Ask the Real Estate Investing Expert

Agency loans. Bank loans. HUD loans. Life insurance company loans. CMBS loans.

These are some of the most popular loan programs syndicators use to fund the majority of their apartment deals.

Many real estate investors are familiar with the first loan programs but not as many are familiar with CMBS loans.

CMBS loans (commercial mortgage backed securities), also referred to as Conduit Loans, are a type of commercial real estate loan that is secured by a first-position mortgage on a commercial property. These loans are packaged and sold by Conduit lenders, commercial banks, or syndicates of banks.

We asked Ashcroft Capital’s Director of Acquisitions Scott Lebenhart about the pros and cons of the CMBS loan for our “Ask The Expert” series and here is what he said:

Although we haven’t secured a CMBS loan, here are the pros and cons you need to know about if you are considering this loan program.

There are two main pros.

First, CMBS loans typically allow for maximum leverage on deals that may typically be viewed as slightly more risky loans by the agencies and balance sheet lenders like banks and insurance companies.

Also, CMBS loans are a good option for deals that one wishes to hold long term as a cash flow investment

There are also two main cons.

First, the major negative to a CMBS loan is the limited flexibility. Once it is sold off as securities in the marketplace, any modification or request needs to be issued though the servicer of the loan who is typically a third party. The servicer makes all decisions off of what exactly the loan documents say, making it very difficult for any changes to be made. Many people find it valuable to be able to talk to the company that issued the loan to work through any changes such as additional capital, changes in the business plan, or trying to sell the property as a loan assumption.

The other con is that the prepayment penalties are typically expensive and you may need to pay defeasance if you decide to prepay.

Overall, you can use CMBS loans for riskier deals and deals with a long-term cash flow play. The downsides to consider are limited flexibility to make changes and higher prepayment penalties.

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As an apartment syndicator, you need bank accounts to deposit your passive investors’ initial equity investment, money for capital expenditures, ongoing revenue, as well as to send out investor distributions, pay operating expenses and debt service, pay contractors, etc.

Today’s ask the expert question is “how many operating accounts are there per property and what are the purpose of each account?”

We asked my business partner Frank Roessler at Ashcroft Capital about the main operating accounts and what they are and here is what he said:

Typically, you will have two accounts. You will have an operating account and either a capital account or a DACA account.

The Operating Account

The first main account is the operating account. This is the account where all the rents and other revenues are deposited and where all of that expenses are paid out of. Since this is the account that holds all the asset’s revenues, it will also be used to pay out investor distributions. When underwriting a deal, one of the cost assumptions is the operating account fund. I’ve received a lot of questions about this assumption. This is an upfront fund to cover the costs of unexpected issues or shortfalls that arise before you’ve accumulated enough revenue in the operating account. Whatever money you raise for the operating account fund will be held in this account.

Capital Account

The second main account is the capital account. If you secure an agency loan or other loan that doesn’t include funds to cover renovations, this account will hold the money you raise from investors to cover capital expenditures. When it is time to pay the contractors for their work, they are paid from this account. Also, this is the account that your investors will wire their investment to.

DACA Account

The other main account you may have is a DACA account. If you secure a bridge loan or other loan that does include the funds to cover renovations, the lender may require you to deposit rents into this account before funneling them to your operating account. The purpose of the DACA account is to control (and stop) income to you, the borrower, if you fall into cash management for not passing the DSCR test.

When pursuing an on-market apartment deal, one way to create a more attractive letter of intent is to offer earnest money that “goes hard” (i.e., is nonrefundable) either day 1, after a specific task – like an inspection – completed, or after a certain period of time.

When you are pursuing apartment opportunities worth tens of millions of dollars, the earnest money required will be hundreds of thousands of dollars. So, nonrefundable earnest money can be a risky strategy. If you end up closing on the deal, great. However, if you need to cancel the contract because something unexpected arises during the due diligence period, you will not receive your earnest money back.

Fortunately, you’re reading this “Ask The Expert” blog post, where we asked Ashcroft Capital’s Director of Acquisitions Scott Lebenhart “what specific things should someone do from a due diligence standpoint to be comfortable putting nonrefundable earnest money down from day 1?”

Here is what he said:

“In order to be willing to put up a non-refundable deposit Day 1, our confidence level in the deal needs to be extremely high. We spend a lot of time on due diligence in order to reach this high level of confidence prior to posting the deposit. During the underwriting and bidding process of a deal, a lot of effort is spent to understand the opportunity, evaluate the market, and create the business plan. This entails doing an extensive market analysis, touring competitive properties, and discussing loan options with potential lenders. However, once we are close to being awarded a deal where we know that we will need to put up non-refundable deposits Day 1, we take this diligence to the next level. Our goal at this point is to be as confident as we could be that we will discover no big surprises during our formal due diligence period. In order to do this, we typically perform the following tasks:

1 – Speak with a Contractor

We will have a contractor (or person with a strong capital background) inspect the property in order to confirm our capital assumptions. A seller will rarely allow us to do physical inspections of the property with roofers, electricians, plumbers, etc. until we are under contract because of liability issues, however, there have been cases where we were able to do this. Ideally, we would want to do a full, detailed inspection prior to putting up the non-refundable deposits but that usually is not the case. We therefore request as much documentation as we can so we can understand what work has been done and what needs to be done. Some items that we like to request include work order logs, historical capex budgets, and future budgets.

2 – Speak with Property Management Company

We have detailed conversations with our management company in order to ensure that they are in agreement of our business plan and assumptions on income and expenses.

3 – Speak with Lenders

We have more detailed conversations with potential lenders including sharing our proforma and capital budget with them to ensure that we will be able to achieve our projected loan.

4 – Speak with Consultants

We engage our tax and insurance consultants to confirm our assumptions.

5 – Speak with Attorney

We discuss any items of concern with our attorneys relating the zoning, title, or any other matters.

During the course of our formal due diligence, we always find a few unforeseen items but we work to make sure the impact of these findings are minimal. In order to avoid something from affecting the projected returns of a deal, we create conservative assumptions that can withstand the potential findings. In our capital assumptions we will always have a “miscellaneous” or “contingency” bucket of money to account for anything we discover and we leave cushion on our income and expense assumptions. When we need to put up a non-refundable deposit, our overall goal is to limit the number of surprises.”

In regards to point number 1, Scott says “If the management company has a person dedicated to capital, I would recommend having them do a visual inspection of the property. If not, or if you want to add another layer of diligence, we typically have a contractor walk the property. A contractor will typically be able to give you more accurate pricing on any capital needs.”

In regards to point number 5, Scott says, “When we put up non-refundable deposits, they are always subject to receiving clean title and a clean environmental report. This is generally a market standard so I would fight for this in any agreement. That being said, a title search is very easy to get so we usually do request an updated title report prior to submitting our deposit to make sure there is nothing alarming that we would find out anyway. No need to waste time and money if there is a title defect that can’t be cured.”

Overall, when you need or want to put up nonrefundable earnest money, the goal is to limit the number of surprises that come up during the due diligence period. To do so, understand the current state of the property in as much detail as possible, confirm your business plan and underwriting assumptions with your expert property management company, confirm your debt assumptions with your lender, confirm you tax and insurance assumptions with tax and insurance consultants, and address any legal issues with your attorney prior to submitting a letter of intent.

“Ask The Expert” is back, where experienced real estate and apartment professionals answer your specific questions about real estate investing strategies.

If you have a question you would like to ask a real estate expert, let us know in the comments section below.

Make sure you check out our other “Ask The Expert” blog posts here, which cover fixed rate vs. interest-only loans, interest-only vs. paying down the principal, and when to stop underwriting a deal.

This week’s question is about the fees paid to a property manager for managing your value-add renovations and ongoing management of your asset.

The vast majority of multifamily investors either hire a third-party company to manage the day-to-day operations of their apartment deals or they have an in-house property management arm in their company. The exception would be investors who pursue smaller multifamily deals (under 50 units), in which case they may decide to be owner-operators (i.e., own and manage the deal themselves).

For this particular post, we are going to focus on large multifamily investors (200+ unit projects) who hire third-party property management companies to manage their deals.

That said, the questions we asked the expert are: (1) Do property management companies charge extra fees to oversee the capital improvements and, if so, what are the typical fees, and (2) what is the typical fee for managing 200+ unit apartment deals?

The expert we asked these questions to was Scott Lebenhart, who is the Director of Acquisitions at Ashcroft Capital, and here is what he said:

(1) Construction Management Fees

Yes. If you are implementing capital improvements after acquisitions, property management companies will typically manage the entire process. In return for their efforts, they will charge a construction management fee.

Construction management fees are typically on a sliding scale. As the project costs increase, the construction management fees decrease. For example, a fee structure could be:

Total Construction Cost Less Than $25,000: 0%

Total Construction Cost Between $25,000 and $100,000: 5%

Total Construction Cost Between $100,000 and $250,000: 4%

Total Construction Cost Greater Than $250,000: 3%

The fees will be a percentage of the total construction costs. For this fee structure example, if your total capital expenditure costs are $150,000, your property management company will charge $6,000 to manage the projects.

(2) Property Management Fees

For 200+ apartments, the typical property management fee is 3% of the total collected income.

Closing Thoughts

Before hiring a property management company, you’ll want to determine whether they will manage your capital expenditure projects and, if so, what are the costs. If you plan on performing any level of renovations on your deals, I would strongly advise that you hire a property management company who provides the construction management services. The construction cost ranges and fees will vary from manager-to-manager and market-to-market, so make sure you know the costs upfront so that you can account for them when underwriting deals.

Same goes for the ongoing property management fee. 3% is typical, but they may charge a higher (or even lower) fee. Not only do you want to know what the fee is but also what is included in that fee. Some property management companies will charge 3% with all services included whereas others might charge additional fees for new leases, turnover, etc.

Would you like to Ask the Expert a question? Let us know in the comment section below! 

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“Ask the Expert” are quick hitting blog posts where an experienced real estate professional answers your questions. If you have a specific question you want answered by an expert, let us know in the comments section below.

Today’s question is about interest-only payments.

As the name implies, when an investor secures a loan with interest-only payments, the monthly debt service is equal to the interest on the principal loan amount. For example, on a $10 million loan at an interest rate of 5% amortized over 30 years, the interest-only payment is $41,666.67. Whereas the debt service on a non-interest-only loan would be $54,486.03 (principal + interest).

The question is: is paying down the principal (i.e., monthly debt service equal to principal plus interest) a more conservative approach than only paying the interest on the principal, especially in the case of a market correction?

We asked this question to Scott Lebenhart, the Director of Acquisitions at Ashcroft Capital, and here is what he said:

“It’s not that it’s more conservative one way or another, however, for an investment, it is usually the preference to get cash back sooner than later. The time value of the additional cash flow received throughout the hold helps increase returns rather than receiving a larger distribution at the sale. Additionally, in the event that there is a catastrophic macro level event where a property loses significant value and [the investor is] unable to pay back the loan when it becomes due, it would be more impactful … to have received the additional cash flow along the way.”

Back to our $10 million loan example – the difference between the interest-only payment and the principal plus interest payment is $12,819.36. Technically, all payments above the interest payment decreases the loan balance. So, rather than receiving that additional payment during the business plan, you will receive it at sale.  Due to the time value of money, that $12,819.36 is worth more now than it would be worth in the future (say once the property is sold in 5 years). In the event of a massive reduction in property value, you’ll be happier if you were able to receive those additional cash flow payments, especially if the value of the property is lower than the loan balance that you would have otherwise paid down.

Would you like to Ask the Expert a question? Let us know in the comment section below!

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.