Cross-collateralization

I’d like to dive into the art of cross-collateralization as a real estate acquisition method. Before beginning, I feel there is a necessary preface to this article. Although utilizing equity in other properties to acquire with less out of pocket can certainly be advantageous, it does translate to a more leveraged position, inherently increasing risk. I’d make sure you’re conformable with this in terms of risk appetite. If you’re buying the right way (beneath market), tying up more funds shouldn’t be as risky, given the result is a forced equity position anyhow. Also, just because I’ve seen this accomplished, doesn’t mean every portfolio lender in every community is willing to structure loans this way. Do your due diligence. Let’s proceed with a couple scenarios.

Example) Investor has a seasoned portfolio of, say, 10 single family units. For the sake of numbers, let’s assume all properties are worth $100K. Depending on loan amounts, the investor could theoretically utilize these properties to acquire more units. See below:

Free and clear LOC: If the investor has no debt tied to these properties, then it would be very easy to acquire a line of credit secured against 1, a few, or all of these units. That line could provide liquidity to acquire and renovate properties with cash, and subsequently the purchased unit could be refinanced after the bank’s seasoning period has surpassed to clear the line out. This can be utilized to cycle units, just as a business uses a line of credit for cash conversion.

Free and clear term loan: Let’s assume the investor wants to buy a new unit for $100K. A typical bank would require 20% of cost as a down payment. The investor could offer one of their existing units to also serve as collateral, and based on the value achieve 100% financing. The bank is examining the collateral on a loan to value basis. In this scenario, the purchase price is $100K, and that plus the other unit being offered (valued at $100K), provide a total of $200K in equity. A 100% loan of $100K would equate to a 50% loan to value ($100K/$200K). This achieves 100% financing with one loan.

Equity but not free and clear: Taking the first two scenarios a step further, let’s assume of the ten units the borrower has $500K in aggregate loans. Back to the loan to value term, that represents a 50% LTV ($500K lent/$1MM equity). Some banks will be willing to use equity even if they’ll be in a subordinate (2nd) position, but some won’t want to. If that issue arises, there are a couple options here. Depending on how they’re financed, you could refinance and consolidate all of the debt. Now, if they’re all conventionally financed on fixed thirty year terms that may not be the best practice from a cash flow perspective. In that case, I would say a good option would be to refinance just a couple and access the equity that route. (Honestly, if you have ten conventionally financed they should be cash flowing enough that you shouldn’t need to leverage equity, but that’s a topic for a later date!) Now, if they’re commercially financed then maybe a full refinance of all debt would be beneficial. In that case the best bet is to tie a minimal amount to the term loan, and clear the others. Again we referenced $500K in debt, and knowing banks are generally agreeable to an 80% LTV, that would mean for a full $500K refinance approximately $625K in equity would be necessary. Based on the assumption that each home is worth $100K, that means 7 homes would be needed. That leaves the three remaining homes free and clear, since they’re paid with the refinance. Now, those could theoretically be utilized to add a line of credit.

Newer investor approach: Let’s assume you think each of those strategies is wonderful, yet you only have one rental unit. Leveraging equity is still feasible… not to the extent of an advanced line of credit, but can nonetheless still be applied to add another property. Just apply the same approach. You owe $50K; the property is worth $100K. Bank is willing to lend $80K, which leaves you with $30K ($80K-$50K) in “lendable equity”. Now to determine what type of purchasing power that gives you... $30K/20% = $150K. The bank could finance 100% by taking a 2nd mortgage on your existing property.

The power of leverage can be a wonderful instrument, if used appropriately. Again, first assess your risk appetite. If I’m fully leveraged based on the cost of a new unit, but I know the after repair value is significantly higher, then I’m probably fine with that. Always assess propensity to risk before incurring debt. As always, thank you for reading and feel free to reach out if any questions arise.

Cain