Pay Attention to These Five Loan Components to Maximize Your Apartment Returns
Multifamily syndicators focus so much on getting equity for current or future deals,
but then they go with the first bank that offers them a loan, especially on the first few deals. In reality, the type of loan we put on the apartment is just as important as raising equity for the deal.
Large commercial loans are not the same as the cookie-cutter residential loans. There are a multitude of options when it comes to commercial financing. When you are dealing with multimillion dollar loans, the difference between two loans can have a huge effect on the cash flow and fees at sale.
Steve O’Brien, an investment officer who was responsible for the acquisition of over 20 multifamily assets totaling close to $200 million in the last five years, understands the different components of the loan and how they can affect an investor’s bottom-line. In our recent conversation, he outlined the five components of the apartment loans multifamily syndicators need to be paying attention to prior to selecting a loan.
1 & 2 – Interest Rate and Loan-to-Value
The two loan components that even the first-time syndicator is aware of are the interest rate and the loan-to-value. “Those are the two most important that everyone focuses on,” Steve said. “It basically determines what your costs are going to be, what is the debt service and how much money you’re going to need from an equity standpoint based on what amount they’re willing to lend you.”
3 – Recourse
While those first two components are relevant to residential loans as well, this next component is not – recourse vs. nonrecourse loans. Steve said, “with most banks these days, given the crash, they want recourse. What I mean when I say recourse is that they want you to guarantee some or at least a portion of the loan that you’re getting personally.” However, a lot of lenders will offer nonrecourse loans as well. Steve said, “on our entire portfolio that we’ve done of about $100 million in financing, we have not signed any recourse, meaning that if the deals were to go bad, the most the lender could do is come after you for the property itself, so you can technically lose your equity in the deal.”
Of all the loan components, recourse is the most important because it can come back to bite you bigtime. In fact, this is one of the things that happened with the real estate crash in the late 2000s. “A ton of people put up recourse and all their loans went bad, and it caused bankruptcies and other issues,” Steve explained. “Not all the lenders will do all the math on all the recourse you have. So you may have guaranteed 150% of your assets, and if everybody comes calling them at the same time, that can be a real problem.”
With a nonrecourse loan, you are personally protected as long as you don’t commit fraud (they are called “bad-boy carve outs”).
Steve said, “In general there are a lot of options for multifamily investing in particular that do not require recourse, and as long as you stay at a reasonable loan-to-value, you can get a nice healthy 75% loan and still remain recourse.” And if you go low enough on the loan-to-value ratio, depending on the lender, you can avoid the bad-bay carve outs too.
4 – Terms
Another component of the apartment loan to pay attention to are the loan terms. “A lot of banks will want to do a 35-month loan, or a 36, or up to five years with extensions,” Steve said. Your ideal loan terms will depend on your business plan. For example, if you plan on a long-term hold, especially with the historically low interest rates, it may make sense to pay a high interest rate and lock in a 15-year loan. If your business plan is to add value and refinance, a three-year bridge loan may be the best option for you.
5 – Prepayment Penalty
A final component of the multifamily loan to pay attention to is the pre-payment clause. If your loan has a pre-payment penalty and you want to sell early, you will have to pay the lender a large fee. Another form of a pre-payment penalty that may be triggered at sale is yield maintenance, meaning the bank will make you buy an instrument to pay them back the interest rate that you would have owed them if you completed the loan.
However, Steve said, “ultimately, that’s a decent problem to have because it probably means that you’re doing well, but it just limits your flexibility.”
Best Ever Loan Advice
Steve’s Best Ever advice for how to approach these five components is “You’ve got to pay attention to your goals. Is your goal to buy and improve a property and then flip it? Well, then don’t put long-term debt on it. If your goal is to buy a property and hold it forever, well then you may want to consider not doing a three-year bank loan with two one-year extensions and going to a longer-term lender that will do a balance sheet loan for you, like a life insurance company or an agency (Fannie Mae, Freddie Mac, something like that) in order to lock your returns in for the long-term, because it’s a nice, warm blanket to have a low interest rate that you know doesn’t mature for 10 years, unless you want to sell it, and then you’ve got a pre-payment penalty. So it’s all very determined based on your goals, and I think that’s what the key is – to set your strategy and your goals for the asset and try and find debt and equity that best mirrors your strategy and goals.”
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