Another week, another syndication school series. This week, Theo is discussing financing for your apartment syndication deals. He’ll be covering all the different options, recourse vs. non recourse, and discussing a loan guarantor. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.
As you already know, each week we air two podcast episodes that are typically a part of a larger series that’s focused on a specific aspect of the apartment syndication investment strategy. For the majority of these series we will be offering some sort of document, spreadsheet — essentially a resource for you to download and use for free. All these free documents, as well as all of the Syndication School series can be found at SyndicationSchool.com.
This episode is going to be part one of a new series entitled “How to secure financing for an apartment deal.” In this episode we’re going to focus on more of the educational background of apartment financing, just to kind of give you an idea of the different types of debt that are available, the different types of financing that are available, and then we’re also going to talk about the loan guarantor as well.
In part two, tomorrow’s episode, we’re going to actually go over some of the most common, popular actual loan programs that apartment syndicators will pursue. Then later on in the series, next week, we’re going to go over how you can determine what is going to be the ideal loan for you, based off of your deal, your background, your business plan, and things like that. I want to set the foundation first, and do an overview of all the different types of debt that you might come across, so that you have a basic understanding of what’s available to you.
At this point in the process you should have already completed the majority of the steps. You should have your apartment syndication education down, you should have your team, and you should have already talked to a mortgage broker, at this point. If you remember when we discussed creating your team, one of the team members — again, they’re not gonna be on your payroll, but one of the people that you’re going to need to work with is a mortgage broker or a lender.
Now, we had a conversation about that, about finding a mortgage broker — I mostly focus on how to find them and what types of things that they’re going to ask you, and how you can respond to those questions in order to win them over… But I didn’t necessarily go into the actual types of debt.
Usually, when you’re initially having that conversation, a good question to ask would be what types of loan programs they specialize in. For example, some mortgage brokers might focus only on agency debt, while others might include agency debt, but they specialize in renovation type loans, or rehab type loans. Or maybe find someone who specializes in HUD loans, or loans from insurance companies.
So that’s definitely gonna be a question that you’re gonna ask, and by the end of the series you’ll know why… Because different loan programs are ideal for different business plans. If your business plan is to buy highly distressed apartments, renovate them and increase the value that way, then you’re going to want a certain type of loan that probably includes some of the renovation costs, so that you don’t have to raise all that extra capital, and that’ll eat into your cash-on-cash return.
So if you are working with a mortgage broker and you decide to do the highly-distressed business plan, but you didn’t ask about the types of loan programs they offered, and when you finally find a deal and send it to them, they say “Oh, we only do agency debt, so here’s the long-terms I can give you for that…, but you’re gonna have to raise 50% of the project costs, because we only finance the purchase price and not the actual renovations.” Or they might not be able to give you a loan at all, because for agency debt the property needs to meet certain requirements.
There’s a lot that goes into it, so let’s just jump right into the first part that I wanted to discuss, which is going to be the two different types of debt. That’s the word that I’m using, but essentially it’s going to be the recourse debt and the non-recourse debt.
According to the IRS, with recourse debt, the borrower is personally liable, while all other debt is considered non-recourse. In other words, if you are securing a recourse loan, then the lender is allowed to collect what is owed for that debt even after they’ve taken the collateral. In this case, that’d be the apartment building.
Let’s say you owe the bank 5 million dollars, but the property is only worth three million dollars, so they foreclose on you, they take the property, they get the three million, and you still owe them two million dollars. If it’s a recourse loan, then they’re able to actually come after you personally for that two million dollars. So they technically have the right to garnish your wages, or to levy accounts in order to collect what is owed to them.
On the other hand, there is the non-recourse debt, and that means that the lender cannot pursue anything that the actual collateral. In the example if you owe five million dollars and the property is worth three million dollars, then they can take that property from you but they can’t come after you for the two million dollars. The only exception to that is what are called carve-outs. The common term is “bad boy carve-outs”, and that means that if one of these carve-outs are triggered, then they are allowed to collect and pursue what is owed to them above and beyond the collateral.
The two most common carve-outs are going to be gross negligence or fraud. So if you are unable to pay them the full amount on a non-recourse loan, and the reasoning is because of gross negligence on your part or fraud on your part, or your business partner’s, then the lender is able to go after that extra (in our example) two million dollars.
Obviously, after learning about those two, one could easily come to the conclusion that non-recourse debt is going to be preferable to recourse debt. Then on the other hand these lenders might prefer the other way around; they might actually prefer the recourse debt, because they can always collect what is owed to them… But there are also — not necessarily drawbacks, but there’s also extra things that come with the non-recourse debt.
For example, you might have a higher interest rate for a non-recourse loan compared to the same recourse loan. Something like this could be more relevant to people that are just starting out – you might not be able to actually qualify for the non-recourse. You’ll take a look at some loans, and they will say “Non-recourse available.” That doesn’t mean that the loan is going to automatically be non-recourse; they’re going to take a look at you, your background, your team, your financial history, your credit history, and determine if they are willing to give you that non-recourse loan versus the recourse loan. Now, that is where the loan guarantor comes in handy.
Before we move on to the next section of this episode, which is to talk about the main two categories of the actual financing, I wanted to quickly talk about the loan guarantor. Whenever you’re securing a loan for a multifamily deal, someone is going to have to guarantee that loan. That can be a person, that can be an LLC, but someone is gonna have to actually sign on the loan and guarantee that loan… And this person is going to be referred to as the loan guarantor. That’s what I call them, or what we call them, but sometimes they might be referred to as a sponsor or a key principal. These words are kind of interchangeables. A sponsor kind of covers the entire GP sometimes… But typically if you’re a loan guarantor or key principle, or the person essentially guaranteeing the loan.
Again, if you’re first starting out, you’re likely not going to meet the lender requirements to qualify for the loan… Whether it be qualifying for the loan in general, or qualifying for the non-recourse type of loan. Obviously, one option is to either find a limit you do qualify for, or just accept that recourse… But the third option is to find a high net worth individual if you personally can’t qualify and your partner can’t qualify; find a high net worth individual to become that loan guarantor, sign on the loan, and once they do that, then you will actually qualify for the loan, or qualify for that non-recourse loan.
I’ve already gone over the differences between those two, recourse and non-recourse, but the loan guarantor – the characteristics of this person – they should have some experience in multifamily real estate; even better, they should have previous experience with the specific type of deal and business plan you’re planning on implementing. So if you plan on doing the value-add business plan, then ideally the loan guarantor is someone who has executed value-add business plans… And they’re also going to have to have some financial requirements. So there’s experience requirements, and then financial requirements that you’ll need in order to qualify for the loan.
Again, ideally, if you don’t have either one of these, you’ll wanna find one person that can cover both of these… But there’s no reason why you can’t find one person who’s really experienced, but can’t help you qualify for the loan on the financial end, and then have someone that doesn’t have experience, but does have the bank statement and net worth to support the lender requirements.
Now, these financial requirements are typically going to be liquidity, net worth and credit requirements, but they’re gonna vary from deal to deal, from lender to lender… But there are some general requirements to keep in mind, again, when you’re searching for this loan guarantor. These are the requirements set forth by Freddie Mac, who’s one of the agency lenders.
If you’re pursuing a loan from Freddie Mac, then you or someone is going to have to have a minimum net worth that is equal to the mortgage amount. If you’re buying a property for a million dollars and it’s an 80% LTV loan, which means that you’re getting a loan of $800,000, then you’re gonna need someone (or a combination of people) that has a total net worth of $800,000. And also a liquidity requirement; for Freddie Mac, this is going to be a minimum of liquidity equal to nine months of debt service. If your mortgage payment is $10,000 a month, then the person is gonna have to have liquidity of $90,000 to equal that nine months of debt service.
Then they also have a credit score requirement. For the credit score it’s gong to be a FICO score of 650 or better with at least two of the national credit bureaus, or an average FICO score of 650 or better with all three of the national credit bureaus.
And then lastly, this person is gonna have to be a U.S. citizen.
Again, as I mentioned, this can be one person, this can be multiple people, but together you’re gonna have to have people on the GP that are signing on the loan that meet the net worth, meet the liquidity, meet that citizenship, meet that credit and meet that experience requirement.
The financial requirements are more specific, the experience once are a little bit more vague, and you’re gonna have to essentially explain to the lender or the mortgage broker your experience and the other loan guarantors’ experience, and they’ll tell you “Okay, you qualify” or “Okay, you don’t qualify. You need more experience.”
But generally, from my understanding, they want someone signing the loan that has previous experience with a similar size deal, following a similar business plan.
Now, of course, if you’re going to ask someone to sign on the loan for you, you’re going to have to compensate them in some way. Like most compensations, it’s gonna vary based on the loan type, the deal, your relationship with this person. But in general, in terms of the recourse loan – that’s the one that they are personally guaranteeing, and if for some reason you owe more than the collateral, then they can come after that person for that additional money. Since that’s going to be riskier relative to the non-recourse loan, then you’re gonna have to compensate the loan guarantor more if you’re obtaining a recourse loan, compared to a non-recourse loan.
Now, the two main ways you’re gonna compensate this loan guarantor – or the two main ways you CAN compensate them – is going to be either an annual fee and/or a percentage of the general partnership.
For the annual fee, if it’s a non-recourse loan – and again, these are general numbers… For a non-recourse loan, a fee of 0.25% that’s paid out annually could be acceptable. Or it could be more of an upfront fee, where they get 1% of the loan at closing. Or they can receive a piece of equity. They could get 15% of the general partnership for signing on the loan.
Now, again, if it’s non-recourse, maybe 10% of the equity. But if it’s recourse, then you might have to give up 30% of the equity. It’s flexible, it’s negotiable; it really depends on, again, the variables like who your team is, your relationship with this person, the business plan, the loan type, and everything like that.
Now, how you actually find this individual – again, it’s really going to vary. If you’re gonna go the route of having one loan guarantor, then you’re likely going to need to find an apartment syndicator who has been doing this for a while, that meets that experience requirement, obviously, but also meets the liquidity and net worth requirements. So that’s one option.
Another option is to have a combination of those two things. Maybe you personally have done some deals before in the past, or you’ve got a business partner who has done some deals in the past, but together you’re maybe trying to do a really big deal together, and your liquidity and net worths aren’t enough; then you can maybe have one of your passive investors, or a family or friend who’s passively-investing in your deal be the loan guarantor.
Essentially, you need to find someone who a) has the experience, b) has the liquidity, and c) has that net worth. Again, either a combination of people, or one specific individual.
Now that we’ve talked about the loan guarantor, the last thing I wanted to talk about briefly were the two different types of actual financing. What I mean – these are two main categories of loans that you’re going to be able to secure when you’re looking at apartments, and that is going to be the permanent agency loans and the bridge loan. A permanent agency loan is going to be a loan that is secured from either Fannie Mae or Freddie Mac. This is gonna be anything that’s a longer or a less expensive, more expensive, relative to the other category, which is the bridge loan. These agency loans are gonna be longer-term, typically; they could be anywhere from 5 to 30 years. They’re going to be amortized over 20-25 years. You’re gonna see a loan-to-value anywhere between 70%-75%, up to 85%. Generally, these are going to be non-recourse types of debt, and you’re not going to be able, most likely, to include — if you’re doing a heavy renovation, you’re not gonna be able to include all those renovation costs in the actual loan.
And there are also going to be lower interest rates for agency loans. You might be able to get a few years of interest-only, really depending on your experience level… And overall, these are gonna be your set-it-and-forget-it types of loans. So you secure it upfront, it’s got a loan term that is longer than your projected hold period… Let’s say you get a ten-year loan and your business plan is only five years – you secure the loan, you pay it every month, and that’s really it. Maybe you might get a supplemental loan at some point, if you are doing some light renovations and are including any of those in the actual loan, but generally, these are gonna be your set-it-and-forget-it types of loans.
On the other hand, the category of the bridge loans… A bridge loan is going to be a shorter-term loan, that a borrower is going to usually use until they’re able to secure long-term financing on the property, or after they sell the property. The most common time a bridge loan is used is when someone is going to be repositioning an apartment deal, like following the value-add or the distressed.
Typically, what will happen is the syndicator will get a bridge loan – let’s say that’s three years – and that bridge loan is going to be interest-only for that entire three-year period. Maybe they buy a few extensions, just in case the stabilization period takes longer, or something happens in the market and they wanna make sure that they’re still able to have debt on the property, at least till the very end of their business plan. And they are going to include some or all the renovations in that loan.
For the agency loan, the loan amount is based on the loan-to-value (LTV), whereas for a bridge loan it’s going to be based on the LTC, which is the loan-to-cost. Loan-to-cost includes a purchase price and the renovation costs. Those two together is what the lender is gonna base the loan off of.
For example, if the purchase price is gonna be $800,000 and you are spending $200,000 in renovations, just to make the numbers simple… Well, let’s say the purchase price is 8 million dollars, and then the renovations are two million dollars. For the bridge loan, if you get an 80% loan-to-cost, then they’re going to give you 80% of that total project cost. So 80% of the 8 million, plus the 2 million. The total is of 10 million dollars, so they’ll loan you 8 million dollars, and you need to bring the 2 million dollars down.
Now, if you look at it from an agency loan perspective, the exact same deal, if the purchase price is 8 million dollars and the renovations are 2 million dollars, and you plan on getting an agency loan at 80% LTV, then they’re gonna loan you 6.5 million dollars of the 8 million… So whatever 80% of 8 million dollars is, is what they’re gonna loan, and you’ve gotta make up the difference, plus you’re gonna raise the additional 2 million dollars to cover all the renovation costs. I think that comes up to 3-4 million dollars capital raise for the agency loan, as opposed to getting a bridge loan where you only have to raise 2 million dollars.
Now, bridge loans are also going to be non-recourse to the borrower… But again, you have to meet those requirements, and it really depends. It could be recourse, it could be non-recourse. It really depends on the lender, and it depends on you the borrower.
Another advantage of the bridge loan is going to be the interest-only period. You’re likely going to be paying interest-only the entire length of that loan… So that monthly debt service is going to be a little bit lower, which means that obviously you are going to be able to have a higher cashflow, and you will be able to distribute money to your investors while you’re repositioning the property.
And the disadvantages are kind of obvious. One, it’s going to be a riskier loan, since they are shorter-term in nature. If you get a bridge loan that, with all the extensions, is only five years, and you end up having to hold on to the property for seven years, then you’re gonna be forced to refinance at some point… Whereas that permanent loan is kind of a set-it-and-forget-it.
So those are the two main categories of loans. A bridge loan, which are shorter-term in nature, and are better for repositioning projects. And the permanent debt, which is going to be longer-term in nature, and is more of a set-it-and-forget-it loan, where you’re not doing very heavy renovations.
Now, if that was confusing, all of this will make sense in tomorrow’s episode, because I’m actually going to go over the specific types of loans that are most common. That’s gonna be those agency loans, HUD loans, and then a few other loans that are available for you to secure from a lender.
So that’s gonna be it for this episode. To listen to the other Syndication School series about the how-to’s of apartment syndications and to download those free documents, please visit SyndicationSchool.com.
Thank you for listening, and I will talk to you tomorrow.