JF1048: Focusing on Lenders to Make MORE MONEY!! #SkillSetSunday With Steve O’Brien
Today we focus on changing our mindset and not jumping at the first lender that says yes. In today’s marketplace there are a lot of options for lending, so why not shop around before agreeing to financing? Often times we do ourselves a disservice by not shopping around more, find out how to change that today. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Steve O’Brien Real Estate Background:
-Co-founder and Chief Investment Officer of Arcan Capital
-Responsible for acquisition of over 20 multifamily assets totaling close to $200 million in the last five years
-Placed nearly $100 million in financing with FMNA, FMAC, HUD, bank and insurance company sources
-Prior to Arcan, Mr. O’Brien was with CBRE
-Based in Atlanta, Georgia
-Say hi to him at www.arcancapital.com
-Best Ever Book: Outliers by Malcolm Gladwell
Click here for a summary of Steve’s Best Ever advice: Pay Attention to These Five Loan Components to Maximize Your Apartment Returns
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Joe Fairless: Best Ever listeners, welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any fluff.
I hope you’re having a best ever weekend. Because it is Sunday, we’ve got a special segment for you called Skillset Sunday. You know what this is – we’re going to help you hone an existing skill or adopt a new skill that is valuable for you.
I was talking to today’s best ever guest about this before we started recording, and he said “You know, we focus so much on getting the equity, but then we go with the first loan that we get offered.” So we focus so much on getting equity for our deals, the cash for our deals to close, but then we don’t focus as much on selecting the right lender, when in reality the lending dollars are just as important. I thought that was such a good tip, and that’s what we’re gonna focus on today – the lenders, specifically for multifamily investing. How are you doing, Steve O’Brien?
Steve O’Brien: I’m doing great, thanks for having me.
Joe Fairless: Nice to have you back on the show. A little bit about Steve, just as a refresher. He is the co-founder and chief investment officer or Arcan Capital. He’s responsible for the acquisition of over 20 multifamily assets totaling close to 200 million bucks in the last five years. He’s placed nearly 100 million in financing via different sources, and prior to Arcan Capital he was with CBRE.
With that being said, Steve, do you wanna briefly mention your background and then we’ll focus our conversation on lending?
Steve O’Brien: Absolutely. My background actually plays into that pretty well because the first job I got in real estate was for the debt and equity finance team at CBRE. I came in as a young analyst and got to watch a ton of deals, do a bunch of different underwritings, build a lot of models in Excel… And I think one of the advantages of being at a broker shop like that is to see the number of deals that you get to see. I got a great exposure to those.
Then I also got to watch first-hand as the market crashed, because when I first got into real estate – I don’t wanna say “Nothing’s ever easy”, but for a while everybody was doing really well, and it felt like pretty simple business. Then you had 2008, 2009 and 2010, so I got to learn a ton; it certainly wasn’t a fun time, but it was definitely one of the biggest learning experiences of my career.
I since have launched Arcan Capital, where we acquire multifamily in secondary and tertiary markets in the Southeast. That includes putting a bunch of loans on multifamily assets and other types of assets, as well.
Joe Fairless: Speaking of those loans, how should we approach our conversation so that we give the Best Ever listeners information that they need to get better at finding the right debt partner for their deals?
Steve O’Brien: Well, I think you have to start off by just changing the mindset a little bit from the beginning. We meet with a lot of people who are struggling to find equity and they’re looking for friends and family or whatever it may be (a partner) to help them, and ultimately you ask about their debt strategy and they say “Oh, a bank”, or “We’re gonna go the agency way.” To me a dollar is a dollar; whether you’re raising on your equity, you’ll spend a ton of time working with an equity partner to make sure it’s the right fit, but you’ll take the first dollar offered from the bank, and the main thing that I hear people complain about is interest rates. That’s like “Oh, I’m gonna get a great interest rate on this” [unintelligible [00:05:49].19] but there are a lot of different parts of a loan, and a lot of different parts of the lender that it’s worth paying attention to, but you also have to weigh that against a lender to give you money, and sometimes you’ve gotta do what you’ve gotta do to get the deal done if you believe in it, but most of the time, especially in a market like we’re in today, there are a lot of options for people, and I think it’s prudent for investors to spend as much time on their loan as they do their equity. I normally don’t see that, and that’s pretty surprising, considering, as I’ve said before to folks – when push comes to shove, the lender’s in control.
Joe Fairless: Yes.
Steve O’Brien: They make sure in any documents that you sign – if you read closely enough, there’s something that allows them to make decisions, from your property manager to the money that you spend. Now, most of the time, if things are going as planned, they won’t enforce their rights to do and make those decisions, but they are often in control, and in the multifamily business you see a lot of loans that are above 50% leverage. So not only are they typically in control, but they’re putting more money in the deal than you are. That gives them a certain level of control.
Joe Fairless: Let’s talk about the different parts of the loan and of a lender, and obviously, we’ll need to start with one or the other. Let’s do the loan first – what are the different components of a loan that we need to be paying attention to?
Steve O’Brien: I think there are probably several basic concepts at the top that all come together to form your loan. One that everybody knows and pays attention to is the interest rate, and the other is the loan-to-value of the proceeds. Those are the two most important that everyone focuses on, because it basically determines what your costs are gonna be, what is the debt service and how much money you’re gonna need from an equity standpoint based on what amount they’re willing to lend you. But particularly with banks – and I think you’ll find most banks these days, given what happened in 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.
Now, what the advantage is with a lot of lenders is that they offer nonrecourse loans. I can say that 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 only technically lose your equity in the deal.
One of the things that happened during the crash was a ton of people put up recourse and all their loans went bad, and it caused bankruptcies and other issues, because 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. So we pay attention to little items like that.
Term is another. If you’re dealing with banks, a lot of banks will wanna do a 35-month loan, or a 36, or up to five years with extensions, but there are a lot of debt options out there that if you think you’re gonna own something forever, especially with where today’s [unintelligible [00:08:54].01] compared to historically, it may make a lot of sense for you to pay a higher interest rate, but to lock it in for 15 years, if it’s a property that you love.
So there are a lot of little items like that, recourse probably being the most important, because that’s where it can come back to sting you. With nonrecourse loans, you will have to sign something that says you’re not going to commit to fraud – they call them bad boy carve outs – but in general there are a lot of options for multifamily investing in particular that do not require a recourse, and as long as you stay at a reasonable loan-to-value. But you can get a nice, healthy 75% loan and still remain nonrecourse.
In fact, if you go low enough on the loan-to-value on some multifamily deals, you don’t have to sign any recourse at all personally, meaning that the entity is the one who guarantees the loan, or the lender will want to make the loan enough that they’ll basically say “Listen, it’s just worst-case-scenario we can’t even come after you for the bad boy carve outs”, and that’s just like any other business – it’s the competitive nature of the market right now; there’s a lot of money looking to invest, and that includes on the lending side, too. That brings us back to doing the diligence and checking all of the different options that you have available.
Joe Fairless: One thing we’ve done is we’ve kept how high the interest rate can go by purchasing that cap. Have you done anything like that?
Steve O’Brien: Yeah, the interest rate caps – they can be a really good idea, too. Some of the lenders on a bridge loan – bridge loan would be typically a three-year type loan and you may have some extensions built into it, but those are typically done on our value-add properties, which is the majority of what we do. You’ll get in and you’ll do a lot of work and you hope you increase the value, so that within the 2-3 year loan term you can refinance after you do the work to the property.
A lot of times, those bridge lenders will require you to buy a cap because of their rate floats; they don’t wanna put you in a situation where the rate goes up by 100 basis points and you don’t have any protection as an owner, so a lot of times they’ll make you buy those caps. It’s like any other investment – there’s a secondary market for it, so there can be value in owning an interest rate cap, too.
Joe Fairless: Anything else as it relates to what we look for in loans that you wanna mention? We’re gonna switch over to lenders after this, but I just wanted to talk about loans in particular, like the terms or anything else we need to be aware of? Maybe carve outs or clauses to watch out for?
Steve O’Brien: The key thing is there will always be a section with regards to carve outs as far as almost every loan has a nonrecourse on it somewhere, and then they’ll carve out what’s included in that nonrecourse, and you just have to read it really closely. When I say “you”, I really mean your lawyer. You should have someone who is experienced in this do it for you. It is money well spent to have someone take a closer look at these documents and just make sure that there’s nothing unique about it.
Some lenders have very standardized documents and some documents will do just like anyone buying a piece of property with a contract; they’ll try and slip something in and see if they can get it, even if it’s not market. It’s great to have someone with experience review it for you.
I think one of the other things that I missed earlier is probably with regards to pre-payment flexibility. We have some properties where we’ve done I think a seven and a ten-year loan and we created an enormous amount of value, and because we created a lot of value in the property, the loan that was originally a 70% loan is now a 50% loan. Our option is to go get a supplemental, but the supplemental loan from the agency – they’ll add proceeds to your current debt, but that’s at today’s interest rate, not the previous one. So you think about selling the property, but if you sell it, you have a huge pre-payment penalty, yield maintenance or defeasance… Defeasance typically with the CMBS loans, but yield maintenance where they’re basically going to make you buy an instrument to pay them back the interest that you would have owed them over the next few years. So you’re talking, as opposed to paying them a 1% or a 2% fee, it needs to be a 10% fee to get out of your property.
Ultimately, that’s a decent problem to have, because it probably means that you’re doing well, but it just limits your flexibility. So as I mentioned before, you can always go to an equity partner and say “Hey, we’ve created a lot of value, let’s sell” and your equity partner can say “Okay, let me go get approval” or “Okay, that sounds great. Let’s do it”, but you can’t go back to your lender and say “Hey, we created a lot of value. We’re gonna go ahead and sell”, because the lender is gonna point back to the documents and say “You told me this is was a three-year loan; if you pre-pay it, there’s a penalty.”
Now, that’s an advantage of bank debt, but typically you can’t get a loan that does everything. The longer-term loans are gonna have pre-payment penalties. The shorter term loans aren’t going to have that length in term, so you get to the end of three years and you wish you could refinance it at that rate, but the rates have changed, so you’ve gotta pay a different rate. So it’s worth thinking about where you think the market is going.
For the last seven years, everyone has said interest rates are gonna go up, and almost every year they go up just a little bit, but I think everyone would agree that was all the economists and every real estate person talking in 2010 or 2011, the vast majority would agree that we all thought rates would be much higher than they are today. Now, it looks like they’re gonna go up now, but it felt like that 2-3 years ago too, so you never know.
Joe Fairless: How would you prioritize these items when you’re looking at loans?
Steve O’Brien: I think it’s on a deal-by-deal basis. A lot of our equity partners need certain things… Whether that’s a particular return or that’s a particular amount of money that they like to invest, it kind of all balances out. Some people like to have a big chunk of cash in a deal, and they understand that if you’re going to get a 60% loan on a multifamily deal, your return is going to be lower than if you have an 80% loan-to-value on the property. It’s also a lot less risky, so I think you have to work it all out and determine your preferences.
Like I said, if you know you’re gonna own a property forever and you love it, I don’t see any reason to put short-term debt on it, unless the benefits so far outweigh the risk of having to refinance in three years at much higher rates. Now, the other hard part is I know there aren’t many investors that know they wanna own something for 20 years, or even 10 years. Most people are making judgments based on a 3-5, maybe on a 7 year horizon, so locking you in for 10 years feels like a long time… But I think you’ve gotta 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 wanna 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 wanna 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.
Joe Fairless: Let’s talk about lenders. I know this could be an hour long conversation and we have about six minutes, so let’s talk about lenders… What types of lenders are there and how should we think about that?
Steve O’Brien: I think you can silo a lot of them into different groups. You have your banks – typically your local, regional, even national banks are going to do shorter term; they’re gonna prefer floating rate debt, meaning that as interest rates change, your debt will change and your cost to borrow will change, and that’s something that in my opinion has always made me nervous. Even though you did floating rate loans previously (in the last 5-7 years) you flipped really good, because rates have stayed low.
I think banks are a little bit easier to deal with in that they have some very straightforward regulations that they need to achieve, and they can tell you “Hey, here’s what we’re gonna need – we need X and Y and Z”, and they’re similar to agencies in that regard… But there’s going to be a recourse issue with the banks.
Most banks that you talk to, they’re going to want amortization and they’re going to want recourse. They’re always gonna push you towards amortizing a loan instead of having interest-only, and they’re going to push you towards having some level of recourse, even if they just wanna get 25% recourse on the loan. But in general, it’s a little bit more of a relationship lending type environment with the bank. You can form a relationship with a lender that’s in your neighborhood, that’s at a regional bank, and you can talk to them about what you’re doing and develop a good rapport with them so that they understand the type of projects you’re working on and willing to lend.
But that’s also possible with an agency lender. Fannie Mae, Freddie Mac – they are also very standardized; it’s an advantage, like the banks… But they are so standardized that it can sometimes be difficult, because everything’s gotta fit in the box. If you just look all around for multifamily lending, I’d say Fannie Mae and Freddie Mac are the best options as far as the best terms, the most flexibility, and it’s largely because at this point — I guess you can’t even call them quasi-government agencies anymore; they are government agencies and their goal is to create liquidity in the housing markets. They are out there trying to lend money on deals. They’re looking for ways to do deals, and especially in 2010-2012 when people were a little nervous, agencies were very helpful because they got on board early, because it’s part of their directives to make those kinds of loans.
Joe Fairless: I guess the same question that I asked earlier with the loans, but now for the lenders, and you’re probably gonna give the same answer – “It depends on the deal and your source of equity” – but how do you determine which lender to go with, matching up that lender with the project?
Steve O’Brien: Well, I think there are certain deals that certain lenders prefer, and that’s why, like I said, it is deal-by-deal, it is project-by-project, but even your local — you’ll probably find differences between a life insurance company (insurance companies are another lender that I didn’t mention previously)… You will definitely find differences in preference between different life insurance companies. Some may love being in a major urban area, and some may be a little nervous because of all the construction that’s gone on in major urban areas in the last few years. They may like the secondary and tertiary markets.
So a lot of this is spending, like I said, the same amount of time looking at your lenders as you do your equity partners. Frequently, there are a lot of mortgage brokers out there that can really help if you use the mortgage broker a lot, because they know of the hundred different sources of capital out there, and they’re professionals at what they do.
Their professionals that when you give them a deal or they send a deal to the lender, they’re gonna tell you “Hey, these are the five guys that probably like this. These are the five underwriters and the five companies that this makes sense for”, but they look at deals very similarly to the way lenders do. The only difference is if we do really well on a deal, the owners can get massive IRRs, but no matter what, the best a lender can do is get their interest rate. So they’re definitely safer, and they’re gonna check probably more boxes than you are, because their return is capped, and kind of an all-or-nothing for the lender. They’re very specific about what they like, and that’s why I think Fannie Mae, Freddie Mac and the agencies can be a great option, because they are a little bit more flexible and they do have some directive to make sure that there’s liquidity in these markets, whereas an insurance company is only gonna lend you money, and a bank is only gonna lend you money if they think they’re gonna get their interest back, period. I mean, that’s really all they’re looking at.
Now, Fannie Mac and Freddie Mac looks at it the same way, but they also have a job to do, to get money out the door.
Joe Fairless: When do you use a mortgage broker?
Steve O’Brien: We use a mortgage broker most of the time just because on the size of our deals it’s an enormous amount of work, and talking to an equity partner and talking to a lender can be very different experiences. There’s kind of a running joke amongst lenders – if you talk to enough underwriters, you just basically take the person who sent you the numbers and cut everything by 10%, because everybody’s over-aggressive. So when you’re presenting things to a lender, we like to use a mortgage broker frequently, so that they can help us look at things through the lender lens.
At our core we’re entrepreneurs; every deal that I’ve done, I’ve loved… So you wouldn’t do it, you wouldn’t put your own money and put so much work in it if you didn’t love it, but there are gonna be people who disagree with you, and if you present a really myopic view of the deal to your lender without doing the background and without doing the research, and if you could dial the numbers back a little bit and make the lender think you’re conservative and they’ll still give you every nickel that you wanted, that’s a good approach to take.
The mortgage brokers can really help you with that and just gathering all the data; I can’t tell you how many times you’ll be in a conversation or in a room with a lender, discussing a deal, and you say one more thing than you should have said, and the lender takes it the wrong way… Maybe you mentioned something about the demographics where you say “The average income in this area is this” and then you mention the median income is a little bit lower, and they dig in on “Well, why is the median so much lower than the average? What does that mean in the market?” and they were sold until you mentioned the median number.
So it’s great to have someone guiding you and helping you say the correct things and provide the correct numbers, and only what you need and nothing more, because I’ve seen lenders turn down deals for crazy reasons that don’t seem to make sense, from parking — they think it has two parking spaces too few, so they won’t do your deal. And that really hurts, when you get that far down the road and you lose it because of two parking spaces. So getting all that information together and making sure you have someone there to help check all those boxes is very helpful.
Joe Fairless: Anything else — and I know this could be a day-long conversation, but as it relates to the topic of identifying the right loan and the right lender… Anything that we haven’t discussed, within the amount of time that we could discuss, that you wanna mention before we sign off?
Steve O’Brien: No, I think we got to just about everything. I think the big key to take away for the Best Ever listeners is if they’re not viewing loans similar to equity, maybe to kind of turn that a little bit and start spending as much time looking through the loans and understanding exactly where they are with regards to their loan agreements and exactly what they’re trying to accomplish with the deal, and seeing if they can find someone that matches up perfectly with their deal. That’s a great way to look at it, because not all loans are created equal, and there’s a lot of people out there right now interested in lending, particularly to multifamily.
Joe Fairless: Phenomenal conversation. Thank you for being on the show again. Best Ever listeners, if you didn’t hear the first episode with Steve, where he gave his best ever advice, it’s episode 940. You can go listen to episode 940 and you can hear him talk a little bit more about his company and his focus and acquisitions and all that good stuff.
Thanks again, Steve, for being on the show, talking about how to identify the right loan, how do we prioritize those different components within the loan, the players within the lender space and the pros and cons or strengths and weaknesses of those. I hope you have a Best Ever weekend, my friend, and we’ll talk to you soon.
Steve O’Brien: Thank you!
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