Host- Trey Stone
Co-Host- Bobby Duncan
Topic- Mysteries of Financing and Refinancing Solved
Financing & Refinancing Explained
This is a very timely issue because properties are in some cases being sold at a big discount compared to what they would have sold for 6-8 months ago because of the volatility in the market. Factors include obviously Covid-19, the stock market, and even the oil and gas industry in Houston.
For property owners who built their properties, they had construction financing that was really aggressive because the market had been doing so well for so long. Construction loans are usually short term loans. When you do a home loan when you build your own house it’s formatted like two separate loans:
- There’s a construction loan where they don’t give you all the money at one time. You have to do a series of draws and they disperse the money to you a little bit at a time. Each time that you’re ready for another draw, they inspect the work that you’ve done so far and you have to submit some of the paid invoices, etc so they can see that you’ve completed that much of the construction.
- When your construction is completed, you make a final draw and transition into a traditional mortgage loan- for example, a 30-year fixed mortgage loan.
Construction loans are considered riskier because there is not a finished product already done. If you don’t make payments on a traditional loan, your lender can foreclose the property and sell it to someone else. With a construction loan, they can’t do that with a partially built house. Because of that, the interest rate is usually higher and there are these two stages. There are some loans where people do one up-front closing for both the temporary loan and the permanent loan for the house but this is just to streamline the process/ make it more convenient. Even if you close on both at once, you still essentially have two notes.
This type of loan format works the same way with apartment complexes. Lenders don’t give you 20 million dollars, up front in cash. You have to make a series of draws and they’ll want to know how long it will take you to complete the construction and be able to bring in residents. They’ll give you a loan term, for example, of no more than 3 years so you would have a year to build it, get it leased and then you have time where you can show how much money the property is going to bring in. From there you get your permanent loan and that might be a 5, 10, 20 year term etc. At that point you have an improved, rentable piece of property rather than a vacant piece of land that you have to build.
The Current Market
The inability to obtain a refinance to get a new loan in this market is forcing owners to sell properties at discounts.
Recently, Trey went to visit a property that was selling for about $20,000 per unit less than they had built it for in 2015 because they had really aggressive financing on their construction loan. They had a 3 year construction loan that they extended for 2 more years. Now, they are 5 years into this high-interest construction loan and the bank is done extending it. This put them in a position where they have to sell it for whatever they can get just so they won’t lose it in foreclosure. If they went to foreclosure, they would lose the equity in the property. If they signed as a recourse signer on that debt they would actually lose other money that they have, even if it wasn’t part of that deal. This happens when property owners owe the bank more than what the bank is able to auction it for at a foreclosure auction.
Financing Investment Properties
The key to not end up in the scenario above is to get in front of it. When Trey first got involved in the apartment business, he did heavy financing in his deals. If everything goes according to plan and goes well, the more financing you get, the smaller your down payment.
For example- if you’re planning to make a million dollar capital gain from a property because you buy an apartment complex with your partners and you plan to rent it out then sell it. This capital gain is possible because your net of what you paid on your down payment and your rehab budget, versus what you sell it for, should allow you to get a million dollars from that sale. Going into that deal, if you put down a million dollars to make that million dollars, you would have made a 100% return on your money. If you finance it so you only put $500,000 down, you’ll pay more interest but your capital gain is still a million dollars. In that instance your cash flow is just less. Your capital gain is now a million dollars on only a $500,000 down payment so your return is 200% on your money. This is the reason people get overly aggressive with debt and they borrow more than they should when they buy these properties.
As an experienced investor, when Trey makes his deals, he does the opposite of the aggressive financing scenario because he made that mistake in the beginning of his career and got through the great recession by the skin of his teeth, without any foreclosures or losing properties. Part of the secret of having a successful refinance even in a down market like we have now is not to over leverage the property in the first place.
Leverage is the term used to talk about how much debt you have against a property. So if you have a $100,000 house and a $90,000 loan then you have a 90% leverage loan instead.
“It’s called investing because you’re supposed to actually invest money”
Trey’s Refinancing Experience
Over the years investing in real estate Trey has done about 60-70 different loans for various apartment complexes. The total of that is in the range of $600,000,000 to $700,000,000 because he adds value to a lot of these properties with his partners by upgrading them. It causes the value of the property to go up. Sometimes they want to continue owning that property but they want to access some of that cash from the appreciation of the value. To do that, they’ll refinance that property.
For example, when Trey and his partners first buy a property they might have a short-term bridge loan for a property that’s in distress. You typically have to put down a bigger down payment and a bigger interest rate with a bridge loan because maybe the property is not making as much money as it should based on comparable properties because it’s run down or mis-managed, etc. Trey and his partners will then refinance the property into a permanent loan and sometimes refinance again to take some cash out and use it to buy another multi-family investment.
Another example is a property that Trey has owned for a long time. Apartment loans are usually around 5 years so in this property that Trey’s had for about 14 years, he’s been through multiple loans. When he first bought it, he had a Fannie Mae loan with a 10 year loan term. Now he has a CMBS loan or a Commercial Mortgage Backed Security loan- for a little over 20 million dollars. The value of the property today is closer to 50 million dollars. As a result when this loan term runs down (because he has no intention of selling the property), Trey will refinance it again. He’ll take some of the money to invest in new properties and still have a lot of equity left in the property. The value of these properties goes up from the improvements but also as you own them over time because of compound interest.
Trey’s Advice on Refinancing
If someone is in a deal like Trey’s previous examples where you’ve done Fannie Mae, Freddie Mac, HUD loans, CMBS loans and you’re looking for your next refinance, you should not go to the bank. You need a mortgage professional.
For example, Trey has worked with Michael Thompson from CBRE and David Schwartz from NGKF. Trey recommends this approach because they will take your loan application and they’re going to send it out to 5 to 10 to 25 different lenders to get you quotes from lenders they know who are looking for those types of properties. Trey has owned a shopping mall with a Macy’s, Sears, Food Court in Pasadena; he’s owned several hundred million dollars in apartment complexes; he’s also owned quite a few single family homes. Those are all totally different product types and lenders who are not looking for one of those may be looking for another. If you get a mortgage broker from a big firm, they’ll come back with a matrix and a spreadsheet that shows the bids, the top 3, and the summary of why they’re the best.
Trey also warns to never do a refinance in a market like this one and let them do it based on an “as-is” appraisal. That means the lender is saying how much the property is worth right now based on a trail of historical financial statements. If you’re going to refinance in a down market, you cannot overdo it and try to get a high evaluation because they might use a much lower value when they decide how to give a loan they’re going to give you.
The higher the value comes in, the easier it will be to pass those hurdles to get your loan closed. A great way to do that is to get an appraisal based on an “as-stabilized” value. The difference is an as-stabilized appraisal is using your proforma of what the net-operating income for the property will be in the future. That gives you a little bit of room to maneuver.
For example, let’s say we look at a property where you will do upgrades- new appliances, flooring, counters, cabinets, lighting, hardware.
- -You will spend a million dollars on the upgrades
- -You look at your increase in value
- -an apartment was renting for $800 before and now it’s $950 so it’s a $150 increase
- -You multiply the added value x the number of units
- $150 x 264 units = $39,600
- -Multiply that by 12
- $475,200/year in added value if the property was completely full
- -Estimate on 90% occupancy
- $475,200 x .9 = $427,680 in added value to the property, realistically
If you take that net-operating income, the profit of the property with the additional $427,680 per year and divide it by a CAP rate of 5, that means that the value has increased by over 8.5 million. This is the formula the bank uses for an appraisal.
The bank will make you escrow a million dollars to know that you have the money to make the improvements but borrowing an extra million dollars so that they’ll appraise it for 8.5 million dollars more than what they would have appraised it for is a good investment. You’ll also get a higher loan amount which might be what you need to pull off a refinance in a down market.
If you’re looking at the current interest rates, they’re really low right now. What you want to do is take a loan with a higher interest rate that doesn’t have a penalty if you pay the loan off early. Those are called prepay penalties. Sometimes your savings on a refinance ends up being so much more than the interest expense on a new loan that paying the early penalty to your old lender is worth it. It’s always better to access equity on a property when the interest rates are low.
The time is now to invest while there are low interest rates and deep discounts on properties. It’s the time to buy in and have the courage to invest when the market is down.
“Each of us only have so many business cycles of buying low and selling high before the end of our career.” Trey Stone