How banks (should) think about risk

Have you ever wondered why banks think in terms of  debt service coverage ratio (DSCR) and loan-to-value ratio (LTV) when they’re considering whether to lend you money to buy property?

They’re really thinking about two different things:

1. Whether you’ll be able to pay the mortgage (DSCR test). This is where the DSCR comes in. The bank wants to see that the net operating income (NOI) from the building (the rents minus the expenses, including property tax but not mortgage) exceeds the total mortgage payments by a healthy margin (right now, by a ratio of $1.20 of NOI for every $1 of debt service).

The cushion (the $0.20 difference) is meant to ensure that, if the rents go down or the expenses go up (something breaks, etc.), you’ll have enough money coming in to cover the mortgage. And, indeed, this has worked very well for banks, as evidenced by the fact that very few 5+ unit buildings have gone into foreclosure over the past four years. (Believe me, I was licking my chops in anticipation of a meal that never arrived at my table!).

2. What happens if you default (LTV test). In the event of default, the bank will move to take title to the property via a trustee’s sale. This is a fairly complicated process, but it boils down to this: An auction is held. If someone wants to pay more for the building than the bank is owed on its loan, then the bank is repaid in full (plus expenses) and the bidder gets the property.

But if no one bids more than the bank is owed, the bank gets the property. Here’s where the LTV test comes in. If the bank required you to put down 30% to buy the property in the first place, it only loaned you 70% of the market value. If you then default and the bank takes the property back, it’s theoretically getting the property for a price equal to 70% of market value. Even if something has changed about the property and it has become less valuable, the bank still has a pretty good chance to at least get its money back.

Imagine, on the other hand, if the bank lent you 96.5% of the value (like FHA does). If you default in that scenario, the bank is very unlikely to be fully re-paid, in part because the cost of doing the trustee sale will likely erase the 3.5% discount the bank is getting. This is why the only way banks will do these kinds of loans is if the government steps in and insures the bank against losses in event of default (that, in a nutshell, is what the FHA program does).

Some final thoughts: Based on the above, you would think that banks would be very, very happy to loan in high downpayment situations. For example, if I’m willing to put down 50% of the value of an apartment building (a value that’s been checked by an appraiser), the bank should be pretty damn happy to make that loan. After all, the DSCR is going to be high (because I’m borrowing less, the ratio of NOI to mortgage payments is higher). And, the LTV is low (I’m putting down 50% so, if I default, they’re getting the property for half the market value – a steal).

If I were a bank, I would be jumping up and down waving money at people who wanted to do these sorts of loans, almost regardless of their income, credit, etc. And yet banks still seem to require a really thorough, punishing approval process, even for people with large down payments.

It strikes me there’s a business opportunity there – make it really easy to get low LTV loans on apartment buildings and you’d have loads of customers.

Anyway, my $0.02.

Questions (redux)?

I’m still looking for more questions about apartment buildings from readers.

I speak with many of you every day, so I know that you’re not all little real estate geniuses (not that I am, by any means!). There are definitely things you’re unsure of. And if you’re unsure, you can bet your bottom dollar a bunch of other people are, too.

So send me your questions (moses at betterdwellings dot com). I’ll publish them anonymously. And then I’ll do my best to answer them for your benefit and for the benefit of everyone else who honors me by reading this blog.

Come on, let ‘er rip!

Atwater Village Rent Survey – June 2012

Continuing our look at Eastside rents… As usual, we looked at ads posted on Craigslist for apartments within the boundaries of Atwater Village as defined by the LA Times neighborhood mapping project.

A few things to note:

  • These are asking rents; you could potentially negotiate them down
  • This particular survey took place towards the end of the month, so these units do not necessarily represent the best deals that were available this month
  • The survey size is very small, because there aren’t many units in Atwater (which is mostly a single family home type of place). There were only 12 bona-fide Atwater Village rentals available when we looked at the data.

That said, here’s a few interesting nuggets from the survey:

  • 2 beds are getting quite expensive. There’s one particularly unappealing listing at $1300 / month. Otherwise, you’re looking at $1800+ with a median of $2100. That’s approaching Silver Lake numbers.
  • Studios in Atwater are clustered in the Rancho Los Feliz development on the west side of the village. There were multiple units available and the rents seemed to fall as the month went on. If you’re looking for a deal, I’d get in touch with them and try to bargain.
  • The supply of 1 beds was vanishingly small – only two were available, with rents of $1295 and $1450.

The fine print: Our survey was based on a search of Craigslist apartment listings using the keyword “Atwater” on 6/27/2012. We checked all addresses to ensure the units were in Atwater; any units without an address specified were removed from the survey. To download the raw data, click here: Atwater Rent Survey – June 2012.

Questions?

I’d like to try something new: Asking for your questions.

If you have a question about apartment buildings, either in LA or more generally, please either:

  1. Put it in the comments below, or
  2. (If you’re shy) email it to me at: moses [at] betterdwellings [dot] com

At some point in the next few weeks, I’ll compile the questions and my answers and post them here.

The following is going to sound like every teacher you ever had in middle school, but who cares?

There really aren’t any dumb questions, so please fire away. If you’ve been reading this blog and are finding something hard to grasp, it’s 100% because I’ve failed to provide a good explanation. And you can bet that, if I’ve failed to explain something to you, I’ve also failed to explain it to many other people reading this blog. So ask, already!

Look at it this way: If you don’t step forward and ask, I’m just going to have to make some questions up, and mine will be more boring for everyone else than yours will be.

Should you hold real estate in an LLC?

Lots of buyers ask me about holding properties within an entity like an LLC, instead of in their own names. I’ll share the advice I give them with you, but only if you promise to remember that I am not a lawyer and this is not legal advice.

First, let’s be clear about why someone would want to hold a property in an entity. The advantage is mostly liability protection. By creating a separate entity to own the real estate, you are theoretically placing a shield between the property and your personal wealth. The idea is that, if something bad happens to the property, the badness stops at the entity level, rather than getting to you personally.

Now, let’s consider the downsides:

  1. Tax headaches. If you hold properties in separate LLCs, each one needs to file state and federal tax returns and issue you a K1 each year. That’s a lot of accountants’ time and, therefore, a lot of your money.
  2. Administrative headaches. In order to preserve the liability protection afforded you by the LLC, you need to be careful not to create the impression that there is no distinction between yourself and the LLC. This means separate letterhead, checking accounts, etc. – in other words, more hassle.
  3. Minimum LLC tax. In CA, an LLC with no revenue still owes the state $800 / year in taxes. This number goes up once revenue exceeds $200k (I think).
  4. Incompatible with owner-occupier mortgages. Banks are VERY familiar with the trick of putting an entity into bankruptcy in order to avoid foreclosure. While they’re willing to tolerate (and often encourage) LLCs for commercial properties (in this case, apartment buildings with 5+ units), they don’t like to see them on residential properties (1-4 units).
  5. Dubious liability shield. Courts have sometimes found that there is no distinction between an owner and the LLC (particularly if you screw up #2 above) and thereby allowed plaintiffs to “pierce the corporate veil” to go after the owner’s other assets. The law is somewhat unsettled on this point but you should be aware that the liability shield is far from absolute.

For most starting investors using owner-occupier mortgages, #4 above means that using an LLC is off-limits. If you’re just starting out by buying a small property for investment purposes with cash or an investor mortgage, I still don’t think I’d bother. But once you start getting into multiple properties, I’d try and move them into one LLC (if they’re small) or into separate entities (if they’re large).

For larger investors, funds, syndicators, etc., the gold standard is having each property in it’s own LLC (a so-called “single asset entity”).