All Forum Posts by: Michael Worley

I can understand the idea of shopping deals. If you feel the deal  you're getting with the bank isn't competitive with the market and/or the bank is taking your relationship for granted then you should address it.

I do think that there are far too many people who 'step over dollars to pick up pennies' though. People who quibble over .25% interest rate or fee only to get into a situation where the new bank has trouble closing the deals on time or with other problems.

Price is just much less important than whether the deal can get done in time and without headache if you're building a real estate investment business.

The other downside to shopping deals each time is that with a banker, you lose future leverage if the deals are seen as transactional. It's a very common discussion in committees for bankers to bend over backwards for 'good customers' and to not give an inch to 'transactional customers'.

I personally think that the first paragraph is good advice, but the second paragraph is bad advice.

As bankers, we want relationships not transactions. Shopping deals and/or re-trading deals means the deal is transactional in nature and the bank will not try hard to make your deals work and the lender won't expend any political capital in the committee meetings on your behalf if you do this.

When dealing with a bank, if they do their own underwriting (portfolio lender) or they have a correspondent bank (they sell their loans to a bigger bank)/GSE (government sponsored entity such as Fannie Mae, Freddie Mac) is the #1 question to ask. It completely changes how the underwriting of the loan is done which is why it's the most critical question to ask.

As an example, if you go to Bank of America or you go to Chase Bank (they both sell loans to Fannie/Freddie) then the underwriting standards will be extremely similar (call it identical for most intents and purposes). If you go to Bank of the Ozarks or to First National Bank (who both use correspondent banks like Bank of America) then the underwriting will be similar.

The final purchaser of the loans will be the final arbiter of how the loan has to be underwritten. Portfolio banks don't sell their loans, therefore they are the final say in how the loans are underwritten.

Once you start talking to a bank, ask the loan officer about what metrics the bank's loan policy looks at. Once you get an idea you can start a spread sheet of portfolio lenders in the area and ask lenders at each one about the metrics.

The key metrics they will be looking at most likely are DSCR (debt service coverage ratio, usually in the 1.2x range or better), LTV/LTC (loan to value or loan to cost, depending on the project), guarantor support, amortization in the 20 year range plus or minus, and maturities in the 5 year range plus or minus.

Just let the conversation go from there. Don't worry about interest rates or fees until you know what the bank's risk appetite is. It doesn't matter if they charge 3% interest if they won't approve anything and conversely, if you have to pay 7% interest but can get the deal done it might still be worth doing.

Worry about pricing last, risk appetite first.

I enjoy reading Bigger Pockets and listening to the podcasts. I’m also a bit of numbers geek naturally so I try to break down things to the basic arithmetic most of the time.

What I have found is that there is an abundance of talk in real estate investing forums or in REI clubs about certain aspects of REI (50% rule, construction discussions, LLC vs. S Corp vs. Individual titling, etc.) but there are also shortages of informed discussions on the big picture of financing the properties.

I look at investing as having 4 major sections that have to be understood to invest effectively.

1. Site selection – broadly speaking which properties to buy (lots of discussion regarding this here and other places) – encompasses property, construction/rehab costs, and the decision points along the way
2. Funding the project – what type of capital stack to use (people love the jargon don’t they!) how and where to source the funding (more on this in a minute)
3. Project Management / Ongoing Operations of the property during the hold period (flip or cash flow, both are included in this section)
4. Exit strategy – even if you plan on holding the property for an extended period, that’s included in the exit strategy section

I think section 1 gets a lot of air time as does section 3. For the scope of this discussion we’ll omit those sections and focus primarily on section 2 with some discussion on section 4.

I’m a banker. I work for a community bank (often referred to here as a portfolio lender). I used to work for a large bank which did not portfolio their loans. What I want to discuss here is a beginning primer on how all banks are not the same.

Banking is a complex industry and it takes years to really understand it, even if you work in banking.

When funding a project there are multiple phases of the projects lifespan. Stages can include but are not limited to acquisition, rehab/construction phase, lease up and stabilization. Each phase has a different type of funding, and each type of funding has different funding sources that prefer to fund that phase.

In the initial acquisition phase of a deal, it could be that you're buying raw land with the intent to develop it. Many banks have no interest in raw land funding (it's very risky to lend money on an asset that provides no revenue). Some banks however will fund law deals at say 60% LTV/LTC. During the next phase which might include construction or rehab of a building/house it's not uncommon to get constructing/temporary financing. After the construction is done, during lease up/stabilization, it's common to get ‘mini-perm' financing which is around 3 years or so on average. After that phase it's common to get permanent financing (longer terms and amortization schedules).

An investor needs to know that all banks are not interested in financing the same stages.

An example would be that a hard money lender might be the best option for the acquisition of land. A portfolio lender is a good option for the construction / mini perm financing stages. A money center bank (think BofA, Chase, Wells) is a good place to go to for permanent financing. Permanent financing is almost always done by a bank that doesn’t portfolio their loans (they aggregate them to Fannie/Freddie, sell them MBS pools, Sell them to mortgage REITS, etc.).

The question often comes up about when to use a portfolio lender or when to seek Fannie/Freddie financing (which in reality just means go to a money center bank/aggregator because you don’t go to Fannie directly for a loan). If an investor knows which phase of the funding project that they are at, it’s a good indication of which type of bank to seek out.

This post is already in the TL;DR category but there is much more to discuss on this topic. The scope of this post is just to begin a discussion about this important aspect of investing.

Also, look into SBA loans. You can get an SBA express loan (for Lines of Credit up to $350,000) or a 7A loan (term loan, but you can get them for working capital, it will be amortizing though).

Joe Rampy is correct. Portfolio lenders will look at those deals all day long.

To me the question really has to do with a couple of separate concepts.

The first being property leverage vs. borrower leverage. A borrower must maintain the proper liquidity and cash flow to service debts, so leverage has to be managed. A property on the other hand, if owned by a properly levered borrower, can be levered to the hilt and still be a great deal.

The next concept that I think bears discussion is this notion of 'don't bank on appreciation' and reference to 2008's property crash. The fact is that 2008 was an anomaly and should be considered as such. If you were explaining a trend that for the last 100 years achieved an average increase of property value of roughly the rate of inflation. When you consider a long term trend, it's absolutely reasonable to expect that trend to continue if the underlying fundamental basis for the trend is sustainable. Real Estate (and all real assets) have a history of approximating the inflation rate, and that's a sustainable trend. So to think say that 'you can't bank on appreciation' of real assets is the unreasonable assumption not the other way around.

Business cycles matter but most of the 'value' of real assets is the fact that with a long enough hold time, they appreciate. The question is then what is the proper leverage of the borrower to allow for a long enough hold time. It's not a question of the leverage on the asset, that's a function of the borrower's capital reserves and the cost of the leverage.

I actually disagree with this statement. Your rate of return with a zero cash down deal is even greater, even if you have a negative cash flow for the property.

Don't confuse a property being over levered vs. a borrower being over levered. Using your example of a $320,000 property with a negative $4000 a year cash flow. If it appreciates 3% a year, you'll have a property worth 370,967 in 5 years. So without any principle reduction at all, and including the $20,000 in carrying costs for the five years, you'll have made $30,000 with 0 cash initially invested. That's a fantastic cash on cash return. Or you could calculate it as having 50,967 in FV on a PV of 0 and a PMT of -4000 with an N of 5 years = 48% rate of return per year. Not exactly a bad deal at all.

In fact the math works out that if given two options of financing:

A) Agency financing at 4% interest, 75% LTV

or

B) Portfolio Lender at 5.5% interest, 80% LTV

With Option A your RoR after 5 years is 21.39% vs. 20.08% for the portfolio financing. The longer you hold the property the better the Agency financing is, but for holding periods 5 years and under it's a wash (with holding periods of 3 years or so better with Portfolio Financing).

The bottom line is that it's better to get the deal going than quibble over the terms, ESPECIALLY if the deal is a value add property for some reason.

Too many investors step over dollars to pick up pennies.

Does CAP rate have to be greater than Financing rate? Of course not. There are plenty of examples where it would make sense to have higher cost of funds than current cap rate.

Examples such as: Value add property with low current cap rate, short term / mini perm financing with expectation of cap rate improvement over the duration of the financing, 'path of progress' real estate where rental growth rates can reasonably be assumed to increase 'x' percentage over the interim of the financing period, financing a development that will be repurposed, low leverage which offsets financing costs, etc

In addition to the reasons why CAP rate can be lower than financing costs, the math also works out that CAP Rate < Interest Rate can still be profitable.

Example: Suppose you don't have the capital to pay cash for a $1,000,000 property. You use leverage to buy a 7% cap rate with 8% financing with 80% LTV. You pay $74,088 per year for that property in Debt Service on a 25 year AM note. Year 1 return on your cash is 2.96% which is better than many alternatives for your cash (no tax benefits are computed, but those are not insignificant). Assuming a 3% annual growth rate in real estate value (again, not withstanding NOI gains due to management quality) you'll have a loan balance of $738,191 after 5 years and an asset value of $1,161,616. So you have $423,425 in equity on an original investment of $200,000. You will have made 5 years of rent payments (assuming all NOI growth goes to funding capital reserves) of a total of approximately $30,000. So total invested $200,000 total return on investment at 5 year mark is 16.48% compounded annual interest.