Term Sheets: Gotta Catch Them All!

There’s a special kind of investor that only cares about one thing, one thing only - Terms. They are not interested in how I can streamline their financing or optimize their current portfolio. All they want is terms and fees, which is perfectly fine if you know what you’re doing. The problem lies in the fact that novice investors don’t know how to navigate this issue. They are so hung up on getting the best rates that they call every hard money and private lender in the name of “due diligence”. Unfortunately, this is only followed by what Igor Ansoff, the father of strategic management, called “paralysis by analysis”. They have all this data but they do not know how to process it or stall and never decide.

The same happens when you have too many term sheets. You get bombarded with rates and fees for difference percentages of ARV (After Repair Value) or LTC (Loan to Cost) with a myriad of terms.

Some clear problems come to mind when making all loan options truly comparable:

• Difference in payment time frames
• Amortizing vs. interest only loans
• Accounting for origination and closing fees
• LTC vs. ARV

Fortunately, this problem can be boiled down to a simple number. Using the concept of present value and dividing the resulting number by the LTV (Loan to Value) offered gives us a true “apples to apples” comparison of each option given.

To illustrate the solution please follow the case study below:

Please note that closing costs are omitted for purposes of illustrating this concept.

Milo, the investor, has found a diamond in the rough in an up and coming neighborhood in Houston, Texas. After reading all the books and information provided in Bigger Pockets he has decided to “Pull the trigger”. The property in question has an ARV of $100K and Milo wants to leverage his cash reserves – Milo picks up the phone and starts dialing different lenders for terms. They all will lend on the ARV but at different rates, LTV and terms.

Lender “A” tells Milo – “We’ll move you forward with 3-year amortizing loan at 8% for 85% LTV and Origination 2.45%”

Lender “B” tells Milo – “We’ll go ahead with an 8-year amortizing loan at 8.75% for 75% LTV and Origination 2.00%”

Lender “C” tells Milo – “We’ll fund you with an interest only 18-month loan at 12.00% for 70% LTV and Origination 4.50%”

Lender “D” tells Milo – “Well sir, we have different options. All our loans are for 12-month interest only for 85% LTV, but rates vary as a function of origination. Therefore, we can present you with loan options with rates between 8% - 12% and origination fees of 1.95% and 3.95%”

After hanging up with lender “D” Milo’s anxiety levels start to increase as he is unsure which lender presented him with the best option. Milo believes he’s got 4 options, but realistically he has 3 for sure (A, B and C) and lender D gave him a range. “Oh brother...” Milo quietly sais to himself.

Luckily, Milo remembered the finance classes he got from Ms. Doris in college and the MS Excel chops he picked up with Mr. Benito’s YouTube video channel.

Milo went on to model each loan option in the following fashion:

Lender A:

Lender B:

Milo knew that option A and B were long term options so he needed a way to differentiate them. What he did was to model out all the cash outflows as interest payments each year – separating them by interest and principal. He proceeded to subtract the principal accumulated from each period from the final principal at payoff and discounted each cashflow by a yearly inflation of 2%. Later he added all these cashflows and added the origination fee. PV + Origination represents the total cash outflow today of each loan options.

Lender C:

Lender D:

Milo realized that lender C and D were short term lenders. In similar fashion, he calculated the value today of each loan.

In other words, he calculated what the TOTAL cost of each loan option would be TODAY.

Great! He thought. “I finally have some hard numbers I can go by. This is such a no brainer Lender C’s option represents the lowest expense for me TODAY – I am calling lender C right now and I am moving forward with her!”

Not so fast eager Milo… Not so fast… Did you forget about the LTV? What would happen if you divided the cost of each loan TODAY by the LTV offered?

To recap: Lender A - 85%, B – 75%, C – 70% and D – 85%.

The figure above shows a deeper (yet simple) layer of analysis. By dividing the total present value plus origination by the LTV offered you get the true cost of each percentage rate offered. This is the result you want to look at when differentiating between loan options. This number shows how much you are paying the lender for each percentage point or LTV while factoring the different origination fees.

From a present value stand point lender C seemed like the right choice, but remember that she was willing to lend Milo less (70% LTV). This made her offer expensive from an LTV stand point. In the other hand, Lender D’s options became attractive because he was willing to let Milo “buy” more money (as a % of LTV) for less.

In conclusion, rates are just one part of the equation. From experience, it is better to pay a premium to get better service from well-funded reputable lenders. Options A, B and D are within $100 of each other so in the grand scheme of things they are not that different. Some lenders are willing to provide you with an extra percentage of the ARV for every deal you close with them. Some other lenders will finance 100% of the rehab or move origination points into the payoff. Doing the analysis above clears up the way for you to make that decision. Once you have calculated $/LTV you can then move on to pick the lender with the features that best suits your investment strategy.

Thank you for your time!

If you’re curious about the mechanics of amortizing a loan or calculating present value, please see the links below:

https://www.thebalance.com/how-amortization-works-...

http://people.stern.nyu.edu/adamodar/pdfiles/cf2E/tools.pdf

Ansoff, H. Igor (1965).Corporate Strategy: an Analytic Approach to Business Policy for Growth and Expansion. New York: McGraw-Hill.

Disclaimer: The views and opinions expressed here are my own and do not necessarily state or reflect those of my employer and its management.