Creating Growth Opportunities - Part I: Securing Lending Opportunities
Part I: Securing Lending Opportunities
Will My Credit Runneth Over?
I’m not an economist. I can understand what I read (most of the time) and can draw nice pictures for my 5 year old of the supply and demand for widgets, but that’s where I draw the line. I am, however, and will always be a full blown opportunist.
So when I recently attended the Real Estate Guys Investor Summit in Belize with really smart economistsy people (Danielle, George, Chris, Russ) who said that credit markets might tighten up, I put on my big girl sweatpants and did some research. The goal was to be super prepared for the inevitable event of X.
The question was: what is X? Well, it turns out no one knows. It’s safe to say that X = Uncertainty. Some say the credit markets will tighten. Some say it won’t. Some are busy watching Alone (which actually might prove to be its own worthwhile preparation tactic). The overall goal then is to prepare for uncertainty. While some may say the forecast is looking cloudy, I would say it’s not only cloudy, but there is a statistically significant chance of meatballs.
Btw, if you want to take your own guesses at X and also sharpen that economical noggin, I highly recommend Lyn Alden’s newsletters like the June one here as well as several real estate podcasts: Jason, Kathy, Victor, Best Ever, Real Estate Guys, On The Market, Roger, & Invest Like a Billionaire.
For my own research, I reached out to four of my lender relationships, including life insurance companies, traditional banks, and credit unions, to get their take on the situation. In regards to their take on the market and what the future may hold, they had the following thoughts:
In terms of real estate sectors,
Office has done poorly for obvious reasons. (Turns out people really love sweatpants.)
Retail depends on the market. (Do malls still exist in California?)
Industrial and multi-family have had significant demand. While the lenders did expect prices to soften, they expect a lag between the sellers’ reality and, well, reality.
A couple of lenders described themselves as “flush with cash”. And all of them thought lenders will keep lending. For the life insurance companies in particular, their alternative investment to commercial mortgages is corporate bonds and the effective rate of return for the latter is not particularly competitive or attractive at the moment.
And one last comment - in some ways the credit market has already tightened. As Steve Streetman from StreetSmart Investments, LLC pointed out to me, with interest rates rising, lenders are finding fewer deals they can underwrite, so in that sense the credit market has already tightened. Victor Menasce from Y Street Capital and The Real Estate Espressopodcast adds to this that the bond market is taking a beating. And a hit to the bond market will directly impact the credit market.
So where does that leave us with lending terms now and in the future…
Credit Terms Uglifying
Of the four lenders I spoke with, the vote was unanimous that lending would continue without hiccup in the upcoming future. But the terms of those loans are not going to be nearly as pretty as they were a year ago. Specifically, they said the following:
Be prepared to possibly put down more cash. Again, the verdict on this was mixed. Traditional banks were willing to go up to 75% loan-to-value (LTV) on full-recourse commercial loans. On the other hand, one life insurance lender was reigning it in to a 50% LTV, while another life insurance company could go up to 75% LTV but had the following caveat…
DSCR is going to be the real driver. The debt-service-coverage-ratio (DSCR) was projected to be the determining factor, especially from the life insurance lenders. The more conservative life insurance companies now require a 1.50 DSCR (non-recourse), whereas others life insurance companies were willing to do 1.25 DSCR (but with 25% recourse). One bank had a different but similar requirement of a 10% debt yield (i.e the net operating income (NOI) has to be at least 10% of the loan amount). And all the banks required full-recourse. Factoring in the DSCR requirements, some lenders thought an LTV around 60% was more realistic than 75%.
Interest rates are going to be higher. Perhaps we should start with a moment of silence. It was so fun while it lasted. As Sir Isaac Newton said, what goes up must come down, or in the case of interest rates, what goes down must come up. On the plus side, the life insurance companies had some pretty good rates, all things considered, ranging from 4.75% - 5.25% for industrial. The traditional banks’ and credit unions’ interest rates were a little harder to swallow - ranging from 5.5% - 5.8%. Gulp. That hurt. And this was before the Fed hiked interest rates by another 0.75 percentage points on Wednesday July 27th.
I felt good, or I should say “better”, about the availability of debt, but still nervous about making any deals work with the interest rates being what they are and seller property prices still being at status “gaga”. What is a girl to do…
Can I Pretty Please Have Lower Rates? Please?
I asked if there were any ways to get a lower rate and here was the feedback:
Lower leverage. A lower LTV could generate a lower interest rate as well.
Shorter amortization period. One lender mentioned they could provide a lower interest rate if we elected for an amortization period shorter than the typical 25 years. Since a shorter amortization would increase the overall payment, I’m not sure if this would just be a wash.
Offer a personal guarantee, even if only for part of the loan amount. While some lenders required a full guarantee regardless (aka full recourse), the lenders with non-recourse options said a lower interest rate might be achievable by guaranteeing all or part of the loan amount. For example, a 25% guarantee on a loan of $4M would mean the first $1M of the loan would be personally guaranteed should anything go south. This may apply for example to any investor with 20% or greater ownership, but varies by the lender.
Prepayment penalty waiver. This was not advertised by the lenders for obvious reasons, but is often negotiable, and in times like this is absolutely crucial in my opinion. Even if we were able to secure a favorable interest rate for “current times”, there is lots of speculation that rates might be cut again in the nearish future, either after the midterm elections or in Q1-Q2 of 2023. It is therefore very important in my opinion to eliminate a prepayment penalty as much as possible to take advantage of future interest rate cuts and resulting pre-term refinance opportunities. For lenders with more strict prepayment policies such as life insurance companies, it may be possible to pay a premium to eliminate the penalty. And regardless, the best option might be an option… (you see what I did there?)...
The options option. Typically, as long-term-hold investors in the commercial industrial space, a 10 or even 15 year fixed rate term causes us to high-five and do the happy dance. However, in the current climate of cloudy with a chance of meatballs, we want options. The banks we spoke with all advertised a 5+5 term which means a 5 year term, with an option to extend an additional 5 years with an interest rate reset at the end of the first 5 year term. The life insurance companies had a 5+5+5 option as well as a 3+3+3 option. While these options, combined with no prepayment penalty would be best, these options alone are still probably better than a long term fixed rate in these times of uncertainty.
So now that we have some clarity on the current terms, and confidence from our lenders on future terms, the next step should be abundantly clear…
Preparing for Meatballs
Though the lenders left us feeling pretty good about securing debt for upcoming opportunities, we still want to be prepared in case an unforeseen event makes lending difficult. The key is to have enough cash on hand to purchase deals without or with much lower leverage.
Our main approach to this is to:
Prepare to contribute greater equity to the deal. We will be looking to contribute more of our own equity as well as opening up to more investor equity for our next deal.
Prepare lines of credit on our industrial and residential portfolios to provide additional short-term capital streams.
In both approaches, the goal would be to eventually secure long term lending at higher leverage, whether that is a typical refinance after a 5-10 year hold, or something in the nearer future.
There are several advantages of the first approach:
It allows us and our investors to put more of our capital to use. On one hand, a greater equity percentage in the capital stack will lower cash-on-cash-returns, at least in the short term. However, a return of anything greater than 0% is frankly better than a return of at least -9.1% which is the latest CPI inflation rate and probably grossly understated. Having inflation eat the money in your bank account like a game of Pac-Man is not fun. Additionally, money invested in real estate is appreciating with real estate, which typically rises with inflation, which means any return is on top of the wealth preservation of your capital.
More equity means less debt obligation and consequently less risk. Though we’re uber conservative and have never had a capital call or negative cash flow, the season of black swans seems to be upon us, and it’s good to remain ultra conservative, even when there are deals to be had.
Working with investors allows us to help people we care about while positioning us for larger deals with bigger economies of scale.
The line of credit (LOC) approach was something we had never thought of before, and was suggested to us by Shannon Kiefhaber at 25/8 Capital. It can be used concurrently with the plan above to obtain more equity and has very limited downside. In particular, comparing it to obtaining long term debt (either first or second positions) on properties in our existing portfolio, an LOC has the following advantages:
Less fees. If we’re not going to need the funds, the loan fees involved in long term debt are simply not worth it.
Faster process. The time frame is only 3-4 weeks for a LOC versus 30-60 days for a traditional loan.
Pay only if used. The payments on an LOC are only triggered if you draw out funds. If it’s approved and just sitting there, there are no interest or principal payments due.
Interest only. The LOC is interest only for a fixed period, ranging from 5-10 years, and you only pay interest on what you pull out. (Now I won’t be jealous of all those apartment syndicators who get to play with interest only debt on the reg).
Higher LTV. The LTV for an LOC is typically 80% versus the 50-75% LTVs for long term debt discussed above.
The potential downside is that the interest rate with an LOC is variable, but is that a downside in this market? It could be argued that the fixed rate that comes with long-term debt is the real downside. Plus, our plan would be to use the LOC as a short term solution.
Ok, let’s round it all up…
Sum Up
Here’s what we learned about the current and projected lending market and what we plan to do about it:
Prepare for X. No one knows what will happen to lending. Prepare accordingly.
Deals Must Make Sense. The NOI has to cover the debt, bigly.
Interest Rates Aren’t Fun. I don’t care what people say about what interest rates were in their day. Right now, they’re high relative to prices. And the deal still needs to make sense per the above.
Bring on the Equity. To make sensible deals, more equity might be required. While this lowers the cash flow, it’s better than inflation bank-eating Pac-Man.
Get Dry Powder. Look at alternative sources of quick funds, like lines of credit, HELOCs, and anything else you can think of. Grandma might trade dough for grandkid time, you never know.
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Any comments? Questions? I welcome all feedback and am always looking to converse with intelligent and productive people. I’m also available for speaking engagements and podcast interviews.