Avoiding a pretty painful “oops”

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A reader wrote in to ask me a question about yesterday’s piece, which argued for refinancing and holding, rather than selling, completed repositioning projects.

The question: “Only thing I don’t understand is why not refi on a LTV more than 60% to get back all of your original 2million dollars.”

It’s a reasonable question. After all, with a property value after stabilization of $3.2MM, you might be able to get a bank to loan you as much as 75% LTV, or $2.4MM.

Remember that we invested $2MM in the hypothetical property, so a $2.4MM loan would allow you to get all of your money out and then some. That seems like a pretty great deal, right?

The reason I stuck to a 60% LTV loan in the example is simple: Risk avoidance.

When you have a fully-renovated property with very high rents, you need to be conscious of the fact that rents can fall in the event of a recession. For example, in 2008-9, rents at our 16 unit building on Reno fell roughly 20%.

Recall our example property, which has net operating income (“NOI”) of $160k. Let’s assume that equates to rents of $220k / year (if you think a 72% operating margin is unusually high, you’re right – our unusually high rents make our properties’ margins unusually high). Now imagine the economy tanks and rents fall by 20% to $176k.

In recessions, expenses don’t fall by nearly as much as rents… the tenants are still going to use as much water / sewer as they did during the good times, right? Let’s say expenses decline by 10%, from $60k / year to $54k / year. What happens to your NOI, the money available to service the debt? Well, it falls to $176-54 = $122k.

Recall that at 60% LTV, our annual debt service was $116k. So, even with the 20% decrease in rents, our NOI still exceeds our debt service and we can still pay our loan and even have cashflow (albeit microscopic).

What would have happened if we had borrowed to a 75% LTV? Our debt service on that $2.4MM loan would have been $146k, which would would have serviced with our NOI of $122k… Ooops.

We at Adaptive get paid a lot of money to avoid “oops” moments. So that’s why we wouldn’t ever lever up as high as 75% on a property with maxed-out rents.

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