Getting a demand from a lender

I have an all-cash deal in escrow right now that’s being held up by escrow’s inability to get a demand from the existing lender. Since it’s irritating me, I thought I’d share the experience, so that you’re not surprised if/when it happens to you.

First: What’s a demand? When a seller sells a property that has a mortgage on it, the loan needs to get paid off through escrow from the funds the buyer brings in (either cash or from a new purchase loan). In order for the escrow officer to pay off the loan, s/he needs an exact accounting from the lender of what is still owed on the property. This exact accounting is called a “demand”, since it is what the lender demands from the borrower in order to satisfy its claim on the property.

So, why would a lender delay in getting its demand into escrow? After all, almost every player in the real estate game wants to get paid as quickly as possible.

To understand the motivation, consider that most loans made 4-5 years ago have much higher interest rates than today’s loans. If you borrowed in 2006 and haven’t re-financed, you’re probably paying north of 6%. A new loan today costs you 3.5-4%.

Now put yourself in the lender’s shoes: You have money on the street at 6% and the borrower is trying to pay you off. You know that you’re going to recycle the money back onto the street and only get 3.5%. How excited are you to make that trade? The answer is: Not very.

Fortunately, there are regulations that require the lender provide the demand to escrow in a reasonable period of time. However, that period doesn’t seem so reasonable when you represent an all-cash buyer who is ready, willing and able to close and just needs the lender to get its act together.

How low interest rates are changing the multifamily market

Had a quick conversation with a loan broker last night about the loans available on 5+ unit apartment buildings right now.

You can now get a 5 year fixed, non-recourse bank loan for 3.62% interest.

Let’s take a look at what that means by using the example of a 5% cap deal, which is a pretty expensive deal for all but the most desirable parts of LA:

  • Price of $1MM
  • Downpayment of 25% or $250k
  • Borrow $750k
  • Net operating income of $50k (5% of $1MM)
  • Annual debt service of $41k
  • Free cashflow of $50k – $41k = $9k

You’re only earning $9k in cash against your $250k downpayment, which is a cash-on-cash return of $9k / $250k = 3.6%. Not great. But that doesn’t consider the amortization of the loan.

By making the monthly payments for 12 months on a $750k loan at 3.62%, you reduce the principal (what you owe the bank) by roughly $12k. To fairly calculate your return, you do need to consider the effect of this principal pay-down, particularly if you plan to hold the building for a while.

If you add the $9k cash plus the $12k principal paydown, you’re looking at a return of $21k on your $250k downpayment, or 8.4% in year one. And, as we’ve discussed before, because of the way that loans work, the amount of principal you retire increases every year (basically, more and more of your fixed monthly payment goes to pay down the debt rather than pay interest on it). So the total return gets better every year.

Am I advocating that everyone rush out and buy 5% caps with lots of cheap leverage? Definitely not. I don’t think the deal above provides enough of a margin of safety for most investors.

But the numbers above do help explain why the market for apartment buildings is so hot right now. With debt that cheap, even bad deals start looking pretty good.

Private lenders are out of their minds

Am looking at buying a small apartment building and using a 50% LTV loan to do it.

Why do I need to borrow money, when I have a loads of cash committed to my fund from investors? Because I’m judged by my investors based on the annual return I generate for them. Because return is calculated by dividing their profits by the amount of their money I use, I’m strongly incentivized to use as little of their money as I can (obviously without taking on so much leverage that I put myself at risk of defaulting!).

Ordinarily, I’d use a bank loan instead of investor cash, but, in this case, I need to close more quickly than any bank can manage.

So, I’ve been talking to some hard money lenders about making the loan. Hard money guys are the people you go to when you need to close fast, because they’re generally just rich guys who make their own decisions about whom to loan their money to.

The first two lenders I spoke with quoted 10-11% / year interest.

On a 50% LTV loan? They’re crazy. This is an incredibly safe loan:

  • It’s a great building in a great area;
  • I’m putting down half the purchase price in cash, which I lose if I default;
  • I’m going to invest hundreds of thousands of dollars in additional cash in the property on top of the downpayment, which I also lose if I default;
  • I’m willing to pre-pay a big chunk of the lender’s interest, so they get it on day one of the loan, instead of collecting it in little bits each month; and
  • If, by some act of God, I default, the lender gets to own the improved building for 1/2 of the market price

Someone is going to be willing to loan me the money at 7-8% / year. It’s just too good an opportunity for someone with a few hundred thousand sitting in the bank earning 0%. I’ll keep you posted.

One problem with leverage

Right now, with interest rates at historic lows, buyers are being tempted to use a lot of leverage when they buy apartment buildings. As we’ve discussed before, leverage magnifies outcomes, both good and bad.

Today, I want to look at how one downside of leverage can manifest itself on larger apartment buildings. But you need to understand a few things about how 5+ unit properties are financed before we can delve in:

  • Banks generally  determine how much they’ll lend by looking at the value of the building and the amount of free cash flow it will throw off under different lending scenarios. (Read this and this for more info.)
  • The loans amortize over 30 years (in other words, if you don’t pay off the loan early by selling the building or re-financing and you make all your payments, you will have paid off the loan after 30 years)
  • Unlike on smaller 2-4 unit properties, the interest rate is usually only fixed for 3, 5, 7, or 10 years, not the full length of the loan
  • After the fixed period is over, the interest rate adjusts based on prevailing rates at that point in time. So, if the prevailing rates are higher than your fixed rate was, your loan payment adjusts upwards (usually within some defined parameters – there is often a ceiling and a floor on the rate)

Can you see how the above conditions can create a problem for the owner? To understand it, you need to understand how higher interest rates and lower rents change building values:

  • With rents down (say, because the economy is in recession), the value of the building decreases, because buildings are valued on a multiple of their rent rolls
  • Higher interest rates also reduce building values, since, if you can earn higher rates by keeping your money in the bank, there’s less temptation to go out and buy a building to get yield.

OK, now imagine you’re trying to re-finance a loan on a building you bought three years ago with a 75% LTV mortgage. Your building’s value has decreased, meaning you probably don’t have the 25% equity the bank would need for the building to pass the LTV test. Your cashflow is reduced because rents are down AND rates are up; reduced cashflow makes it harder to pass the debt service coverage ratio test.

Bottom line: It’s going to be hard to re-finance, so you’re going to be stuck either selling the building at a loss or else paying the higher, adjustable rate from your initial loan for a while.

Fortunately, the government usually helps you out of this bind by lowering interest rates when the economy gets bad, making those adjustable rate payments go down and therefore making it easier to for your building to service the existing debt. That’s why there were very, very few foreclosures of larger apartment buildings during this last bust.

But the above scenario is why I usually push my clients not to borrow the absolute maximum they can get, even if it notionally produces the highest returns. Better to accept a slightly lower return up-front but have a margin of safety in the event the world goes to hell.

Are apartments still worth buying?

This period of sustained, low interest rates is driving every sane person out of cash and into hard, income producing assets. Why? Because, after inflation, keeping your money in cash right now is basically like lighting 1-2% of it on fire each year.

This has been true since 2009, but I think most people are just now getting the message. The result, for the real estate market, has been a sharp increase in demand for apartment buildings. I got an email today from a broker I really respect letting me know she has a ton of clients looking for 2-4 unit deals. Guess what? So do I!

Does this mean it’s a bad time to buy? Ordinarily, I’m a contrarian… I like to buy what no one else is buying and sell what everyone is buying.

But right now, I think income-producing apartments (properly investigated and financed) are still a pretty good bet. Here’s why:

  1. Unemployment is still high, meaning that there are still loads of (young) people sitting around without jobs. As they start to get jobs, they will move out of their parents’ homes and rent apartments. This is going to drive rents up sharply.
  2. When you purchase below-market, rent-controlled units at a fair price using fixed, long-term debt, you are effectively buying a bond. The return you get in the first year should be the lowest it will be for the entire time you own the property, because a greater and greater portion of your annual debt service will go to reducing your loan balance and, therefore, increasing your equity in the property.