What’s the best way to buy with a small downpayment?

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.

Debt yield explained

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”.

For example:

  • 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…

Why more sellers should be carrying back

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!

Is it too late to buy?

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:

  1. 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…
  2. …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.
  3. 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.
  4. 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.
  5. 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.

Are you an investor or a speculator?

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.