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THE CRITICAL-TESTS OF THE SOUNDNESS 3,
OF REAL ESTATE LOANS IN
TODAY*S MARKET

Address Before
Louisiana Bankers Association
Group Meetings
October 21 to 26, 1946

By HOMER HOYT
Division of Research and Statistics
Federal Deposit Insurance Corporation

*i.E CRITICAL TESTS OF THE SOUNDNESS
OF RIAL ESTATE LOANS IN
TODAY*S MARKET

By

HOMER HOYT

Today, after the expenditure of <*337 billion for war resulted
in a tremendous upthrust in the national income from the $>71 billion
level of 1939 to over $>160 billion annually during the past three years,
we wonder whether the factors that have borne us upward will continue
or whether they will suddenly subside*

Nearly all of us have more money

in our pockets or in our bank accounts than in 1940«
The amount paid in wages and salaries increased from «¿48 billion
in 1939 to oyer «$>116 billion in 1944, 1945 and 1946*

The net income of

farmers increased from $>5 billion in 1939 to from .*14 to *15 billion
annually in the last four years.

|e have accumulated over $>160 billion

in savings, of which 62 percent is concentrated in the 30 percent with the
highest incomes.
As a result of the tremendous infusion of money generated by
war financing, the net incomes and capital values of most types of
properties have greatly increased in the past five years*
hourses have doubled*

The prices of

Farms are selling at 77 percent above pre~war

figures, as an average for the United States*

Stores, office buildings

and hotels have frequently doubled in value, and even apartment buildings
under rigid O.P*A, rent control have increased more than 50 percent in
price since Pearl Harbor*

The «*64 question now is5

Can these present

values be sustained and are the loans based on them sound?




Do we look

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forward from our present elevation to a plateau of values extending forward
into the 1950‘s or do we stand on the brink of a precipice, over which we
are about to plunge?
Y,re have the painful analogy of the break in farm prices a little
over a year after Yorld l«ar I, followed by the tremendous wave of fore­
closures of farm
from 1920 to 1921.

lands.

There was likewise a serious business depression

Does the sharp September break in the stock market

after an almost continuous 41 month rise, forecast a business depression
next year?

Vihat tests may be applied to loans now to determine their

margin of safety in the event of a decline in prices or values?
I would like to suggest that four fundamental principles be used
in combination to determine the stability of values of any type of farm
or urban real estate or any other type of security for that matter.

Those

four basic factors are:
1.

The stability of the gross income.

2.

The trend of operating costs or production costs.

3.

The operating ratio or the percentage of the operating
costs or production costs to the total gross income.

4.

The price or capital value of the property under ex­
amination.

Let us consider each of these factors in turn:
1

.

The Stability of the Gross Income.

The principle here is

that the soundness of the value or loan based on the value is greatly
increased if the prospects indicate a stable or increasing gross income
for the property, unless rising operating costs are indicated.

To il­

lustrate this principle let us consider the gross income prospects for
two types of property:




Farms and urban apartment buildings.

- 3 ~

The gross income of farms is derived from multiplying two
factors, the crop yield, which is affected by the weather, and the prices
of the crop.

Farm prices have more than doubled since 1939, and the

physical yields of leading cereal crops have reached record levels for the
past four years, so that the gross yield of farms in the past four years
in the United States generally has been the highest on record, increasing
from |10 billion in 1938 to over *£4 billion in 1945.
There are such world-wide shortages of food and textiles that
the current large crops will doubtless be absorbed at relatively high
prices but after this backlog of demand is met there may be some recession
in farm prices.

A level of crop prices, considerably higher than pre-war,

however, will probably be sustained by the higher level of national income
and wages and by the greater domestic consumption resulting from higher
wage levels.

But farm prices fluctuate with the national income, so they

would be vulnerable to any post-war depression which lowers employment
and payrolls.

Consequently, in analyzing the value of any farm, we should

consider the effect on the value of any appreciable drop in price or the
yield of the crop raised on that farm, whether it be cotton, sugar, rice,
wheat, corn or oranges.

As there a cushion or safety factor to protect

the security of farm mortgages?

This depends on the operating ratios and

the existing selling prices of farms.

These we shall consider later.

In possible contrast with farm prices, the gross income of
apartment buildings, under O.P.A. rent ceilings, will undoubtedly remain
stable during the next decade.
is abolished,

It might advance sharply if rent control

this stability of apartment incomes follows the fact that

new apartment buildings will cost over 50 percent more to construct than




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existing ones with rents considerably higher than the ceiling rents on
existing buildings,

«ence old buildings will not suffer from the

competition of new buildings.with the same or only slightly higher rents.
Existing apartment buildings will remain 100 percent occuoied for
many years to come, if ceilings are retained, because most families will
not move out of quarters for which they pay - say *>§Q a month - into a
new apartment unit of the same size for which 180 or *90 is charged.
If rent ceilings are removed, and rents in existing apartment buildings
are allowed to rise appreciably so that a great volume of new apartment
construction is encouraged, vacancies will increase in the older
apartments but the decline in income due to lesser occupancy will be offset by greater income derived from the higher rents.
Prospects for the stability of the gross income of office build­
ings and hotels are likewise very good because no new office buildings or
hotels will be erected until the rents rise to

the point where it pays

to erect new buildings at costs over 50 percent higher than pre-war.
Ihe great source of risk for loans on office buildings, hotels
and apartment buildings in the past has been overbuilding.

Here the

apparent stable gross income is undermined by constant additions to the
supply of space until the double effect of

falling rents and increasing

vacancies produces a sharp drop in net income.

Ihus, an office building

of 100,000 square feet of rentable area built in 1925 in a certain city,
and rented at ¿3 a square foot, with operating costs of $1.50 a square
foot and vacancies of only 5 percent, would have a gross income of
$285,000 and a net income of $135,000.

This building was erected then

at a cost of $500,000 for the building and $500,000 for the land or a




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total of $1,000,000 and financed by a first mortgage bond issue of
$600,000 at 5 percent*

The net income of $135,000 covers the $30,000

interest requirements 4*5 times, and the loan appears unusually safe,
Miile there was sufficient demand in the particular city to
take up all the offices in this one building there was not enough demand
to fill another building of the same size.

Nevertheless, under the lure

of high rents and the high net return on the first building, another
office structure is erected.

As a result of this building in excess of

the demand and also of a general business

depression which causes firms

to economize on office space, vacancies in the two buildings increase
to 25 percent and rents fall from $3 a square foot for 95 percent
occupancy to $1,50 a square foot for the 75 percent of the space occupied
Meanwhile operating costs drop only slightly to $1,25 a square foot.

The

gross income on the first office building falls from $380,000 to
$112,500, which fails by $12,500 to cover operating costs.
income is reduced from $135,000

The net

to a minus $12,500, leaving less than

nothing for interest or amortization on the mortgage.
The building is foreclosed and the bonds on the building
themselves are sold at a great discount.

This hypothetical case in fact

is an exact protrayal of what actually happened when most of the office
buildings in the United States were foreclosed after 1929, when average
vacancies rose to 27,6 percent, office rents fell 50 percent and the
average price of $1,000 office building bonds dropped to $286 by

1939*

I want to emphasize, however, that the present gross income
of existing apartments, office buildings and hotels will not fall in
the next few years as it did after 1929, because existing buildings can




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be duplicated only at much hi$ier costs.

Hence, since rents in the new

buildings will be much higher than in the old ones, the older structures
will hold their tenants because they can offer them cheaper rents*
2.

The Trend of Operating Costs*

Even if the gross income is

maintained, a rise in operating costs can lower net income or even
eliminate it altogether*
of America*

This is illustrated in the case of the railroads

The gross income of the railroads in the year ending July

1946 was double that of the year 1939, yet as a result of the rise in
operating costs their net income for the last twelve months was only
half that of 1939.
The traffic volume for the year ending July 1946 was 8 percent
greater than in 1941 but the net income was only one*«tenth as much as in
1941: v47 million in the last year compared with $500 million in 1941*
ihe gross income of the railroads has declined from the war peak as a re­
sult of the fall in the volume of freight and passenger traffic, while
operating expenses have risen as a result of higher wages and materials
costs.

The slight increase of 6 percent in freight rates has not offset

the falling physical volume of traffic and the higher operating costs.
As a result, the net income of the railroads has declined sharply, and
the value of their stocks and junior bonds likewise suffered a severe
decline*
Rising costs of production, caused by higher wages and a
drop in the efficiency of labor have cut into profit margins where th«
prices of the finished goods are held down by 0*P*A. ceilings or by
refusal of consumers to pay a price high enough to cover the costs.




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Those types of properties or securities in which production is
highly mechanized are at an advantage in combating higher production cost
trends compared with industires using handicraft methods.

Thus mechanized

agricultural operations on large farms show smaller increases in costs than
those on small farms using much hand labor*

The cost of single family

homes has doubled in many cases since 1940 because primitive hand methods
still are used detrimentally.

In every industry where labor or material

costs are rising rapidly, future gross income is being jeopardized,

Even

if prices are allowed to rise to cover the higher costs, the market is
constantly narrowed by reducing the number of consumers able to pay
the higher price,
3,

The Operating Ratio,

Other things being equal, the higher

the operating ratio or the greater the proportion of operating costs to
total gross income, the smaller is the margin of safety protecting ang loan.
Thus in the case of apartment buildings in New York City where the oper­
ating expenses, including taxes, consume 65 to 70 percent of the gross in­
come, there need be only a little decline in rents, a little increase in
vacancies, or a little rise in operating costs to wipe out most of the
net income available for debt service,

^e have already pointed out that

the prospects for a decline in gross income on apartments are negligible
in the next five years.

The apartment net income, therefore, will be

chiefly impaired only by a slow rise in operating costs, and by the
expense of deferred repairs and maintenance.
One great advantage in the case of many types of farms, on the
other hand, is that the operating ratio is at present low.




In the past

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three years, average farm operating expenses for the entire United States
have been only 50 percent of the gross income#

This allows a considerable

margin to cover a fall in farm prices or a reduction in physical crops#
There are of course, great differences in operating ratios between dif­
ferent types of farms, but I would like to cite an example of citrus
groves in Florida of which I have made a recent study#
The yields and the prices of Florida oranges,
tangerines have been relatively high since the war#

grapefruit and

The average gross

income on all citrus groves reporting to the Florida State Department of
Agriculture was $500 an acre, the operating cost $150 an acre and the net
return $350 an acre*

An average orange grove would yield 200 boxes of

oranges selling for $2.50 a box on the trees or $500 and all the costs
of cultivating, fertilizing and spraying would be $150 an acre.

Here

the operating ratio is only 30 percent, and even if prices of oranges
fell 50 percent or to $1#25 a box, there would still be a gross return
of $250, and a net return of $100 an acre,

if, instead of a fall in

prices, hurricanes or freezes reduced the orange crop 50 percent, the
net income would still be $100 an acre, if prices remained the same*
Suppose, however, that operating costs are $250 an acre, due to higher
costs for irrigation, spraying and frost protection —
while the gross return is still $500 an acre.

as in California —

The operating ratio is

here 50 percent instead of 30 percent, and if prices or the value of the
crop falls 50 percent, the net income is reduced to zero.

A combination

of low prices and lav/ yields of any crop would likewise drastically re­
duce net incomes based on both high yields and high prices*
large safety factor




A very

is necessary in those areas of fluctuating climate

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where a period of wet years with bumper crops at high prices may be
followed by a succession of drouths*
4,

The Price or Value of the Property*

Even if all the first

three factors are favorable for mortgage safety, a situation of extreme
danger may be created if an unusually high earning rate is capitalized and
reflected in selling prices*

Thus, suppose that an orange grove with a

net income of $360 today is sold now on a 6 percent capitalization basis
or at $6,000 an acre, and that a loan of 50 percent of this amount is
made*

The net income of $360 would cover the interest requirements of

$150 or 5 percent on $3,000 by a ratio of over 2 to 1.

Suppose that the

price of oranges drops 50 percent so that the gross returns are reduced to
$250 and the net income to $100*

Then the returns are insufficient to

cover interest charges and the loan is in risk of default.
If as is actually the case, the Florida orange groves with net
incomes of $350 an acre are selling for no more than $2,000 an acre and
loans are made at $1,000 an acre or less, there is sufficient cushion
to absorb even an abnormally large decline in the price or in the crop.
It is true of farm lands generally that the present selling
prices of the farms do not capitalize the present high earnings.

Prior

to the collapse of 1920, farms were selling on the average at 8 times the
net income of farmers from farming*
3.4 times net earnings*

In 1945 farms were selling at only

On this basis farm prices or gross income would

have to decline 50 percent or farm land prices would have to double above
the present levels before farm loans would be as risky as in 1920,
Farmers generally have not been indulging in wild speculations they have
reduced the farm debt fjrom nearly $14 billion in 1923 to $7 billion in




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1945, 'while their net income rose fro
$15 billion in 1945.

$3 billion in 1933 to nearly

¿ven with a drastic fall in farm prices, farm loans

on most productive farms would still be secure.

fihere is very little

chance that another debacle in farm land values such as took place in
1920 will occur in the next few years*
The stability of real estate values and of all other types of
property should thus be tested by considering all of the four cardinal
principles I have discussed, because the strength in one factor may off­
set the weakness in another.

*'or example, even if farm prices decline,

production costs of mechanized farms can be held fairly stable, the
operating ratio now is favorable and the capitalized value represents a low
multiple of net earnings.

On the other hand, in the case of apartment

buildings where the gross income is held down by O.P.A., the operating
costs are tending to rise, the operating ratio is fairly high and the
capitalized value somewhat high.

There is practically no possibility of

a decline in gross income and some chance of a considerable rise*
The most favorable combination for a safe and secure loan would
be a mortgage on property with an assured stable or rising gross income,
fixed or declining operating costs, a low operating ratio, and a low
multiple used in capitalizing net earnings into value or price •

Such

an ideal combination can seldom be found*
On the other hand the most risky loan and the most unstable
value is that of a property in which the gross income is about to decline
sharply, the operating costs are fixed or rising, the operating ratio
is high and the selling price represents a capitalization of peak earn­
ings or an overcapitalization offhture earnings,




^uch were the loans

made on office buildings and large apartment buildings in the 1920*s
but there are practically none in this category today.
Home loans have had a good record in the past*

^he most

dangerous real estate loans today, however, are those being made at a
high percentage of the current prices of single family homes that sell
even at a premium above today*s inflated reproduction costs due to the
extreme scarcity of living quarters,

A recent study made for the Joint

Legislative Committee of the State of New York disclosed that only 4
percent of the employed veterans can afford the minimum new house erected
in New York today which costs $10,000*

Houses sold beyond the means of

the purchaser must inevitably decline in price when materials become
more available and labor becomes more efficient.

Of course, in the case

of down payments on houses bought on G, X* credit, the chief loss will
not be borne by the lending institution, but it may be suffered ultimately
either by the veterans or the taxpayers#
The outlook for stability in most forms of property income is
good for the next five years, I believe, because of the enormous unsat­
isfied demand for goods, particularly automobiles and houses.

Yet our

success in maintaining prosperity and a high level of income for the
whole nation depends upon the same factors as those "which protect the
safety of any investment - greater efficiency of production and lower
operating costs.

If costs of production continue to mount as a result

of strikes, delays, low volume of output, and a decline in labor effi­
ciency, prices will rise to a point where most consumers simply cannot
afford to buy the goods*

The margins out of which interest, debt

reduction and profits are paid will be squeezed out by mounting costs, so




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that property values will fall, and the whole productive mechanism of our
country will be stalled by buyers1 strikes and declining employment due
to reduced demand.
If the $160 billion income of 1944 to 1946 inclusive can be
maintained during the next few years without any further increases in
prices, we will all share the benefits of full employment and a high
level of buying power*

This will insure stability of property income

and the soundness of most loans made under current conditions.

To secure

this goal of maintaining our existing level of 58 million employment - the
highest ever known — weneed only

a reasonable degree oi team-worK and

something resembling the cooperation that won the war.

With the vast

unsatisfied demand for goods, with $160 billion of savings, a tremendous
plant capacity, a super-abundant supply of raw materials and mechanical
power, a highly skilled labor force, we need only the will to work to
guarantee prosperity for a decade to come.

Tf we cannot get that simple

honest willingness of everyone to play ball and if we break up into dis­
cordant factions, then we can starve in the midst of plenty.

Our for­

tunes are dependent upon a machine which produces a copious flow of goods
and services for all of us, when we each do our part, but which slows
down or stops running altogether when any member of the team deserts his
post.
It seems probable that after the removal of price controls, and
after a shakedown in costs due to a recovery from our post-war let-down
in efficiency, our economy will be sufficiently stabilized within a year
to carry forward production at peak levels for four or five years*




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After 1951 or 1952, however, many of the deferred demands for
durable goods - except housing - will be satisfied and we will enter a
period in which the number of young people reaching marriageable age will
fall off drastically due to the low birth rates of the 1950's,

% e n the

major post-war depression will be due, which will be all the more severe
if in the meantime, we have had speculation and rising prices.

fJ-his de­

pression is, however, by no means inevitable and there will be time to
safeguard ourselves against it after we have had several years of high
level production.

Certainly, some of the factors which produced the deep

troughs of the 1930*8, overbuilding of homes and offices, and excessive
speculation in vacant urban sites and stocks are now conspicuously absent*
At the rate we are now going, we will not be able to catch up
with our housing needs for ten years or until after 1956.

With

the

backlog of demand for automobiles,»even with factories operating at a
peak capacity of 6,000,000 cars a year, we can’t catch up until 1952.
Nevertheless, since real estate loans are frequently made for periods of
from 10 to 25 years, it is the policy of wisdom to require substantial
amortization in the good years ahead, so that loans may be carried safely
through any adverse conditions that might prevail in the middle 1950*s.