We’ve heard Theo explain in great detail all the different loan options we have as apartment syndicators. How do you decide which is best for you? Luckily, Theo is going to cover that today so get your pen and paper ready to take notes! If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
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 know, each week we air two podcast episodes, every Wednesday and Thursday, that are a part of a larger podcast series that’s focused on a specific aspect of the apartment syndication strategy. For the majority of these series we offer a document, spreadsheet, some sort of resource for you to download for free, that accompanies that podcast series. All of these documents, as well as past and future Syndication School series can be found at syndicationschool.com.
This episode is going to wrap up a four-part series that is entitled “How to secure financing for an apartment syndicated deal.” If you haven’t so already, I recommend listening to parts one through three. In part one we talked about the two different types of debt, which are recourse and non-recourse. We had a conversation about how to approach qualifying for the loan as a loan guarantor, either as yourself or finding someone else, and if you’re finding someone else, how to compensate that person/people. Then we also introduced the two main categories of financing, which are the bridge loans and the permanent loans.
In parts two and three we went over the top most popular/most common loan programs that apartment syndicators secure for their apartment deals. In part two we discussed the Fannie Mae and Freddie Mac loan program, so we discussed the agency programs. Then in part three we discussed the remaining top loan programs, which were the HUD, the CMBS, the traditional bank and the life insurance companies. Then we also had a discussion on how to approach assumable loans, as well as how to approach supplemental loans.
Now, I wanted to begin this episode by finishing off the last episode, which is to talk about what documents you need to bring to the lender in order to begin the process of qualifying and securing that loan. Then we’re gonna conclude with walking you through the thought process of selecting the ideal loan for you.
Really quickly – the things that you need to provide to the lender to initiate the process of securing that loan… Number one is your biography. Taking a step back, some of these things you might have already sent to the mortgage broker or the lender that you’re working with prior to finding a deal. So if you remember back in an earlier Syndication School series we talked about putting your team together, and one of those team members is going to be a mortgage broker or a lender… So you should already have a list of potential mortgage brokers to reach out to, that should already know who you are, that should already know what you’re trying to do, but now you actually have a deal, so the information you need to provide to them needs to be more specific.
So if you haven’t done so already, they’re gonna need a biography, they’re gonna want to know about you and your team members, and the information they wanna know about you and your team members needs to be relevant to the deal and the business plan. I’ll talk about that here in a second.
Next you’re gonna need to send them your personal tax returns. Pretty simple. Then you’re gonna need to provide them with a personal financial statement for each loan guarantor. Anyone who’s signing on the loan. If it’s just you, then you send them your personal financial statement. If it is you and someone else, then you’re gonna need to get your hands on their personal financial statements as well.
Typically, the mortgage broker should send you a template to fill out, maybe the Excel spreadsheet to fill out with all the information, prior to you finding a deal, just so they can qualify you preliminarily for a loan amount… But at this point, they’re gonna want actual documentation and actual evidence to support the information you already provided. Obviously, if you didn’t provide the information already, then this is when you do so.
They’re also gonna request the financials for the subject property. Typically the T-12 and a current rent roll. Then they’re gonna want a breakdown of your budget. This might mean they just want you to send them your cashflow calculator, which probably is not going to happen because all cashflow calculators are different… But they’re going to want to see your hold period projections; if it’s a five-year hold period, they’re gonna want to see the proforma for that, so an itemized list of the incomes and the expenses, and then the NOI at the end.
They’re also gonna want to have a list of what you plan on doing to the property after acquiring it, as well as the costs. That’s going to be your cap ex budget. A list of the interior upgrades, the estimated costs, a list of the exterior upgrades and the estimated costs, and then any contingency budgets that you’re accounting for, and anything else that you plan on raising capital for.
Then lastly, they’re gonna want to know what your business plan is. This can be a formal business plan, or you can just describe to them “Hey, I plan on buying this property, I plan on investing a million dollars into the interiors, and based on these rental costs we’ll be able to demand a premium of $150. I plan on stabilizing the property at a 95% occupancy within 24 months, and I plan on selling after 5 years at this cap rate, and here’s how much money I expect to make at sale.”
So depending on what your business plan is – let’s go back to the biography here for a second. If your business plan is to add value and then sell, then in your biography you’re going to want to provide evidence that supports your ability to execute that business plan. So if you have experience with that specific business plan, outline the experience; maybe even provide some case studies. If you don’t, that’s when you need to rely on the experience of your team members. If you have a consultant or a mentor, if you have a partner, if you have a property management company, that’s when you want to talk about them.
So that’s generally what you’re gonna need to give the lender. They might have additional items that they request, so make sure — and I believe I mentioned this during the Syndication School series where I talked about types of questions to ask the mortgage broker and the questions they’re going to ask you… Ask them what information they need from you in order to qualify you for a loan once you actually have a deal under contract.
Now, to the conclusion of this series is — alright, so you gave me all the information about all the different loan types, the pros and cons of each, what I need to bring to the lender… But how do I know what loan to get? Which loan program is going to be a deal for you. Of course, like the majority of answers to these general questions, like “What’s the best thing for me to do?”, is it really depends.
Obviously, if you remember from parts 3 and 4 when I went through the different loan programs, they all have different requirements, they all have different terms… So you’re gonna want to go through a list of questions, so to speak, to ask yourself; based on your responses to those questions, you will eventually land on the ideal loan. We’re gonna go through that right now.
First, I wanted to mention something which is an issue that I ran into, and I’m sure others have run into as well… If you talk to a lender and they say “Hey, these are the types of deals I’m looking for. Can you give me some estimated loan terms for this value-add deal at this size?” They might say “It’ll be between 70% and 80% LTV. The interest rates right now are around 5.5%, so they’ll be somewhere around there… The loan term can be anywhere between 5 and 12 years.”
Now, when you’re underwriting a deal, before you actually have the deal under contract and you’re getting specifics from the lender, how do you determine what your debt service is going to be? I spoke with a lender and he gave me a very interesting solution to this problem. Essentially, what you wanna do – and this is after you fill out your cashflow calculator, following the steps that I outlined in a previous Syndication School episode… And if you don’t know what your interest rate is going to be, you don’t know what the LTV is going to be, there is kind of a workaround to calculate the debt service. There’s a term “debt service coverage ratio” (DCSR), which is a ratio that is a measure of the cashflow available to pay the debt obligations. This ratio is calculated by dividing the net operating income by the total debt service.
As we learned in algebra, or maybe it was calculus, if you have a formula with three variables, as long as you know two of the variables, you can calculate the third variable. At this point in the underwriting process you have your net operating income, so you have the current net operating income based on the owner’s financials, and then you also have a debt service coverage ratio. Now, at this point you need to have an idea of what loan program you’re going to be pursuing. Fannie and Freddie? Are you going to be going for some sort of renovation loan? This is all based on your business plan, and we’ll get into that in a little bit… But once you know which loan program you’re going to pursue, then you know what their minimum debt service coverage ratio requirement is.
For example, if you’re pursuing an agency loan, then the debt service coverage ratio is 1.25. That’s the minimum. Since this is a ratio, when I’m gonna say “minimum debt service coverage ratio”, that’s actually going to be what your maximum debt service is going to be… Because as the debt service coverage ratio goes up, the debt service goes down. So again, based on the calculus, if you know the current net operating income and you have an idea of what the minimum debt service coverage ratio is going to be, you can calculate what is going to be the estimated or really the maximum amount you’re gonna have to pay for debt.
Again, if you don’t have all the terms for the loan while you’re underwriting the deal before you put it under contract, a simple way to get an idea of what your maximum debt service is going to be is to take the current net operating income and divide it by that debt service coverage ratio. That will give you an annual debt service. Divide that by 12, and that is going to be your monthly mortgage payment.
Now, this is a worst-case-scenario analysis, so if the deal doesn’t make sense at that debt service, it doesn’t mean you should automatically eliminate that, because you might be able to get a lower debt service once you’ve actually talked to a lender. So this isn’t perfect, but it’s better than just making up a number yourself, and it’s better than leaving it blank, and it’s better than just not looking at a deal at all until you know exactly what your loan terms are gonna be, because they always change.
Now, with that out of the way, let’s talk about how to select your ideal loan. The first thing that you’re going to determine is if you qualify for a non-recourse loan. That happens by having a conversation with your mortgage broker. Ask them, based on that personal financial statement that you provided, based on how you plan on raising money for this deal, based on the types of deals you’re looking at, do they believe you can qualify for non-recourse debt? Because if you can’t qualify for (let’s say) agency non-recourse debt, then you’re either going to have to pay a loan guarantor a lot more money, because they’re going to be personally liable, or you’re gonna have to find a loan that you do qualify for the non-recourse. Or you’re gonna have to figure out what you need to do in order to qualify for that agency non-recourse loan.
Let’s say you qualify for non-recourse. The next question you’re gonna ask yourself is “How long does the loan need to be?” If you’re a long-time Best Ever listener or if you’ve read the blog, or if you’ve read any of our books, you know about Joe’s three immutable laws of real estate investing – law number two is to secure debt that is longer in term than the hold period. That means if you have a five-year projected hold period, which means you’re planning on selling the property after five years, then you’re gonna want your loan to be able to be greater than five years.
Now, if you remember in the top loan program episode, some of those renovation loans, those bridge loans had a term of three years. So if you plan on holding on to the property for five years and the loan term is three years, then according to the three immutable laws of real estate investing, that alone will not work for that project.
However, you have to remember the extensions. So if you do have a five-year hold period, then you can secure a bridge loan or a renovation loan with a three-year term, and the ability to extend it by a year two times. That means that the total potential length of the loan is five years, and that does meet the three immutable laws of real estate investing… Which is actually — it needs to be equal to or greater than the project hold period. The reason is because you don’t want to be forced to refinance or forced to sell at a loss.
Once you have that question answered, that might eliminate some loans from contention. If you wanna hold on to the property for 10 years, then a loan program that has a maximum loan term of (say) seven years isn’t going to work.
Next is you’re going to want to ask yourself if you want the renovations to be included in the loan or not. The first thing that you need to ask yourself about that is what is your budget per unit. If you remember, some of the renovation loans, or some of just the regular agency loans, have a minimum or a maximum per unit cap ex cost. So if the maximum per unit is, for example, $6,500, which I believe is what it was for the 221 HUD loan, and your budget is $10,000 per unit, then that HUD loan is automatically disqualified.
You also want to keep in mind that if you do not include the renovations in the loan, then you’re gonna have to raise capital to cover the renovations. So if you have a large renovation budget and for some reason you can’t qualify for a renovation loan, it’s going to throw off the cash-on-cash return to your investors by a lot… Because rather than, for example, getting a 80% or a 75% loan to cost renovation loan, or to bring 25% down of the total project costs, instead you’re going to be stuck with, say, an 80% LTV loan. So you put down 20%, plus you have to raise an additional 10 million dollars for renovations.
Now, sometimes that might come out to be lower than the down payment for your renovation loan, but more likely than not it is going to be higher. And if the deal still makes sense by you raising money, then great. If not, then you’re gonna have to consider getting one of the renovation loans that meet all of your requirements.
Something else you’re gonna want to ask yourself is if you want a fixed rate or a floating rate. As I mentioned, the fixed rate means that the interest rate stays the same throughout the entire hold period. For the floating rate, it is typically based on the one-month LIBOR rate. We’re going to be doing a “Ask the expert” blog post on the pros and cons of the fixed interest rate versus the floating interest rate. That should be live by the time this episode releases.
But just at a high level, both are good options. One’s not absolutely bad and one’s not absolutely good, but at a high level you’re typically going to want to pick either fixed or floating based on your business plan. For deals that you plan on adding a lot of value to and drastically improving over time, then a floating interest rate might make the most sense, because it provides the most flexibility for you to sell or refinance the deal once you complete that business plan… Whereas for deals that you plan on maybe improving a little bit or not improving at all, then it is likely going to be better to have a fixed interest rate… Because it might be a little bit more difficult to refinance the fixed interest rate early on. You’re gonna be able to offset that by securing a supplemental loan to capture some of that value instead.
The reason why it’s more difficult to refinance the fixed interest rate compared to a floating rate is based on how the lenders actually create their loans. The longer-term loans like Fannie Mae and Freddie Mac, that offer the fixed interest rates, they tie their loans to Treasuries. And since these lenders have priced their loan with the expectation of that loan being in place for a long period of time, there’s going to be a higher pre-payment penalty to either sell or refinance the loan early… Which again, it doesn’t make it difficult to do, but it makes it costly to you, which I guess in turn makes it difficult… Whereas as I mentioned, the short-term lenders who offer the floating rates, tie them to them one-month LIBOR rate; since it’s tied to such a short-term security, they offer a lot more flexibility for refinancing or selling, without that large of a prepayment penalty.
Again, based on your business plan, fixed and floating rates might be better. And then if you determine that “Okay, I plan on holding on to this property for a while, and I’m not necessarily doing a lot of improvements, so I wanna go with a fixed interest rate”, then you’re gonna find a loan program that has that long-term fixed interest rate.
Something else to keep in mind in regard to the floating interest rate – which is typically going to be lower than the fixed interest rate at the start – is that since it’s floating, you might want to consider purchasing a cap. In that case, again, it’s kind of crystal-balling here, but you wanna ask yourself, “Okay, do I think this interest rate is going to shoot through the roof? And if it does shoot through the roof, how much more will I be paying per year compared to how much money will it cost to just buy a cap of, say, a few percentage points instead?” So it’s kind of a pros versus cons, risk versus reward analysis.
Something else you wanna consider is if you want to do interest only. For interest-only — let’s say you buy a property that is not stabilized at all, and you still want to be able to distribute some cashflow during the renovations process; then doing an interest-only loan might be your best option, because as the name implies, you’re only paying interest on the principal, rather than paying down the principal, so your debt service is going to be lower, which means your cash-on-cash return is going to be lower.
And it might even make sense if the property is stabilized, and you plan on drastically increasing the rents, and you still wanna hit that preferred return year one, get an interest-only loan for one or two years while you’re doing those renovations, so that you can distribute cashflow. Then by the time that interest-only period expires, you’ve increased the income to the point where the increase in your debt service does not eat into your cashflow.
Something else to keep in mind about the interest-only as well is that as I’ve mentioned, one of the return factors is the IRR. All things being equal, if you give me $10,000 and I give you $1,000 at the end of year one, versus $1,000 at the end of year two, the IRR in scenario number one is actually higher because of the time value of money. Similarly, with the interest-only, since your debt service is going to be lower, if you look at the difference between “Okay, so if I have an interest-only loan, it’s $10,000/month, whereas if I don’t have an interest-only loan, it’s $15,000/month”, you’re able to distribute that $5,000 earlier on in the business plan, which again, based on the time value of money, is worth more than paying down that principal, paying down that $5,000 and then distributing that $5,000 five years later, at sale.
So when you think about interest-only, you wanna think about “If I do interest-only, will I be able to distribute my preferred return to investors earlier?” and also you want to consider that time value of money.
If you decide to go with the interest-only loan, like all the other factors I’ve discussed, then you’re gonna have to pursue a loan program that offers interest-only, and the ones that do not, automatically get eliminated from contention.
You also want to consider whether or not you want an assumable loan – and I recommend listening to part three for the pros and cons of the assumable loan – essentially, it might make your deal more competitive on the back-end when you sell, if all the pros are in place. If the terms now are better than they are at sale, and if the buyer can actually qualify for that loan.
Based on all those factors I discussed, you’re gonna be able to narrow down the programs that are right for you. A really good starting approach is, again, to reach out to your mortgage broker, tell them what you plan on doing, give them background on yourself, and then ask them what they believe is the best loan program for you, and then ask them what are a couple other loan programs that you think would be a good fit as well, and then what you can do is you can create a loan matrix. You can do that upfront, but then you’ll also wanna do that on the back-end, when the deal is under contract, and you’re going out to different mortgage brokers and lenders and sending them all that documentation, asking them to provide you with a quote. You wanna drop all those quotes into the loan matrix as well.
Then we’re also gonna be giving away another free document, which will be a loan matrix template, where essentially you input all the loan terms and it spits out your monthly debt service. You might not necessarily wanna go for the one that has the lowest debt service, because other factors need to be considered, like interest-only, fixed versus floating interest rates, are there renovations included in the loan or not, how long are the loans, is it recourse versus non-recourse? Things like that. That’ll give you a snapshot of the various loan, and you can look at those, analyze those and then move forward with the best loan for you, again, based on your specific business plan. Of course, you can download that free document at SyndicationSchool.com, or in the show notes of this episode.
That concludes this podcast, as well as the overall podcast series for how to secure financing for your apartment syndication loan. In the next episode we’re going to be talking about the second thing you should be doing during the contract to close period, which is performing your due diligence. We’re gonna take a deep dive into that process. Then, as I mentioned, the third thing you’ll be doing from this contract to close period is securing those commitments from your investors, which will be the podcast series directly after the next one about due diligence.
In the meantime, I recommend listening to parts one through three of this podcast series, as well as the other Syndication School series we have on the how-to’s of apartment syndication. Make sure you download your free loan matrix, as well as the other free documents we have available at SyndicationSchool.com.
Thank you for listening, and I will talk to you next week.