From whom should I borrow?

(Sorry for the obnoxious headline… my inner grammarian wouldn’t allow me to end a headline with a preposition.)

Had a friend call me today asking that simple question. Turns out a broker has been pushing her to use a particular loan broker and my friend wanted to know if that was good advice or not.

So, without any further pre-amble, here’s my advice re borrowing:

1. If you are buying a single family home in relatively good condition and have good credit, go directly to a bank, preferably Wells Fargo or Bank of America, rather than a loan broker. Why? The big banks get their capital incredibly cheaply (something like 70% of the money deposited at Wells Fargo is in non-interest-bearing checking accounts). So, those banks can offer loans at rates which are materially cheaper than those offered through the small banks that work through loan brokers (and which have to pay high interest rates to attract deposits).

2. If you are buying an apartment building in LA, go with a loan broker. It’s really hard to find good deals on LA apartment buildings. When you do find one, it almost always has something wrong with it (mold, foundation settling, etc.). Big banks have zero interest in making problematic loans, so, when a problem crops up, they run for the hills. Loan brokers, on the other hand, only make money from slamming loans through smaller banks. So, when you’re buying something with issues and you absolutely, positively need someone to get the deal done, go with the guy / gal with skin in the game… eg the loan broker.

3. If you are buying something which is uninhabitable or you have terrible credit, then your only option is to work with a private money lender (eg a loan shark). These guys are willing to take on all kinds of risk, but they get paid exorbitant interest rates to do so (usually 8-10% once all the fees are factored in).


The economics of buying a home in an improving neighborhood

You can now get regular financing on a house under $419,000 for up to 95% of the purchase price.

These aren’t FHA loans with high mortgage insurance payments; they’re relatively standard bank loans.

Thought I’d run the numbers on a standard, $350k house in an up-and-coming neighborhood to determine if it makes sense for renters to dive in.

Obviously, this post comes with my standard caveat about using lots of leverage: Leverage magnifies outcomes, both good and bad. So, if you’re going to use 95% LTV leverage you better be damn sure that either the value of the house is going to increase or that you will be easily able to cover housing payment even in a down economy.

That said, let’s get to the numbers on a hypothetical $350,000 house with 2 beds, 1 bath and a bit of land:

  • Put down $17,500
  • Borrow $332,500 at 4.125% fixed for 30 years
  • Monthly mortgage payment of $1,611
  • Monthly property taxes of ($350,000 x 1.25%)/12 = $364
  • Monthly insurance of $1500 / 12 = $125
  • Reserve $100 / month for repairs
  • Total monthly payment of $2,200

Now, for most of the neighborhoods in question, $2,200 is a bit more than it would cost to rent the same property.

But owning is a bit more tax efficient than renting. Of your $1611 x 12 = $19,332 in mortgage payments in the first year, ~$13,620 is mortgage interest, which is tax deductible. Assuming your marginal tax rate is 30%, that $13,620 in mortgage interest saves you $4,086 in taxes, or $341 / month.

So, after taxes, you’re actually paying out $1859 / month to live in a 2 bed / 1 bath house in an improving neighborhood.

In my opinion, that is a deal worth doing. If you’re interested in doing something like this and you have good credit and around $25k-30k in cash, get in touch.

Where are interest rates going?

I have no idea and anyone who says they know for certain is either:

  1. A liar; or
  2. Should be trading interest rate futures on Wall Street

That said, having a view on interest rates is pretty important in our business.

Why? Because the price of income producing real estate is highly dependent upon the cost of borrowing money.

If interest rates move up, cap rates (the “unlevered return”) move up, and the price of income producing real estate falls. If interest rates drop, cap rates drop, and the price of income producing real estate rises. (For more on this subject, check out this post.)

Given that the future prices of the assets I invest in are heavily dependent on interest rates, I have to have a view, so:

  • Believe we’re in for a period of sustained low rates
  • This is due to a huge glut of savings (worldwide, but also among baby-boomers who are all at peak net worth right now) chasing returns… eg competing to loan money
  • Also do to sustained weakness in almost all of the major developed economies, with the exception of the US
  • Persistently low inflation in the US, causing the Fed to fear deflation (as happened in Japan)

I have no idea if the above is correct. And, even if it is, it doesn’t mean rates will stay as low as they are now… just that it will be a long time before mortgages are 6-7% again.

The problem with banks

I’ve been working on a simple bridge loan for a month.

We bought the property all-cash and are capitalized with additional cash to fund the rehab (which has already begun).

We paid $2,051,000 for the building and intend to spend another $700k renovating.

I have asked a bank to provide the following loan:

  • $1.2MM
  • 5% interest only
  • Term of 12 months
  • They asked, and I agreed, that we keep $700k in an account at their bank and use it to pay for the construction

This is a very, very safe loan for a bank to make. Why?

Well, first of all, they’re loaning $1.2MM on a $2.05MM property. That’s $1.2/$2.05 = 59% LTV.

Second: A whole bunch of the cash is staying at their bank during the rehab.

Third: I’ve done this a million times (though never with a bridge loan).

Fourth (and most importantly): We have investor commitments for the $700k we need for the construction, so they’re not loaning to 59% LTV… they’re loaning to $1.2MM / ($2.05 + 0.7MM) = 44% of the total capitalization of the project.

The above is pretty much all you need to ascertain that, yes, there is plenty of security for the loan.

Do you know what would happen if I didn’t pay back the loan:

  1. They would take the building back from me at a basis of $1.2MM plus whatever it would cost to foreclose. They could turn around and sell it for $2-2.1MM that day;
  2. I would lose the ability to work with this investor ever again; and
  3. I would have a foreclosure on my record, dramatically increasing the difficulty of accessing capital for a long time to come.

In light of the above, what are the chances I don’t pay this loan back? Zero, right?

You’d think this would be a simple “yes”. But you’d be wrong. Do you know what they’re doing as I write this? They’re messing around with my (very complicated) tax return trying to figure out what my income is. Look back at the information above… where does my personal income come into the security for the loan? It doesn’t.

And that’s the problem with banks: They fall all over themselves to make risky loans that fit into their cookie-cutter boxes, but can’t get out of their own way on the simple ones where the risk is miniscule.

Avoiding a pretty painful “oops”

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.