In this Syndication School episode, Theo Hicks explains how to compare the different loan options and factor in different variables that are at play.
Loan terms will determine what kind of ROI your multifamily unit will generate for the investors. Factors such as interest rate, debt service, loan term, and the amount of capital you put down will affect the cash flow and the future earnings. It’s also important to remember that some of these factors can benefit you short-term, and some will give you long-term advantages (i.e. having adjustable vs fixed interest rate).
To listen to other Syndication School series about the “How To’s” of apartment syndications and to download your FREE document, visit SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow.
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Theo Hicks: Hello, Best Ever listeners, and 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’m your host, Theo Hicks.
Each week, we air a podcast episode that focuses on a specific aspect of the apartment syndication investment strategy, aka Syndication School. And with a lot of these episodes, especially the first batch of episodes we released, that went by the step by step process, in order, from not really even knowing what apartments syndications are, to completing your first deal and selling it on the end and returning a big, fat, whopping check to your investors. We gave away free documents during those episodes. We give away some free documents with the more recent episodes, but really every single series we did before had a free document, so you’ll definitely want to check that out. Those are at http://syndicationschool.com.
This episode is going to be part three of a three-part series. So we’re wrapping up the series on multifamily lending; so this was a Multifamily Lending 101 course. Make sure you check out parts one and two, which have aired the previous two weeks, or if you’re listening to this way in the future, 7-ish and 14-ish episodes ago, since we release the episodes every week.
So overall, this series is about understanding how to select the best loan for your apartment syndication deal. So in the first episode, we talked about the different type of lenders that you can use, and then whether or not you should use these lenders, or whether you should use a mortgage broker, or what type of loan you should get, whether if you get a bridge loan or an agency loan, and then when to actually engage your mortgage broker and your lender.
And then in part two, we talked about how to qualify for agency loans, since agency loans are usually going to be the best loans you can get on your standard value-add syndication deal. So obviously, there are a lot of exceptions, with the main one being if you plan on selling early, and you don’t want to pay a large prepayment penalty with that agency loan, you might consider getting a bridge loan, and then either selling it or refinancing it into an agency loan later on. But assuming you want to get an agency loan, how do you qualify for that? So we talked about in part two the qualification process which involves qualifying the borrower… So you, your partners, any big investors, any loan guarantors and really anyone who’s signing on a loan or meets the criteria to be a borrower in the eyes of the agencies; what do they look at? What do you need in order to qualify for agency loan? And then assuming the borrower qualifies for agency debt, what types of properties? What are the characteristics of the actual deal itself that the agencies look at before giving debt on that property? So that was part two.
And we also talked about some of the changes in the upfront reserves requirements due to the virus, as well as talked a little bit about the renovations on value-added deals and how those could be included in the loan up to a certain dollar amount.
Now, this last part, part three, we’re going to wrap up and talk about – very high-level, because we’ve only got 20 minutes to talk about this; very high-level, how to compare different loan options and what the different factors for the loans mean when you’re looking at it, what the terminology means, and how to look at those numbers and those figures. So that’s going to be what we talk about in this episode. So let’s jump right into it.
So the output of the loans – you input all these different loan terms and the output is going to be a debt service. So the debt service is the technical term for the payment that is owed by the borrower to the lender each month. So when you’re looking at a T12, for example, profit and loss statement, usually the debt service is not going to be on there, because the debt service is below the net operating income line item and usually the T12 will stop at net operating income.
The reason why the debt service is obviously going to be very important is because the net operating income is used to calculate the value of the property, and so the type of loan you get won’t necessarily affect the value of the property, but it will impact the cash flow that the property generates… And the cash flow that the property generates determines the returns to your investors.
So you have the exact same deal, bought at the exact same price, and two different investors execute the business plan flawlessly, you get the exact same brands, you get the exact same operating expenses, but the operator that can get the better loan terms is going to be able to distribute a higher ongoing cash-on-cash return to their investor. It’s not going to change the value of the property, it is not going to change the sale proceeds. Well, actually, it might change the sales proceeds, but it’s not going to change the overall value of the property. But the lower the debt service, the more cash flow the property is going to generate.
Now, when you’re comparing loan options, the lowest debt service isn’t necessarily the best, because – some of the caveats, some of the exceptions… For example, let’s say that there’s two investors and one investor’s debt service is way lower than the other investors debt service from the get-go… But maybe it’s because of the fact that they have an IO loan, or maybe it’s because they have an adjustable interest rate. So you have two loans – one is a fixed interest rate, one’s an adjustable interest rate. The adjustable interest rate starts lower than the fixed interest rate loan, so the debt service is lower at first. But if the interest rate goes up, at the end of the business plan, the one with a floating rate might have paid more than the one with the fixed interest rate over the 5-10 year business plan, whereas maybe the adjustable interest rate was better at first.
There also might be higher closing fees for the one with a lower debt service, maybe the loan is not assumable, maybe there’s really a high prepayment penalty… So some of the other factors we’re going to talk about later on in this episode, those are going to be different from loan to loan. So you can’t just look at debt service, that’s the entire point here.
So to start off [unintelligible [00:09:57].22] the loan debt service, the more cash flow. But also there’s other things to take into account as well, which we will, as I mentioned, talk about here in a second. But that’s one thing to be aware of, because the fact that the cash flow is going to be dependent on the debt service.
The next few terms to know, which aren’t necessarily going to be something you’re really comparing or not something that’s super important, because they’re not going to be that different, which is the loan amount, which is going to be based off of LTV, which we’ll talk about in a second… But this is basically how much money the lender is going to lend to you.
There’s also the loan term, so that is the number of months until the loan must be repaid in full. Generally speaking, on the loans with the shorter terms, you may have an option to purchase an extension, especially when we’re talking about a bridge loan… But for the loan term, you’re going to want the loan term following the three Immutable laws of real estate investment we’ve talked about the past – to be at least twice as long as the value-add business plan portion. So if the plan is to renovate all the units and the renovation timeline is two years, then the loan term should be at least four years. That way you aren’t forced to sell or refinance before you’ve finished the value-add business plan.
Generally speaking, the longer the term, the higher the interest rate is going to be. So there’s kind of a fine line, like, you don’t want to get a 20-year term because you don’t plan to hold down the deal for 20 years, and you’re going to pay more interest than if you got maybe a five-year term when you plan on selling the deal after three, four or five years.
So the longest term loan isn’t necessarily the best, but then the shortest term loan also isn’t the best. There’s going to be a sweet spot, which is at least 2X the value-add business plan.
Next is amortization. So amortization and loan term are different. So the loan term is how many years until the loan needs to be paid back in full. The amortization is the time period that the principal and interest payments are spread over. So the longer the amortization, the lower the monthly payments are going to be, but also the higher the interest payments are going to be. So a 30 year amortized loan doesn’t have the lower debt service than a 15 year amortized loan. But a 15 year amortized loan, when you look at the amortization schedule, you’re paying more principal on that loan from day one than you are on a 30-year loan… Because the way that it works is there’s an inverse relationship where in the beginning you’re paying mostly interest and a little bit of principal, and then towards the end, you’re paying all principal and very little interest. So usually, you can have an option, the loan will have an amortization, like, it’ll be 30 years or 25 years or 20 years. So that’s something to kind of be aware of because you can know, “Okay, well, this amortization is longer, which means that I’m not going to have as much principal to pay down. So I’m not going to take advantage of that benefit of real estate investing, which is having residents pay down the principal.”
This next one is going to be one of those factors that might result in one loan having a lower debt service upfront and then ultimately being higher overall. It’s interest only. So an interest-only period is going to be the number of months that the operator only pays interest payments, and then once this interest-only period is over, the principal and interest payments are going to be due, so you need to pay both. So interest only obviously is going to be lower than the principal and interest.
Now, the main benefit of the interest-only period is the increase in cash flow, which results in a higher IRR, because investors are getting more money faster and this increase in cash flow is even more beneficial on value-add deals because of the fact that you can immediately begin sending distributions to your investors upon closing, because your debt service is lower while your cash flow is lower, because you haven’t forced the rents yet.
Now, there are a few drawbacks. There’s no principal pay downs [unintelligible [00:13:37].28] that benefit, which might also impact future supplemental loans or refinance proceeds, which will ultimately reduce the IRR because you’re not able to give a large chunk of capital back to your investors sooner.
And then once the interest-only period expires, the debt service is going to pop up. And so you might have a fixed interest rate loan of say 4.5%, and they’re paying principal and interest from day one. Or you might have a fixed interest rate and loan at 6% with interest-only that’s at 4%. So at first is better than the 4.5% loan but then once it expires, it goes up to 6% [unintelligible [00:14:11].14] principal and interest, you’re paying more. I guess it wouldn’t be exactly like that. But I’m saying — you have two loans; one’s a 6% interest rate loan and one’s a 4.5% interest rate loan. And in the 4.5% interest rate loan, you might have a higher debt service if you’re paying principal and interest compared to a 6% interest-only loan. But once that interest-only loan goes to the principal and interest, it’s going to be higher than the 4.5% loan.
I know it’s nice that the more experience you have, the longer interest-only period you can get, and so you might have to worry about this second drawback. And then the third drawback could be that an unsophisticated investor might do a bad deal, because they say, “Oh, why you’ve got two interest-only deals cash flow and so much money. Let’s go and buy this deal,” without realizing that, oh, your three shoots up and then the cash flow went from 7% down to like 2% and now my investors are mad at me.
I did a whole episode on interest-only loans. So you can check that out at syndicationschool.com.
Next is going to be the debt service coverage ratio. And so this is a ratio of net operating income to the debt service. So the debt service is your monthly payment. It’s basically saying, “Okay, well, what percentage of the debt service is the net operating income?” Usually, it’s 1.25%. So the net operating income needs to be 125% of the debt service and often they’ll give you a loan. And then sometimes the higher that debt service coverage ratio, the better loan term you’re going to get. And then certain loans might have different types of loan terms for different windows of debt service coverage ratio. And this also might determine how much they’re going to loan to you. So they look at the net operating income, and they say, “Okay, well, you can get debt service up to a certain number and then based off of that, let’s reverse-engineer how much we’ll actually loan you on the deal.” And so overall, the lower the debt service coverage ratio, the more money that you can get loaned to you, but then also the less wiggle room that you have, because if the net operating income drops too much, you won’t be able to cover the debt service, you get foreclosed on and that’s not a good thing.
Another thing to think about is the interest rate, which we’ve kind of hinted at already, but… This is the rate the lender charges you to borrow their money. And the two different types of interest rates are going to be fixed or floating. So we kind of talked about that before, where fixed is going to be the same no matter what; floating, it could go up, it could go down and it usually starts off as lower than the fixed interest rate, it doesn’t necessarily mean it’s going to remain lower. So if the interest rate is floating, you want to know what’s the floating interest rate tied to, how long is it updated… Right now, it’s usually based off of the one month LIBOR rate, but I know in 2021, at some point, that’s going to change to something else. So you can take a look at that trend of that index just to guesstimate if the interest is gonna go up or down based off of previous trends. Again, it’s impossible know for sure, but at least it’ll give you a better understanding of whether you can expect interest rates to go up if they’ve been rising for a long time, or to continue to go down, or at least not go up too much.
And then for the floating interest rate, you can also buy a cap, which is helpful and reduces the risk. You basically pay an upfront fee, and it says, “Okay, my interest rate will not go higher than 100 basis points or 200 basis points or 500 basis points or whatever.” So this is ideal regardless if you’re doing a floating rate loan. That way, the interest rate doesn’t explode and go too crazy. And then also you’re going to want to know for these loans when the rate actually locks in. And so if the rates are all over the place, you want to be able to lock in the rate earlier, rather than later in the due diligence. So kind of comparing the different loans between when the rate locks in, and how much the cap costs, what the cap actually is for the floating rate, or things to look at.
We also have a Syndication School episode or at least a blog post on fixed versus floating rate interest rates. So check that out.
Some of the other things that are definitely important, but I think the most important ones are going to be the interest rate and the interest-only period and the debt service and probably the loan term, too… But these things are still important nonetheless. I just skipped one; loan-to-value, which I’ve currently talked about; that’s the ratio of the loan amount to the appraised value of the apartment community. How much money will they lend? So the higher the LTV; 80%, 85%, 90%, the more leveraged the deal, which means the less equity we have in the deal. This is good, because you get to put down less money, which means the return on your investment is higher, but you also have less wiggle room or less cushion against any market fluctuation. So we always recommend to not go above 85% maximum, right? But ideally, a little bit lower than that. But if you have to go super high or you really want to go super high and test it, 85% of the absolute max. And usually, if you’re looking at agency debt, you can’t go higher than that anyway, so it shouldn’t be an issue.
Okay, something else is recourse. So usually, most loans are going to be non-recourse, which means that the people signing the loan aren’t personally liable. So if something happens and the deal is foreclosed on, the lender can only go after the property, they can’t go after the property and your home and your other properties in your portfolio and your wife and your wife’s stuff or your husband’s stuff or whatever, your family. Whereas a recourse, you are personally guaranteeing this. So they can come after your personal assets if something were to happen. So usually, the agency deals are going to be non-recourse with certain exceptions, certain carve-outs, like fraud and misrepresentation, or gross negligence… Or maybe, depending on your background, you might not have the track record, the financials to qualify for a non-recourse loan. But again, ideally, to reduce your risk here, you’ll want non-recourse.
Some other things you might think about are lender reserves and then tax and insurance escrows. So these are going to be things that are acquired upfront by the lender. Maybe the lender wants you to pay for the first years of taxes and insurance upfront, even though they’re only paid on a quarterly or a monthly basis. Or maybe they’re going to be monthly instead, and you pay them along with your debt service. If escrows are required, then you’re going to raise more money for that loan, which means that the cash-on-cash return is going to be lower. Same thing with lender reserves, which we kind of talked about in part two, upfront, but it’s also going to be ongoing [unintelligible [00:20:09].25] reserves as well. So again, these are operating expenses that are going to lower your cash flow. So you’ll want to think about when you can access these funds as well, because that’s also going to vary.
So then the other terms that are going to be important on the loan are going to be prepayment penalties. And so comparing the prepayment penalty amounts, as well as when they come into effect. So when are you allowed to exit the loan without paying a fee, basically. This is one of the reasons why bridge loans might be more advantageous than agency debt, if you plan on selling before the end of the prepayment period… Because you’re talking about a $50 million deal and it’s got a 2% prepayment penalty – well, that’s a million dollars that you’re losing right off the bat, right? 2%. So that’s a pretty big deal. So you’ll wanna understand how the prepayment penalties work on the property, as well as — another term [unintelligible [00:20:58].01] the loan is assumable, because that’s something that is attractive to buyers on the backend, especially if loan terms are less advantageous now than when you bought the property. So they could just take over your interest rate; that could be something that’s attractive. So if the loan isn’t assumable, that might be something that you want to consider.
Something else to think about is how these supplemental loans work. So a supplemental loan is a secondary loan you can take out on top of the existing mortgage; usually, it’s a year after the first mortgage. But the LTVs might be different, the fees associated with it might be different, the number you can take might be different… So that’s something you want to think about as well.
And then a few other things, like financing fees is another upfront cost; how much does it cost to get the loan, a certain loan. There’s like streamline loans that the agencies have that have lower fees. So again, that’s more money upfront that lowers the cash-on-cash return.
And then this isn’t something that’s necessarily going to be a deal-breaker for a deal. It is just something else to think about when it comes to debt – it’s the reports that are required. Some lenders might require more due diligence reports, which again, is a higher cost to you upfront.
So a lot going on there, for a lot of these terms… I defined them in this episode, but you also have them defined on the passive investing resources site on joefairless.com. And then for a lot of these like prepayment penalties, assumable loans, supplemental loans, the due diligence reports, fixed-rate versus floating interest rates, the pros and cons of interest-only periods… We’ve written blog posts on the past and/or we’ve done syndication episodes. If you just type in those words into joefairless.com, you’ll come across a lot more resources than that, because this already a 25-minute episode, and I can’t keep going on and on and on.
So those are some of the things to think about when you are comparing loans, other things to look at and to compare, to determine which loan is ultimately going to cost you more and which loan comes with a higher risk. And the loan that’s going to be best for you based off of these terms is going to vary from deal to deal. So I tried to as much as possible mention when that’s the case, which of these facts are the most important, and kind of looking through this list of facts.
Let’s say that the loan term is obviously important, the interest¬only period is going to be very important, the interest rate section is going to be important, and then depending on the business plan, prepayment penalties, is it assumable, and supplemental loans is also going to be good.
And then things like taxes and insurance escrows, lender reserves, financing fees, the required reports – those are going to affect the down payment that you have to give for things that aren’t necessarily going to result in ROI. So I think that’s it. Makes sure you check out The Top Loan Programs free document that you can find in the show notes of this episode, and make sure you check out part one and two, because this concludes the Multifamily Lending 101 course.
So I hope you learned something. If you have any questions, feel free to email me at firstname.lastname@example.org. No one’s taking me up on this yet. I give my email address out on the show every once in a while and no one’s emailed me yet, so I’m willing to answer any question you have. So that’s email@example.com.
Thank you for tuning in and make sure to check out our other Syndication School series episodes at syndicationschool.com. Have a best ever day and we’ll talk to you tomorrow.
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