The guys are back with part two of what to do after you find a syndication deal. Today’s episode follows them discussing the due diligence period. Today we’ll hear all about how to finance these deals, including which loan products to use and how to find a loan guarantor. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.
We’re doing Follow Along Friday, we’ve got Theo Hicks. How are you doing, Theo?
Theo Hicks: I’m doing great, Joe. How are you doing?
Joe Fairless: I’m doing great, and I have a bowl of oatmeal next to me, because we did this a little bit earlier than we usually do, because you’ve got some things going on on your side… So I am going to be talking, and when I’m eating, I will not be talking.
The episode we’re doing today is a continuation from last week. Last week we discussed – you’ve got an apartment community that you’ve identified, you have it under contract, and now here’s the next step… You do due diligence, and we talked about all the different due diligence documents – you took the lead on that, and you talked through different things to consider and what to look for.
This week we’re gonna talk about debt financing, the differences between different types of loans, and then different variables within each of the types of loans. I really wish that this episode aired about four years ago, five years ago, when I knew not a whole lot about apartment syndication… And I’m really glad and grateful that we’re able to have this conversation, so that the Best Ever listeners can learn more about different types of loans… Because I had no clue about this stuff. I had no clue the advantages of a bridge loan versus Fannie Mae/Freddie Mac loan, or vice-versa, the advantages of a Fannie Mae/Freddie Mac versus a bridge loan.
I had no idea the importance of interest-only, I had no idea about loan terms, and buying caps on loans etc., and thankfully, we’re gonna address all that for everyone. This will be incredibly valuable for you if you’re looking to do syndication investing and you want to get a refresher, or perhaps pick up some additional tips on debt financing.
With that being said, how do you wanna approach our call?
Theo Hicks: So the key when you’re deciding on what type of financing to put on your property is a balance between the returns. Because as Joe mentioned, there’s bridge loans, there’s permanent loans, there’s interest-only, there’s different interest rates, different terms of the loans, and for each of those, essentially you’re gonna be paying a different amount in debt service. Obviously, debt service is the expense, and the higher the debt service is, the lower your cashflow is. So that’s the return perspective. But on the risk side, not all loans are the same risk. This will be the main topic of discussion when I’m going through these different types of loans.
Before I go into the actual bridge loan and the permanent loan, I wanted to make another distinction, which is the differences between the two different types of actual debt, and that is the recourse and the non-recourse debt… Because that’s something that’s a pro and a con of the different types of loans.
For recourse debt, that means that the lender can collect what is owned on top of collateral, which is the actual apartment community. So if you have a loan, the property is going in foreclosure, the lender can take the property, and if you own more than that, they can take more from you personally… Whereas non-recourse is when the lender cannot do that, unless certain exceptions are triggered, like growth negligence or frauds of some sort. If that occurs, then they can come after your personal assets. But generally, recourse – they can come after your assets above the collateral; non-recourse – they can’t, unless certain exceptions are triggered.
That’s important, because again, this is just very general. There’s always exceptions to all these rules, but this is overall what you’re gonna see most commonly – there’s two different types of loans, as Joe mentioned: the bridge loan, and then there’s the permanent loan, the Fannie/Freddie type of loan.
The bridge loan is gonna be a shorter term loan, with a potential to extend it. It will be anywhere from 1 to 3 years for the initial loan term, and then you can pay to extend it a year or two years. So it is possible if you have a hold period of five years to have a bridge loan the entire time. Generally, bridge loans are gonna be interest-only, but they’re gonna have a higher interest rate because they are shorter-term.
One of the main reasons why if you wanna use a bridge loan, is because you have the ability (generally) to include the renovation costs. Let’s say for example you’re doing a value-add deal and you need to spend $500,000 on renovations, and if you’ve had to raise that extra $500,000, it’s obviously gonna affect your returns. But if you can include that in the actual financing – all of it in the financing, in some cases – then that reduces the amount of money that you need to bring to the closing table, than you would have if you actually had to pay for it up-front.
Joe Fairless: And with the bridge, if you do not get it pre-funded, but you just have a commitment to fund, and then you borrow after you show that you’ve done some work, then you’re not borrowing at the beginning, you’re not basically paying for money that you’re not using; you only pay interest on money that you’ve actually used. Think of a personal loan, versus a line of credit. Personal loan – you get it from a bank, and immediately, as soon as you sign on that dotted line, you’re paying interest on that, because the lender has loaned you money of X amount… Whereas a line of credit – okay, you sign on the dotted line, but you don’t start paying interest on it until you actually use it, and then when you do pay interest, you only pay interest on what you’re actually using.
Theo Hicks: Yeah, that’s huge. So if that’s the type of loan that you get, then you pay interest on the actual purchase price loan, but you don’t have to pay interest on the money on top of that until you actually use it. So that’s the description of the bridge loan.
The permanent loan is not necessarily the exact opposite, but the permanent loan (or the Fannie/Freddie) is a longer-term loan, so it’s gonna have an actual term of five or ten years…
Joe Fairless: Five, seven, ten…
Theo Hicks: Yeah, five, seven, or ten years, and then it’s gonna be amortized over 20, 25 or 30 years, depending on the type of lender you use. So for the permanent loan there is the potential for interest-only still, so that’s still something that you could possibly do… And you will get lower interest rates on this type of loan.
I forgot to mention this for the bridge loan, so I’ll mention it now – for this Fannie/Freddie loan, generally it’s gonna be that non-recourse, which means that they cannot come after personal assets above the collateral, unless exceptions are triggered… And the bridge loan is typically full recourse, which means that they can’t. That’s something else that’s different between the two.
Joe Fairless: And there are certainly exceptions; all of our bridge loans are non-recourse… All the bridge loans that we have.
Theo Hicks: Exactly. Those are the two descriptions of these… So what are the pros and the cons of each of those? Of course, for the bridge loan you’ve got the pro of the generally interest-only, and the ability to include those renovation costs in the loan, and as Joe mentioned, not having to pay interest on that until you use it. The drawback is that it’s a little riskier.
Let’s say, for example, you’ve got a two-year bridge loan, and your plan is to refinance at the end of that – or sell, I guess, maybe, at the end of those two years… But what if you can’t? What if you can’t raise the rents to the degree you expected? What if there’s unexpected maintenance issues and you need to spend more money? What are you gonna do? Because you have to get a new loan at this point.
Whereas for permanent financing, you’ve got the advantage of the lower interest rate, and you have the advantage of the set it and forget it. So you get the loan, and you’re gonna have it – the same loan – for the entire duration of the hold period, and you don’t have to worry about it. Now, of course, you can refinance if you want to, as long as it’s not a pre-payment penalty, but you don’t have to refinance.
I know [unintelligible [00:09:00].05] to this blog post… If you’re listening to it on Facebook, it was yesterday; if you listen to it on Friday, two days ago… About the three immutable laws of real estate investing. One of those three laws was Don’t get forced to sell. I guess a hybrid of that is don’t get forced to refinance, because in this case, if you have a bridge loan that ends and your projections are off, and you don’t have enough equity to refinance – because again, remember, you’re paying interest-only – then that’s a risk, where you don’t have that same risk for the permanent loan.
Joe Fairless: Yeah, in that case there’s some serious flaws in underwriting and management if you get to the end of your loan and you’re not able to do a refinance or a supplemental loan, or something… Because you should never be at the end of the loan before you wait to do anything, number one, and number two, if you do get a bridge loan, the whole reason why you’re getting a bridge loan is you want to maximize the returns prior to either selling or putting long-term financing on it.
Think of what we’re calling this loan, right? And point A is where you’re at now, point B is where stabilization is, where you wanna go, and so that bridge loan takes you there, so therefore you do a bridge loan when you have a property that is either severely distressed, or kind of distressed, or even has a major value-add component to it that you need to do, and you’re able to go in and add that value, and then exit out of it after you add that value, and then put more longer-term financing on it.
Compare that to if you initially put Fannie Mae/Freddie Mac financing on it – otherwise known as agency debt – then those pre-payment penalties are higher and you probably will be locked out when you want to refinance shortly after you get the loan. So you don’t have that flexibility; bridge loans give you more flexibility, but they are riskier, because you don’t have as much equity in the deal initially.
Now, certainly, if your business plan works out, then you’re building equity along the way, because I assume you are adding value to the property through renovations or expense optimization, or something else.
Theo Hicks: Yeah, absolutely. Based off of your company’s experience buying your deals, what percentage of those were the bridge loan to permanent financing, as opposed to what percentage of those were just straight up permanent financing from the get-go? And the renovations, I guess, coming out of pocket, or you raising the money for them.
Joe Fairless: It’s about 50/50, bridge loans to permanent financing right out of the gate. And with the permanent financing, what we do is [unintelligible [00:11:53].05] after we do the value add. That acts as – for all intents and purposes – a refinance if you had a bridge loan, because with the supplemental loan then you’re able to get money back out by putting more debt on the property, because you have a higher valuation, because you’ve added the value. So the question might be “Well, why don’t you just always do agency debt, and then do a supplemental, versus just a bridge loan initially?” and the answer is, well, the property might not qualify for an agency loan; or if it does, then you might need more equity out of pocket in order to qualify, and then the returns don’t work.
So there’s a balancing act on what you look at in terms of risk and reward, and then how do you mitigate the risk, depending on whichever direction you take.
Theo Hicks: That makes sense. Because I was wondering, why wouldn’t you just always do a bridge loan? You might as well, but the qualifying for the actual permit of financing is the big one, especially if you’re buying a super distressed property that’s 60% occupied; they’re not gonna give you a loan on that property, so you’re gonna have to do something else.
Joe Fairless: And we don’t buy 60% occupied properties, but we might buy an 85% occupied property, or 90% even, and that still might not be enough to qualify for a loan proceeds for Fannie Mae/Freddie Mac; we want to make the returns healthy enough, but also mitigate the risk, therefore we might go bridge.
Then also something to consider is even though interest rates, generally speaking, are lower for Fannie Mae/Freddie Mac, it’s possible to find very comparable interest rates from some bridge lenders if you have a good relationship with them, especially with interest rates increasing, where bridge lenders – you might find that they’ll be very close to the interest rate that you’ll get. Then it almost becomes a no-brainer to do a bridge loan, get that refinance after year two, and then put some longer-term debt on it, or figure out what you wanna do… Sell it after year two — and I say year two because I’m assuming that’s when the business plan will be fully executed with the value-add. And I say that because primarily, at least with our company, it’s interior renovations, and we do it on unit turns, and everyone, for the most part, is on a 12-month lease, so that allows us to cycle through all the renovations, as well as have some period of time for stabilization afterwards.
Theo Hicks: Exactly. Alright, so the second aspect to this conversation about debt financing has to do with the loan guarantor, or the person who’s actually signing on the loan… Because if I right now find a 200-unit property in Tampa Bay, Florida and I go to a lender and tell him I have this deal, and it’s just me, they’re not gonna give me a loan, because there are certain requirements that that person who’s actually signing on that loan needs to have.
Now, obviously, when they’re doing the underwriting and qualifying the actual deal itself, they’re looking at the property and how it’s operating, but they still take the person into account that’s signing on the loan.
So the qualification the person needs – either you or someone else – in order to qualify for the loan [unintelligible [00:15:11].18] have a net worth that is equal to the mortgage amount. So if I am getting a million dollar loan, I need to have a million dollar net worth.
Joe Fairless: Post closing the deal, right?
Theo Hicks: Yeah, not including the deal. And then you also need to have liquidity equal to nine months of debt service. So that means you need to have a net worth of the loan, and you need to have liquidity of whatever nine months of the payments you’re giving to the lender. Now, that actually is money-wise… But they’re also gonna want someone who has experience actually doing what you’re going to do, so they’re gonna qualify the individual, who is either that same person or someone else – they need to have experience in apartment syndications.
Joe, do you know – do they look at you and it’s kind of like a case-by-case basis, or is it specifically you need to have completed this many deals, or you needed to control this much? Or is it just “You have to have done a similar deal in the past”?
Joe Fairless: It depends on who “they” is. Basically, it depends on the lender.
Theo Hicks: Okay.
Joe Fairless: I’ve found that if you have been successfully doing what you’re about to do, then that will qualify you. If you don’t, then you need someone on your team who has that experience.
Theo Hicks: Awesome. And if you’re listening to this in 20 years from now, in 2030, these numbers might change; in nine months they might change, so…
Joe Fairless: I think the percentages just — you’re right, it depends on the lender what the liquidity and net worth is that they require, but 10%, 100%. Just think about that. 100% of net worth equal to loan balance, and 10% liquidity of the loan after closing… Not including the down payment. If that’s the down payment, then after you close, you’ve got 10% liquidity of whatever that loan balance is. You can also do the nine month thing… And again, these are just general rules of thumb. Your lender is gonna be different; it might be plus or minus on either side of those.
Theo Hicks: Exactly. So ideally, either you or the person you’re gonna bring on as a loan guarantor covers both of these, because then you only have to pay one person, as opposed to two different people, or compensate two different people.
In regards to the actual compensation, of course, it depends on what type of loan it is. It specifically depends on if it’s a recourse or a non-recourse. If it’s recourse, the person signing the loan is exposed to more risk, so you’re going to want to compensate them more. But the general range is 0.5% to 1% of the loan balance at closing. That’s usually what the compensation is. The person who meets these requirements will sign on the loan, and at close they will get a fee of, let’s say, 1% for signing on the loan.
Now, I know we’ve done shows specifically on the loan guarantor in the past, and I know you’ve talked about how this is something that should be very attractive to people, because all they’re doing is — not “all they’re doing is signing on the loan”, but they’re signing on the loan and they’re getting 1% of the purchase price, as long as obviously all of the risks are addressed… You’ve qualified the actual syndicator, and the deal, and the team. What are your thoughts on that, Joe?
Joe Fairless: Yeah, you’ve gotta know the person really well to sign on their loan. I would be less concerned about gross negligence, I’d be more concerned about fraud… Think about the risk vs. reward though from the loan guarantor’s standpoint. They’re risking a million dollar loan balance, so a million bucks, 1%… That’s $10,000, to risk a million dollars. If I was in Vegas, I think I’d risk 10k to win a million, and I don’t think I’d risk a million dollars to win 10k. So all the risk should be taken away from it as much as possible.
I don’t know if it’s necessarily a no-brainer, and I don’t think you used those words, but I don’t think it’s a no-brainer. I put myself in that position, and I am in that position – if people were to reach out to me, “Hey, Joe, I want you to sign on a loan, non-recourse. I’ll give you 1% at closing”, I wouldn’t do it unless I had a relationship with them. Because what could happen is one deal goes south, and then you get blacklisted on Fannie Mae/Freddie Mac, and then you’re not able to do loans for any of your deals. That’s a big ol’ risk.
Theo Hicks: Yeah, that’s a good disclaimer. So that kind of concludes the part two… We went over the different types of debt – the recourse vs. non-recourse; we went over the two different types of loans – the bridge loan and the Fannie/Freddie permanent loan, and we kind of went over the pros and cons of each, and when you wanna use them, and Joe mentioned now his business does it 50/50… And when they go the permanent loan route, they will usually get a supplemental loan after the fact.
Then we also went through the loan guarantor, which is the person who’s signing on the loan, and the qualifications they must meet in order to be qualified by the lender. Then we’ve kind of had a conversation about how if it’s not you, then the person who does it needs to know you really well because of the risk/reward we’ve discussed. Is there anything else on the lending that you wanna talk about, Joe, before I move on?
Joe Fairless: Nope.
Theo Hicks: Okay. Really quickly before we wrap up, we had a question submitted from a listener last week. His name is Matt, and he said:
“Hey, Joe. My name is Matt, I’m from Texas, and I wanted to see what you thought about Des Moines, Iowa as a market, with the large involvement of the insurance industry making it especially vulnerable during a recession.”
Joe Fairless: Will you repeat the question?
Theo Hicks: “…with the large involvement of the insurance industry making it especially vulnerable during a recession. I’m curious to hear your thoughts on it. Thanks.”
Joe Fairless: Well, it depends on what that insurance company is heavily invested in and how they are diversified from a business standpoint. And ultimately, the short answer is I don’t know. This person’s asking about a particular city?
Theo Hicks: Yeah, Des Moines.
Joe Fairless: Des Moines, okay. I don’t think we pronounce the “s” with Des Moines.
Theo Hicks: Probably not…
Joe Fairless: You pronounced the “s”, and I don’t think you’re supposed to pronounce that “s”. I’m not 100% sure. I would look at all the industries in that city, and I would determine how much of that is the insurance industry, and then if it’s more than 25%, then I certainly would dig deeper and understand more about those companies, and see how they did in 2008, and how they have done historically over the last 20, 30, 40 years. I imagine they’ve been around a while, that’s my assumption… It might be incorrect, but that’s my assumption. Because some insurance companies thrived during 2008, and some didn’t do well, depending on how heavily they were invested in certain types of loans that went downward in 2008. So that’s what I would do.
Theo Hicks: Yeah, so that’s basically the job diversity factor in the market, and it matters if you want to have a strategy for the market as a whole; you can go to a blog we have on that, the ultimate guide to selecting a target market. We go through all the different factors that we look at when we’re evaluating a market.
Joe Fairless: And that’s TheBestEverBlog.com, we have a category called…
Theo Hicks: Market Evaluation.
Joe Fairless: Market Evaluation. Pretty intuitive.
Theo Hicks: Yeah. Great. Well, thanks for that question, Matt. Just to wrap up, make sure you guys join the Best Ever Community on Facebook…
Joe Fairless: And girls.
Theo Hicks: …BestEverCommunity.com, for your opportunity to be included in the weekly blog post we create. This week’s question, which we posted yesterday and we’re seeing great engagement on is “Which is more important for success as a real estate investor – hustle or knowledge?”
Joe Fairless: What do you say?
Theo Hicks: This is a tough question, because it’s one of those things where you need both. If you’re the smartest guy in the world but you’re just super lazy, it’s not really gonna matter. But if you’ve got a lot of hustle… I would probably say hustle, from personal experience. It’s kind of how I got started; I didn’t know anything. If I would have waited on the knowledge, then I probably wouldn’t have ever gotten started, just based on my personality. So for me, it’s hustle, for sure.
Joe Fairless: Yeah, I think it’s 100% hustle. Knowledge, you’ve gotta apply it. Hustle, you’re applying it, and you’re smart enough to know that you should hustle, therefore that leads me to believe as you hustle, you’ll continue to learn from what you’re doing… And it’s harder to teach hustle, than to teach knowledge. 100% hustle.
Theo Hicks: Yeah. Alright, so make sure you guys check that out and get involved in the conversation. I think we have over 20 or 30 comments on that so far.
Joe Fairless: Well, whoever said knowledge is wrong. [laughs]
Theo Hicks: I quickly breezed through it and it was 50/50, so…
Joe Fairless: [laughs] Well, 50% of the people are wrong. It’s hustle.
Theo Hicks: We’ll make sure that’s in the blog post. Alright, guys, so before we end, make sure you guys go on iTunes to the podcast, and subscribe, and leave a review. It really helps us out when we get the feedback.
Joe Fairless: We’ve got a good one today, or we’ve got someone else poking us?
Theo Hicks: No pokes. We’ve only had one poke in our history of the podcast, and you’ve resolved it, as you said last week.
Joe Fairless: Oh, look, this is a silent keyboard that I’m holding up. It types silently, so…
Theo Hicks: Let’s hear it…
Joe Fairless: Here, I’m typing. Can you hear it?
Theo Hicks: No.
Joe Fairless: That’s because it’s silent, so from now on… I’m about 25 days out, so the interviews starting about 25 days that you hear, you will not hear keys. I believe the listener’s name was Eric – was that Eric last week?
Theo Hicks: I think so.
Joe Fairless: I think it was Eric, yeah. So Eric, and everyone else, we’ve got a silent keyboard.
Theo Hicks: Perfect. Well, this week we’re back to a great review, five stars, titled “A great podcast for real estate investors”, from KK3377. They said:
“Joe does a great job doing podcasts for real estate investors of all levels. The Best Ever Podcast gives valuable knowledge to the real estate investors of all levels.” I guess they said the same thing twice, so yeah, advice for all different experience levels, which is one of my favorite parts about the podcast. Anyone can listen to it and get something.
Joe Fairless: Yeah, me too. Because when I interview someone who’s just starting out, I get inspired; I perhaps don’t learn much, but I get inspired, and it reinforces inspiration. That’s just as valuable as knowledge, and in some cases it could be more valuable. People who are experienced – then I always learn something, and that’s valuable, too. Great.
Well, thank you, everyone, thank you Theo; I enjoyed hanging out and talking about debt financing. Not the sexiest topic, but a very important one. Best Ever listeners, I’m really grateful that we spent some time with you and you spent some time with us, so thanks for listening and we’ll talk to you tomorrow.