we were managing were my clients at Wells and I what I didn't understand was these clients certainty of execution is extremely important.
And if they're only borrowing money for 6 to 12 months, the interest cost difference over that period of time really doesn't matter. It's about getting the project done, adding the value and moving on to the next project. They they create wealth by rehabbing and building and doing different types of things to value add of real estate.
That's how they build wealth, not by saving interest. And so if they can come to a group that they trust can execute in a timely fashion and get the project done, they're willing to pay a premium for it and they're willing to personally guarantee it and all the other kind of things that the structure around what you would see at a Wells Fargo, we're able to get those same structures, but still still charge a premium because we can move very quickly.
And they need to get that deal done. Otherwise they don't have a project to fix up and rehab, add value and then turn around and sell to make money.
Yeah, about a perfect example. About 50% of our business is what's called build to suit retail for credit tenants. So 7-Eleven, Starbucks, Chick fil A's, McDonald's, Autozone's. I mean, just go down the retailers that are investment grade credit tenants. These these clients of ours are preferred developers for them. So they probably have 12 to 15 locations that they're going to be building out for them.
They've got an executed ten or 15 year lease in place before they close on the property. They've got their building permits, they've got everything ready to go. They can build out these locations in 6 to 9 months and then move on to the next one. It takes six months to get a bank loan. So they're they're almost done.
If they come to the private side and they borrow at a higher interest rate, they're almost done with that project where the tenants now paying rent. They either sell it or they refinance it and keep it and they're moving on to the next one. And so when you think of it that way, and about a year or two ago, these guys were making anywhere from about a million to 2 and a half million per location.
So it doesn't matter if they pay us $50,000 more of interest, if they're making $2 million and they can move on to the other ones. The other thing to think about, and I never really thought about this seven, eight years ago, was if you frustrate the tenant because you can't get their store built because you're waiting on a bank or whatever is happening, it's costing the tenant money.
So what if they say, you know what, you're not going to be a preferred developer for us anymore, We're going to go work with somebody else. Now, you know, ten projects in the pipeline, let's say $1,000,000 each. You just lost $10 million of future revenues because you didn't want to pay 50 grand more of interest. So, you know, there's a lot of scenarios like that that make a lot of sense.
One of the things that is happening actually right now we're looking at this deal right now is a client is offering a cash like a cash purchase, and they'll close in three weeks or less, but they want a 15% decrease on the listing price. So, you know, I can't remember what the listing price is, but they're saying we'll close in three weeks, all cash if you give us this price.
Now what they're going to do is they're going to come to me and I'll probably do half and they do half, but we can close in three weeks. So once again, it doesn't matter the interest they're paying us. If they can get that amount of a discount on the property so that they are still a net win. So those are the kind of scenarios that we get involved in.
We are not the lender for every deal. No private lender is the lender for every deal. But we, you know, find the places that it makes sense and we execute extremely well.
That's a great story. And I really appreciate you kind of sharing that and helping people understand why somebody would use a private lender versus a traditional bank. You've been in in real estate lending for a long time. And I would say that it's been a pretty interesting cycle over the last 20 years. Probably when you got started early on, the banks or the Fed were raising interest rates because we were coming out of the sort of dot com bubble.
Sure. And you had 2008 financial crisis that, you know, real estate loans. And we had that struggle and then we had 10 to 13 years of zero interest rate policy. And now we've had the last year and a half of interest rates going from 0 to 5. So you've seen a couple of times where rates have come down and rates have gone up.
Sure. What are your thoughts on the real estate market today?
You know, there there's a lot of different things going on. As you've mentioned, you've got interest rates going up the fastest that they've gone up and maybe ever you've got this banking crisis that's going on right now due to interest rates going up where they took short term liabilities and they invested in long term assets and obviously that's the banking 101, You don't do that.
And they got caught or.
That was that happened in the seventies though as well. Yeah, people got hurt.
And I mean literally I took a banking class in college and that's the first lesson you learn is you have to you have to match duration with assets and liabilities and you have to make a spread. And that's what a bank does. Well, obviously, a lot of banks did not do that. You know, maybe there's a lot of excuses of why they didn't do that or whatever, but that's it for another podcast.
So you've got the banking crisis, you've got interest rates going up, you've got rent that was continually outperforming operating expense increases and stuff like that. But you're not seeing that anymore at least.
So you're starting to see rents sort of stabilize or potentially decrease.
Yeah, I would say plateau and or even come down a little bit in a lot of different not just office. Right. You kind of office is the big word today, but you're starting to see it in multifamily. You're even starting to see it in industrial and some other, you know, space and operating expenses just keep going up. The best managers out there cannot manage their operating expenses, you know, and one of the things that I don't know if it's being talked about much is insurance premiums.
Insurance premiums are not going up five, 10%. They're going up 50, a hundred, 200%.
I had a conversation with somebody that owns a commercial building just right down the street here in Westlake, Texas, and their insurance premiums went from $37,000 a year to $240,000.
And by the way, that doesn't add any value to your property. All that does is deduct that straight from net operating income and you put a five cap rate on that. And it's that's millions of dollars of value.
The value of that property just was decreased, but expensive cause they can't raise rents to offset.
Or maybe you can raise rents a little bit, but you can't raise it that much. And so I think you're seeing that industry industrywide owners are getting killed by interest rates that are going up. Their cost of capital has gone up significantly. They can't control operating expenses there for a couple of years at least. Rents continue to grow and so your revenue is growing maybe at the same point that operating expenses were.
But that's just not the case anymore. And so and then if you've got a loan, so, you know, most real estate owners have a loan on their property. If you have a maturity coming up in the next year or so, you've got to be very concerned, even if it's a great piece of property, even if it's performing well with regional banks not lending.
And a lot of even the bigger banks have kind of pulled back, where is that capital going to come from? So there there is some good news for private lenders because in the short term, there could be a lot of really good sponsors and really good properties that we can put debt on that we would never get the opportunity to do if it wasn't for kind of this bank crisis.
But the double edged sword of that is how do we get paid off in a year or 18 months or whatever it is? You know, our rates, I would say, our rates a year ago, let's say, was eight and a half and two on average. Today our rates are 11 and two, so 13% a year. How long can a property sustain that, you know, without it eating into the profit margins and the and the equity of the of the piece of real estate?
And so so if I if I can summarize a little bit what you're saying is saying there's there's a lot of pain in real estate because of higher expenses and costs and the fact that, you know, rates aren't able to or rents aren't able to be increased as much as some of these other costs. Right. And so the value of properties have come down from where they were a couple of years ago, Right, when money was cheap.
And so they might if they have loans that are coming due in the next couple of years, they might have access to somebody like you to help bridge the gap for a while. But it's not sustainable long term. So, you know, the best way out of this is for these small or medium sized or larger banks to eventually kind of open up and be willing to lend because right now they're not.
Otherwise, that can cause really interesting stuff.
Yeah. I mean, if banks and here's another thing to think about the private lenders at least the competitors of mine that let's say we're lending a million to 15 million, let's say that's our range. The big banks aren't taking out our loans. It's the regional and small banks, right? It's the credit unions. It's sometimes agency money. But with those small to regional banks kind of significantly pulling out of the market, it's how do we get paid off?
And so that's very concerning, not only how do we get refinanced out, but let's say the sponsor says, well, man, I can't refi, I'm going to sell it. Well, where does the buyer get a loan from? So maybe the buyer has to be all cash. How many all cash buyers are out there that that could potentially put even more downward pressure on pricing in the interim.
So you know, that's where our concerns are. That's why we're a lender, not equity. Right. So, you know, if we go into a loan at a 65% value based on where the value is today, there can be downward pressure on values and we can still protect ourselves. We look at our portfolio more than we ever do. Right now, we're doing a lot more extensions and modifications versus new loans.
We're trying to help our sponsors get to the finish line. But with those extensions, there's usually some form of credit enhancement that we're having to get. Perfect example, last week we were supposed to get paid off on about a $2.1 million loan. And so we said, all right, great. Here's the wire instructions. Send it over. And of course, we get a call.
Hey, there's been a delay. I don't know if I'm going to get my financing set up. Can I get six more months? And we and this now, this sponsor is very well-heeled. So we said, all right, we'll give you six months, but pay down the loan 50%. So they sent us 1,000,050 wire. We paid down the loan and we gave them a six month extension.
So we enhanced our credit position by getting more cash into the deal. But we were flexible with them and gave them more time. Instead of putting them into default. So you and I have been talking a lot recently and we've had some playing golf and doing other kind of charity events where I've been on the phone a lot and in most of it is this type of stuff.
It's not new deals anymore. It's how do we help a sponsor. We've been banking for ten years. How do we help them get to the finish line in an extremely challenging position? Yeah.
I think that's a great story. Thank you.
And just to add to that, the reason why we bank strong sponsors is they've got the ability to send in the million dollar wire. If you were doing a non recourse asset only loan and values come down 30% you might be in the woods. Right. So to be able to go to our sponsors and say, hey, we'll help you, but you got to help us, you've got to give us another piece of collateral.
You got to do a pay down. You need, you know, there's a bunch of different structures that we can do. Sometimes there's investors outside of the fund that will come in and do a cash injection. So there's a lot of different things we do to protect our investors. And I'll be very honest, as of today, when I look at our portfolio, I don't see any issues for fund investors, but even our strongest sponsors are feeling pressure.
And because we've had such long term relationships with these guys, they're telling us the truth. They're telling us they're getting hit on rents, they're telling us their operating expenses are impossible to manage if it's a construction deal. Construction costs are out of the you know, out of this world. There's delays because the cities and the utility companies and I mean, it's just like everywhere you look today, you're kind of going, man like.
And so it's an interesting time. And I'm happy to be a debt provider, not an equity provider today.
And I'm glad as well. And I know from some of the conversations that we've had recently that's causing you to take pause and, you know, look at it with a look at new opportunities with a fine tooth comb. I mean, you've seen over 500 deals that you've done probably in the last seven years, but you've looked at probably three or four times that amount.
So you've looked at several thousand deals over the past decade. You've done around 500 of them. What are some other ways besides working with your tenant and negotiating better terms and having them pay down that you're doing to help protect investors in this timeframe? I believe I heard you tell me a story that, you know, in the past you were doing a lot of loans at 60-65% loan to value, charging 9% now interest rates have come up.
And instead of doing the same deal at 60 or 65% and charging 12%, you're likely to do that deal at 40% or 45% loan to value and still charge that 9%. Like, is that still frequently happening?
Yeah. So one of the things that the two things that we're focusing on right now are increasing yield for investors while decreasing risk. So there's a lot of different ways to decrease risk. You can get a much higher quality sponsor that and you get full recourse to them. You can do lower leverage, you can do higher quality real estate.
And so we're trying to do a combination of all of those things while we raise yield to investors. So if you remember a couple of years ago when we launched, we were targeting around a low 7% unlevered yield. Yeah, well, today we're returning nine and a half probably. I don't have the numbers for May yet, but it might breach the 10% number.
And we're starting to take a loan loss reserve every month now, which every prudent lender should be doing, is taking a little money off to the side because regardless of how good a lender you are, you're going to lose money if you do this for 20, 30 years. So we're starting to do that a little bit. But what we're really focused on today, and I've got another great example for it is how can we get a much higher quality sponsor?
Because I think we're entering into a time period where it doesn't matter what real estate you own, there's going to be pressure on it. I think cap rates are going to come up on all properties. I think obviously interest rate expense is crushing people today. So what we are really focused on is the quality of the sponsor. So this goes back to my banking days and I think one of the advantages that managers who come from kind of a banking background and know the banking community really well, I think have a huge advantage going into this next 12 to 24 month period.
A couple of weeks ago, I got a call from one of my best friends in the banking world. I've known her for probably 16, 17 years. She was actually one of the bankers that was kind of a mentor to me as I was growing up in my early twenties at Wells. So she's been a real estate lender for probably 25 years, very respected in the community, knows all the top people.
She's over at Fifth Third Bank today and so she calls me. There was an issue where they were giving this client one of her best clients a $30 million loan. They had loan docs. They were getting ready to close. And then the regional banking crisis started to happen. And so the bank said, well, we're not doing 30 million anymore.
We're going to do 27.5, but we'll still do the loan. But 27.5. Well, here's a client that's got probably $100 million net worth, multiple millions in liquidity, properties in his real estate portfolio that are owned free and clear. And he just got cut almost 10% of loan proceeds and it's one of their best clients. Yeah. So it kind of tells you if he's getting cut what are what are the normal clients?
They're probably not even getting a loan. But anyways, so she called me, she said, Scott, I need your help, he is one of my best people. He's super strong. He'll sign recourse. He's got the liquidity, but he wants to use his liquidity for opportunities right now, not for this refi. He needs two and a half million dollars very soon and he owns multiple properties free and clear.
So I said, All right, have him give me a call, send over his real estate schedule. So we start looking through his real estate schedule. We ended up doing a 40% LTV on a McDonald's. O'Reilly's Quick Quack carwash and a Dollar General, 40% LTV, and we charged him 11 and two and he signed for recourse and he was happy to do it.
So those are the opportunity today where that guy probably should have never come to a private lender. The bank should have taken that piece of property, gave in to it. But that is what's going on right now in the banking world, is there's this red tape, there's this confusion, there's this uncertainty where if people want certainty, a strong sponsor like that can come to us and we can get it.
We can get it done. Now, here's the great part of this story, even the better part of the story. So we closed the deal. We closed it in like two and a half weeks. The guy actually called me on the phone. He's walking through and I said, You're approved. And he's like, What? And I'm like, You're approved. It's done.
Just get us all the stuff. We've got to pull legals, we've got to do environmental, we've got to do all that stuff. But if all that stuff checks out, your loan is done. We'll close in two or three weeks. So we closed. He calls us the next day. He's like, That was unbelievable. I've never had an experience like that.
I think I want to do more business with you guys. So this is where that private lending, you know, speed, certainty, it's not the price. It's all the other things that, you know, ever since Dodd-Frank, the relationship model of a bank has continued to, you know, just fall apart. And we can still provide that.
And Dodd-Frank was implemented. Dodd-Frank was implemented post 2008 financial crisis. Correct. And we're still seeing some of the ramifications of red tape of that today. But it's likely not to get any better.
No. Make it worse. It is. Yeah. You know, there was the big they originally it was 50 billion. If you were 50 billion or larger, you had to go through all these things.
The stress testing.
They pushed it up to 250. That's probably going to come back down to 50.
Arguably although I think a lot of the banks smaller regional banks that went under recently, if they were subject to the testing, there's arguments that they would have passed the testing because very few of the tests ran scenarios where 25% of the deposits were requested to be withdrawn within a day. But I think that banks need a little bit more testing.
Any time you're taking in $100 and lending out $90 and people want safety and security of their deposits, we need to we need to be careful. I feel like I could talk to you for days. Scott, thank you so much for joining us. This was fantastic and really appreciate all the hard work that you go into in terms of helping protect, grow and generate income for our clients.
Yeah, no, I appreciate the invite. Glad to be here and thank you everybody.
Disclosure: Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your financial, legal, and tax professionals before implementing any transactions and/or strategies concerning your finances.
