Archive for the ‘Debt’ Category
One couple, two incomes.
Live on one, save the other.
Buy first 4plex FHA.
Live in one unit, accelerating savings.
Accumulate downpayment for building #2.
Buy building #2 with 25% down.
Resist temptation to increase spending; saving accelerates due to income from building #2.
Buy building #3.
Assuming we’re talking about 4plexes that cost in the range of $800-900k, repeating the above strategy four times results in you retiring with $3+MM (maybe much more, depending on how good the deals were) in equity in today’s dollars 30 years from now.
In our business, we frequently have clients come to us with pre-approvals from direct lenders like Bank of America, Wells, etc.
The clients love the banks because they promise high loan amounts and low interest rates.
And, on simple deals where there are no real issues with the borrower or the property, the direct lenders do fine.
So, why do we strongly recommend to our clients that they use a loan broker instead of a direct lender?
Because, when problems come up in a deal, which they almost inevitably do when you’re wading through shit, the direct lenders just decline the loan and head for the hills.
Why do they do this? Bank of America does not care about closing your loan. They’re going to close a million loans. All the bank cares about is not doing anything non-standard so as to avoid upsetting regulators. So, when a problem pops up, it’s much better for the bank to run away. There’s always another loan to do.
Contrast this with a loan broker who gets paid to close deals. All he cares about is closing the loan. If the lender raises an issue with the property or the borrower, the loan broker is there to figure out a creative way to jam the loan through. Because, if she doesn’t, she doesn’t get paid. And, if she does jam a questionable loan through, it’s the bank’s problem, not the loan broker’s.
Now, it should be noted that you’re going to pay for a loan broker’s services. The loan may be a hair more expensive.
But you’re paying for a greater certainty of closing. And, in our business, where the problem is the lack of reasonable deals, the last thing you want to happen as you near the finish line is to have some drone at a big bank tell you they can’t close.
Regular readers know that I’m not a fan of using lots of debt. Debt (“leverage”) magnifies outcomes… so if you’re highly levered and the deal goes well, you do REALLY well, but if it goes badly, you get crushed.
There are, however, some nuances to my view and it has to do with where you are in a given real estate cycle.
If you are at or near a bottom, for example the years 2009-2011, then you want to load up with as much leverage as possible. The reason is simple: You’re going to have relatively strong cashflow (cap rates usually go up when the economy is recessed / depressed), so you will be able to service the debt. As the economy improves, your cashflow is likely to improve, too, because rents will grow. And the likelihood is that prices will increase over time as the market heals, meaning that your equity will increase and your loan-to-value will decrease.
If, as is the case now, you’re in an up-market, where rents and prices are high, you want to be very careful. It’s going to be tempting to lever up, because banks are loose with debt. But, whether you’re at the actual top or just approaching it, the likelihood is that you will experience rent and/or price decreases within some relatively short period after making your acquisition. If you are highly levered, you will be at risk of defaulting on your debt.
Obviously, the problem with the above advice is that it’s very hard to call the top of the market. You might follow my advice, under-lever, and then find that the market continues to rise for years, meaning you missed out on returns you could have got had you used more debt.
But our game is about longevity. It’s about hitting singles and doubles, lucking into the occasional homerun and, most importantly, avoiding striking out / hitting into double plays. It’s about the certainty of being rich in the long run and not about staking it all on a roll of the die.
Here’s an interesting piece re the systemic risk being created by FHA loans.
For those just joining us: FHA is a program through which the federal government insures banks against losses on loans for 1-4 unit properties, allowing banks to make loans up to 97.5% of the purchase price and to people with beat-up credit.
During the worst days of the recession, in 2009-2011, FHA was incredibly important. It was the only way a lot of people could buy and, if you used it correctly, was an incredible source of leverage. (For example: I have clients – hi N&J – who bought a duplex is Echo Park with 5% down and have probably made $200-250k on their $35k investment in a few years.)
At the time, I was a big cheerleader for the FHA program. The reason was pretty simple: Using lots of leverage is always pretty risky, but it’s least risky when prices are low.
As prices have increased over the past few years, it has become riskier and riskier to loan up to 95-97.5% LTV, because the chance of a price drop putting the home underwater is high.
FHA was a great lender of last resort during this past crisis. But, now that those loans are risky and there is private capital in the marketplace, the government should absolutely not be in the business of making very high-leverage loans to people with bad credit.
Let private capital take that risk (and be compensated for it!), not the taxpayers.
As a result of the huge number of foreclosures across the country over the past five years, numerous states and the federal government have created all kinds of road-blocks to foreclosing on a delinquent borrower.
This is feel-good stuff… no one likes to hear about families being kicked out of their homes and politicians absolutely love the press they get from standing up to the big bad banks.
So, why do I think the government is crazy and that foreclosing should, if anything, be made easier? Am I some kind of hard-hearted jerk?
Let me ask you a question: Have you ever stopped to consider what happens when you borrow money to buy a property? You get in touch with a bank, often one with which you’ve never done business before. You submit to a credit check and supply some documentation. Then, you sign some paperwork and they lend you hundreds of thousands of dollars.
Again, let me repeat: They hand someone they’ve never met hundreds of thousands of dollars. Would you be willing to do this?
The reason banks are willing is because they know they can get the property back from borrowers who don’t pay. The process, foreclosure, isn’t cheap. Depending on the state, it can take a bank anywhere from 3-4 months to years to get a property back from a defaulting borrower, with legal bills running the whole time.
Because they aren’t stupid, banks assume a certain percentage of borrowers will default. They have good estimates for the costs / delays inherent in the process. So, banks are in a good position to price the risk of default into their loans (to ensure that they make enough money on the loans that perform to make up for those that default).
Now you can see why making foreclosure easier, rather than harder, makes sense: The cheaper it is to foreclose, the less the bank has to charge borrowers. I prefer to live in a world where ambitious people can get relatively easy access to cheap credit (until those people screw up), I want foreclosure to be relatively easy.
Today’s NY Times has an interesting comparison of 5% down FHA and conventional loans. (For more about the basics of FHA loans, read this.)
It turns out that the increased mortgage insurance premiums currently demanded by FHA make FHA loans a worse deal than 5% down conventional.
If you’re considering buying with little money down (always a risky move, by the way!), it’s worth reading this article and then asking your lender or loan broker some tough questions.
Was at a conference on syndication yesterday and came across an interesting idea: debt yield.
Debt yield is yet another test lenders use to determine whether or not they should make a loan on a 5+ unit deal.
The math looks like this: Divide the building’s NOI by the proposed loan amount. The resulting quotient is the “debt yield”.
- Say we’re buying a $1MM building
- Because it’s one of my deals, the NOI is $70k (if it were someone else’s, we could use $50k)
- We want to use a sensible purchase loan at 65% LTV, or $650k
- Bank calculates a debt yield of $70k / $650k = 10.8%
Attentive readers will recognize that this equation looks a lot like a cap rate, which compares the NOI to the price of the building. Except, because the equity isn’t taken into account, the debt yield on a given deal will invariably be higher than the cap rate (unless you’re asking for a 100% LTV purchase loan… in which case I’d like an introduction to your bank, please.).
The similarity to cap rate is intentional. What the bank is using the debt yield to understand is this: Assuming the borrow misses the fist debt payment and the bank needs to foreclose (wiping out the equity and trading its unpaid loan balance for ownership of the property), what kind of yield can the bank expect on its money?
Two problems occur to me in thinking about debt yield, one small and one big:
1. The small problem is that the equation does not take into account the time and expense involved in foreclosing. There’s probably a rule of thumb out there (varying by state, since foreclosures are different in each state), but I don’t know what it is, since I’ve never foreclosed on anyone before.
2. The larger problem is with the NOI part of the equation. In the event someone borrows and then misses an early debt payment, you have to assume something is royally messed-up at the property. In that scenario, it seems extraordinarily unlikely that the NOI upon completion of the foreclosure is going to look anything like the pro forma NOI against which the bank loaned. In real life, the NOI is 99.9% certain to be materially less than pro forma (since, if it was close, the lender wouldn’t have defaulted).
Based on the above, I’m pretty convinced debt yield tells you nothing that the DSCR and LTV tests don’t already tell you. But bankers have to have some analysis tools to use to talk themselves into and out of doing deals, so they might as well use this one…
One of the things that bothers me about today’s real estate market is the relative scarcity of sellers willing to carry back mortgages.
To understand why I think it’s weird, we first need to understand what seller carry back financing is.
Simply put, seller carry back financing is when the seller of a property provides the mortgage for the buyer to buy it. The way it works is that the buyer comes in with a downpayment, just like in a regular sale. But, instead of getting a loan from a bank for the rest of the purchase price, the buyer executes a note in favor of the seller. Then, over time, the buyer pays off the note.
Here’s an example:
- Buyer agrees to buy a property from Seller for $1MM
- Downpayment is $250k
- Seller agrees to carry back a note for the balance of the price, $750k, at 7% interest only, with a balloon repayment after five years
- At closing, Seller gets the $250k (less transfer taxes, escrow fees, and whatever he has to pay his broker)
- Buyer makes monthly mortgage payments of $750k x 7% = $52,500 / 12 = $4375 / month for five years
- At the end of five years, Buyer either re-finances the $750k loan with a bank loan or else sells property and pays off Seller’s note
- If, at any time Buyer fails to pay, Seller simply forecloses, takes back the property, and keeps Buyer’s $250k downpayment
It’s pretty easy to see why a buyer might like to get seller carry back financing. First, if it a seller might agree to a higher loan-to-value or a lower debt service coverage ratio than would a bank. Second, a seller probably doesn’t need to get the ridiculous amount of paperwork that a bank requires to do a loan. Third, a seller might be willing to loan to someone with bad credit or insufficient income, which a bank wouldn’t do.
All of the above makes seller carry back financing sound pretty risky. So, why do I think more sellers should do it?
Well, one important reason is that, because the seller can offer as much leverage as he wants, he can probably get a buyer to pay a higher price than the buyer would otherwise be willing to deliver.
But, perhaps even more important is the interest rate the seller can earn on the note. In our present, low interest rate environment, it’s pretty hard to get a safe 6-9% / year return. So, the question is, if you sell your property, what are you going to do with the money?
Why not get a chunk of money now (the buyer’s downpayment) and invest the balance in what is effectively a bond paying 6-9% for, say, five years? That’s better than you’ll do anywhere else. And, in the unlikely event the buyer defaults on the loan, you take the property back, keep his downpayment, and sell it again!
A lot of people are wondering whether it’s already too late in the cycle to buy.
After all, prices have bounced back up off the floor of 2009-10. For context: I sold a bunch of totally renovated buildings in 2011-12 for 10-10.5x the rents. I would get 11x all day right now, and possibly more. (Ouch!)
So, is it too late?
Syd Leibovitch, the president of Rodeo Realty, doesn’t think so. His prediction is that prices will double from the lows… implying there’s plenty of room to run.
Now, I love Syd. He’s a sweet guy and he’s brokered more deals than I probably ever will. (In fact, before I set up the brokerage part of Adaptive, I considered signing on at Rodeo… before remembering that I don’t play well with others!) But I always get a little nervous when I hear brokers predicting price increases. It’s a little too potentially self-serving.
But let me give you another data point: I’ve bought five apartment buildings over the past 3-4 months for our funds, several more for fee-for-service clients, and am making offers for myself now.
Why am I so bullish on the market?
First, let me acknowledge that I don’t have a crystal ball. Anyone who tells you they are certain which direction prices are going to go is a fraud. There’s just no way to know.
Here’s what I do know:
- I don’t pay high prices. The buildings we have bought were all cheap on either a price per square foot or GRM basis, or both. I can’t predict the future, but I know if I buy for less than replacement cost and/or at a price which allows me to lock in a good return from the cashflow (with increases to come), then I don’t really care that much about where the market goes…
- …because I don’t use a lot of leverage. If you don’t over-lever, then there’s no way you’re ever going to be forced to sell. If you’re never going to be forced to sell, then you can always wait out bad markets.
- Rents are rising. There is a lot of demand for quality apartments in good areas. We put a 2 bed / 1 bath in Echo Park on the market for $1850 and had 40 inquires within 24 hours. I think this demand is likely to increase as the economy improves and jobs come back. More demand in supply-constrained in-fill markets (like Los Angeles, generally, and Echo Park, specifically) leads to rapidly rising rents.
- There is a long-term trend away from the suburbs and towards city centers. Long commutes are among the largest contributors to unhappiness. Cities have culture, entertainment, exchange of ideas and, most importantly, good jobs. Over time, I just can’t imagine prices in the 2nd largest city in America not increasing faster than inflation, because living in the middle of a vibrant city is a good life decision for most people.
- Interest rates are incredibly low. Sure, they’re not as low as they were six months ago, but they’re really low by historical standards. If you lock in a 4.5% loan for 30 years right now, I can’t see how you will look back and wish you hadn’t done it.
So, there you have it… a slightly scattered, but fairly emphatic defense of buying now. If you buy my logic and want to get serious about buying a good apartment building, get in touch.
Market prices are up across the entire city. Where you could once buy stuff for 10x GRM, almost everything is now 12x+.
If you’re looking at deals now, it’s important not to get caught up in thinking about buildings relative to each other. At any time, I can tell you what the best thing to buy is in any of the neighborhoods I like. But just because something is a better deal than the other stuff out there doesn’t necessarily make it a good deal.
Now, there are still some genuinely good deals out there. For example, there are stabilized apartment plays at 11x where there is upside because the zoning allows for denser development in the future. And there are non-rent control buildings where the rent have room to move, allowing you to get closer to 10-11x by doing a little management work.
And, if you get one of these reasonable deals and you finance it with reasonable leverage for as long a fixed period as possible, you’re going to do very well.
But there is no magic that transforms a rent control building bought for 14x the rents into a good play. Unless you have (1) a plan to increase rents / reduce costs, and (2) the capital and experience to pull it off, you should probably not buy any rent control building at that multiple, because there is not going to be any real cashflow for years and you’re exposed to re-finance risk in the event rates continue to move (hint: they will).
On the other hand, you don’t necessarily have to pay attention to cashflow if you don’t want. You could just decide to bet on prices increasing. You can figure: I’ll buy at 13x now and hope some fool down the road is willing to buy at 15x two years from now.
But just understand that, if you’re doing that, you’re a speculator. And speculating right now hoping for multiples to increase, when we know interest rates are also increasing, seems like an extremely risky play to me.