045: What You Need to Know to Loan (Commercial Edition)
APPLE PODCASTS | SPOTIFY
Your time means a lot to us, and we want to ensure you’re getting what you come for. That’s why today we’re giving you a well-rounded picture of a topic a lot of passive investors don’t take into consideration. Financing options.
Normally when it comes to financing options, especially when it comes to commercial real estate, passive investors take the hands-off approach. Really putting the word passive into practice. Who determines how each apartment syndication deal will be financed usually lies with the general partner, or sponsorship team. 🤟
However, we think we know you guys well enough to guess that even as passive investors, financing is an important topic you want to know about. You know, to see what happens behind the scenes.
We’ve never been ones for the spotlight, so when it comes to behind-the-scenes work, we’re your gals.
And maybe you’re the same way! Honestly, being a passive investor is a sure-fire 🔥 way to get in on the action, without having to do any of the, ya know, action.
However, being educated on financing gives you an edge.
As a passive investor, these are the topics that make you a little dangerous. I know, we just said “no action” we mean in the sense of keeping others on their toes– you don’t want to walk into a webinar without asking the right questions or knowing what to look for, right?
This topic of financing is just as important as securing the right deal or raising equity. And as sponsors ourselves, we spend a lot of time weighing the pros and cons of bank and agency loan products on both the front and back end of every apartment syndication deal.
And all those hours talking to the lenders and reviewing loan contracts, it only made sense to share what we’ve learned and give all of you insight into how the sausage is made.
Right off the bat, there is a huge difference between a commercial loan and a residential loan.
👉 Residential loans are conventionally more 🍪 cookie-cutter because a lot more people are looking to buy homes, not ya know, full-on buildings.
But for those lucky enough to get into the underbelly of commercial loans and financing, there is nothing cookie-cutter and cutesy about it.
If residential financing is Barbie, neatly packaged and pretty in pink, commercial financing is your great-Aunt’s pioneer doll collection. There are maybe too many of them and slightly off-putting.
And by too many we mean, there is a multitude of options of commercial loans to choose from, and which one you choose can heavily impact your cash flow and sales proceeds. The good news is there is no right or wrong choice, but knowing the differences and equipping ourselves with knowledge will help us determine which loan products work best for your next investment.
So to kick things off, what is a commercial loan? 🤔🤔
A Commercial Break
The simple definition of a commercial loan is any property with 5 or more units. This includes smaller, single-family units all the way up to full-scale thousand unit buildings. Taking out commercial loans can feel daunting and downright scary– pointing back to the creepy doll collection analogy– but not impossible.
This is a process we believe you cannot take a shortcut on. But understanding how it works, gaining the right knowledge, and listening to this podcast, 🎙️ the Cashflow Multipliers, of course, will help you understand the best positions to be in to buy properties that you wouldn’t be able to pay for in cash.
And for more on that topic, be sure to listen to Cashflow Multipiers EP008 〰️ Actually, Debt is a Good Thing where we dig deep on the topic of good debt vs. bad debt and spill the real tea about how the rich get richer and how the littlest effort can generate maximum results.
And while people are scared here’s the secret debt is still cheap! As you know inflation has arrived. So what this means is we’re buying apartment buildings at today’s dollar, and paying it off with tomorrow’s “less valued” dollars. And we along with our passive investors’ are not even paying the debt off ourselves, our tenants are!
So what exactly are we looking for when it comes to these commercial loans and how it will affect our investments?
We’re so glad you asked.
Here are 7 financing components an apartment operator needs to pay attention to before selecting a commercial real estate loan. 🔽 And passive investors need to keep a pulse on. 💗
No.1 Interest Rate
Anyone who has ever pulled out any type of loan, including school loans, is familiar with this one. How it relates to apartment syndication is through the rate. The rate will determine what the sponsorship costs are going to be.
An interest rate refers to the amount charged by a lender to a borrower for any form of debt. It goes without saying, the higher the interest rate means the higher the cost of doing that transaction. The rumor right now is that interest rates are at an all-time high when that isn’t true. 😵😵
The interest rates we’re seeing now are still lower than what we were willing to pay back in 2018/2019.
Keep in mind your general partners underwrite the interest rate at whatever the current rate is. So that means if they see an 80–100% return later down the line, it’s still a great deal! Don’t let the rising interest rates deter your choices here. These are opportunistic times.
You know we 🧡 love numbers, we love data, yes, Palmy is the data cookie cruncher here!
So recently what we’ve done is … for our most recent acquisition in Houston, TX, we performed several different stress or sensitive tests in order to see what will happen in a worst-case scenario and one of those stress tests was on increasing interest rates.
What the interest rate stress shows was that even as the interest rate increases, it barely impacted the overall return of the property, thus even if the interest hits 6% for example, the property will still return close to 100% in 5 years 🤩🤩, which definitely can help reassure our investors that the doom and gloom news they are hearing really isn’t based on the reality of the situation, it’s just another scare tactic to get people glued to channel or medium.
No.2 Loans-to-Value Ratio
The second thing to look out for is the Loan to Value Ratio. The Loan to Value Ratio represents the ratio of debt in relation to the value of the asset involved. The LTV, as it’s also sometimes referred to, is used to quantify the borrower’s maximum leverage on a loan.
So, getting the most bang for your buck– loan edition.
By not lending the full purchase price, the lender is reducing the level of risk involved. But plot twist, enter LTC. The LTC is a formula, and that formula is Loan Amount divided by Total Value. 😗😗
In today’s market, it is fairly common for an LTC around 65% to 75% and sometimes a bit higher, all of which depend on many factors. ☑️ For example, in a certain economic climate, you don’t want high leverage. You want to make sure you don’t have to do any major cap-ex to add income so that you can pay off the mortgage.
Yep, this goes back to the strategy and business plan put in place to not only maximize the profit, but also minimize the risk. A word of caution: while it may be rational to try to get the highest LTV, this may also increase the investor’s exposure.
For example, if the General Partner gets a 95% LTV, there’s really no income wiggle room should there be a change in the market.
No. 3 Types of Loans
Okay, let’s talk about the differences in the types of loans you can get. The biggest differentiator between bank and agency apartment financing is whether the loan is a resource or non-resource.
What’s the difference between a resource and a non-recourse loan? 👀
Non-recourse loans mean the debt is secured only by the loan collateral, like your apartment complex. So if you default on a non-recourse loan, the lender can only recoup the pledged collateral. So whatever you state as collateral is what they can go after, so your personal assets are safe.
And this is a huge benefit of working with non-resource lenders– your liability is protected.
As for the resource loan, this is where apartment financing from a bank usually comes from. Also, this is where you tend to put a lot more on the line liability-wise. The sponsors are personally liable for the full loan amount in the event of the default, not just what was pledged.
So this means that if the apartment does not sell for the price that covers the loan amount, the lender can go after assets that were not used as loan collateral. Kinda risky.
Sometimes banks will offer non-resource financing, but the risk is often reflected in the higher interest rate. You have to make it up somehow.
Did you know that Sallie Mae, your favorite student loan association, has parents? 😆😆 And their names are Fannie Mae and Freddie Mac. And they raised Sallie right since they are loan agencies themselves that are used by people who are looking to buy or refinance apartment buildings that are specific to non-recourse loans.
That family has a way of getting you to pay. While the non-recourse loans offered by Fannie Mae and Freddie Mac might help you sleep better at night since they aren’t after any personal, liable assets, resource loans tend to offer more flexibility when it comes to loan structure and pricing.
Why?
Because it’s more difficult to recoup on a non-recourse loan, lenders are going to impose more restrictions on what can be done on an apartment building.
Here’s a key thing to look for 〰️ your goals should be the same no matter the loan agency you choose. You want to keep the apartment asset competitive and in good repair.
And more importantly, make sure the building sells to cover the cost of the loan. Fannie and Freddie also need to secure that bag.
As such, loan provisions might include capital expenditure and maintenance schedules, which, if you’re on top of it, are no biggie.
Going back to the resource loans for a second, they are from Banks that tend to offer a slightly higher advantage on interest rates. And we love a good offer.
Non-recourse multifamily loans are typically structured with a floating interest rate spread over an index, which is typically the 30-days SOFR average.
We know– that’s a weird term. “Floating interest rate spread over an index” but hear us out for a sec.
A floating interest rate is one that changes periodically: the rate of interest moves up and down, or “floats,” reflecting economic or financial market conditions. So another term for floating could be adjusting.
As for “spreading over an index” we’ll have to look at it in two different parts. The spread represents the risk associated with the borrower. What tends to happen is the spread on a variable rate credit product will remain the same. Therefore, the borrower’s variable interest rate will change.
And you can bet Fannie and Freddie Mac are fully aware of this. Their rates can be locked in at a fixed rate, and can offer better, long-term fixed-rate loan terms than traditional banks can offer if you’re looking to “set it and forget it.”
Agencies also have the benefit of higher leverage, which tops out at 80% loan to value (LTV) in certain markets. Banks usually top out around 75% LTV. Hopefully, now you can start seeing the advantages of going to Freddie and Fannie. But also infer which agencies align with your goals and investments.
But there’s also a third option we have yet to mention, and that’s bridge loans‼️
The benefit of bridge loans is they are easy to get approved for– but these loans should only be used by very experienced general partners as it comes with higher risks. 💪
One of those major risks is timing since bridge loans tend to be shorter-term loans instead of long-term loans of 10-12 years that you can get with Freddie and Fannie. Bridge loans offer 3-year loans with the option of 1-2 year extensions.
The risk can be obvious, especially in this case with the economy we are currently in. If the economy softens, and the apartment market dries up, then there is a high risk of default if the borrower is unable to refinance into a long-term agency loan.
For us though, we mitigate the risk of bridge loans by purchasing the insurance cap rate. Here’s the bottom line we’re trying to communicate when it comes to picking out loans: The loan your sponsorship team uses will determine the profit you make. ✔️ Of course, it’s not a one size fits all endeavor either. And just because one deal works well with one type of loan, doesn’t mean the same loan or rate will work for another.
I guess you can really say, it’s the dealer’s choice.
No. 4 Terms
Moving on to the fourth thing: terms. Applying for loans is always the easy part, but the terms? The fine print? That’s a different story.
Terms and conditions tend to be the worst part when it comes to buying just about anything these days. Have you bought a concert ticket recently?! Like we get it, take all my data, I just need to get these tickets!
And that little clock ⏰ in the corner, counting down until the tickets disappear from your cart? Anxiety inducing. That just makes us want to “accept all” on the terms even faster!
However, when it comes to real estate commercial loans, you have to pay attention to the apartment loan terms. And those terms will be dependent on your business plan. For example, if your investment opportunity hold period is 5 years, it may make sense to get a floater interest rate loan.
Because as we learned earlier, a floating interest rate changes throughout the life of the loan, it depends on the economy. The rate might then adjust–or float– for the rest of the loan’s life.
Okay, so where do we stand on floating vs. fixed loans?
Our answer is, it depends‼️
There are seasons when we may prefer a fixed or floating interest loan. And just like people, no loan is perfect. In the past, fixed interest rate loans were the popular choice because they have been viewed as “lower risk” since the interest rate is already set. It also provides a level of predictability for the duration of the loan term which typically is 8-12 years.
But most 🏢 multifamily syndication purchases are not long-term investments.
If your investing group is aiming to own the asset for 2-5 years, the prepayment penalty the loan comes with maybe too exorbitant for the investment to make sense. This is especially true when the interest rate is relatively low, which has been the case in the last few years. As the interest rate rises, at some point, it may make more sense to go with a fixed interest loan.
On the other hand, there’s a floating interest rate loan which offers greater flexibility in a time of relatively stable interest rates. Believe it or not, back in the day, floating rates used to be the bad guy, but with loan interest rates, it actually becomes a lower-risk loan strategy.
But then you have those people who want to have their cake and eat it too. Which, a side note, never made sense to us. If you have the cake 🍰 – just eat! What’s stopping you?
Well, most borrowers will elect to take out a floating rate with an insurance rate cap.
So they are definitely not stopping anyone from having cake.
An insurance rate cap is an insurance policy that sets the maximum rate increase the borrower will need to be responsible for.
Take this example:
On one of our property purchases last year, we used a floating rate loan. Our loan entry interest rate was 3.15% with a cap of 50 basis points, which means that during the loan term, our interest payment will never exceed 3.65%, which keeps us safe on the cash flow side while providing us with an extremely flexible exit strategy. With this type of flexibility and safety, we had a couple of options.
The first one is to sell the property in year 2 or year 3 without taking on any prepayment penalty. OR, if we decided to hold on to the property for longer, we may choose to refinance into a long-term fixed interest loan.
There you have it, our official take on fixed vs. floating loans all comes down to one question. What is going to help us to get our goals faster and with flexibility?
No.5 Prepayment Penalty
The prepayment penalty is a fee charged to a commercial borrower if they pay off their loan earlier than the agreed-upon maturity date.
So, getting punished for being responsible is what it sounds like, right?
Who gets mad when they get their money back early? 🤯🤯
Apparently loan agencies.
Prepayment penalties often come in the form of either step-down or prepayment penalty, which starts at a certain percentage and goes down by 1% every year.
Another type of prepayment penalty comes in the form of yield maintenance. Yield maintenance requires the borrower to make a payment to a lender that compensates them for all the interest returns the lender would have gained had the borrower not paid off the loan early.
So weird right? Why are these prepayment penalties? Because the lenders themselves promised their bond investors a certain return and thus, basically, the penalty covers their investors’ return shortfall. Everyone’s just covering their own behind, and you’re gonna have to pay for it somehow.
The status currently when it comes to investment opportunities is many of them couldn’t sell due to the huge pre-payment penalties attached. And of course, depending on the loan size, this could be in the millions and possibly wipe out any gains. 😣😣
No.6 Debt Service Coverage Ratio
And the sixth thing is the Debt Service Coverage Ratio. AKA the DSCR. No, not the name of your new favorite rapper, just a simple way to quantify the borrower’s ability to pay back the outstanding debt collection. The Mae family, or whichever loan agency is decided, has to make sure you can back what is theirs!
The Debt Service Coverage Ratio evaluates the cash flow to determine if it is sufficient to cover the standard mortgage payment during a payment period.
👉 The formula used to determine the DSCR is the Net Operating Income (NOI) divided by the Total Debt Service. Most lenders require at least a 1.25 DSCR.
To make the math easy on you, that means for every dollar that gets paid for the mortgage, we keep 25 cents.
Again, as a passive investor, this is great insider knowledge on how you can determine if the investment opportunity is well worth it. Find out the DSCR for each investment opportunity, anything lower than 1.25 DSCR is a red flag.
No.7 Debt Yield Ratio
The debt yield is a figure that represents the income a property generates in comparison to the amount of a loan that the lender has, well, lent out.
The formula for debt yield is Net Operating Income divided by the Loan Amount. ✨
If a lender is using the debt yield to qualify for a loan, typically they would like to see a stabilized debt yield of 7.0 or above. Debt yield quantification may occur when the year one or year two DSCR is below 1.25 but no less than 1.0.
For us here at the Kitti Sisters, when we see a property that is so far under market rent that the capitalization rate seems artificially compressed below market standard. We make the most out of the opportunity– no wasted lemons 🍋 around here! We will use the debt yield ratio to quantify the attractions of the deal.
Alright, that was a lot for today but we hope you’re getting to a place where understanding some of these finer details, and getting to know the Mae family, will help you make better decisions as a passive investor. Even as general partners and apartment operators ourselves, we’re learning every day the ins and outs of some of these concepts to be well-rounded and educated investors.
As always, we loved hanging out with you and taking us wherever you go. We can’t wait to return in a few days. Before you go, be sure to share this podcast, leave us a review, and check out our website, thekittisisters.com linked in the show description.
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