Call it leverage, call it a mortgage, or call it a liability; debt is a key tool used in the majority of any real estate investments. We call it a beautiful thing–and one of the things we like most about investing in real estate. The ability to create and use leverage to your advantage attracts investors near and far to the real estate space.
Especially in today’s market, the use of leverage as a tool has never been more important. With the 10-year treasury hitting 2-year lows and dipping below 2%, and LIBOR falling (and on the precipice of being replaced as the standard measuring stick) it’s an important time to understand and evaluate your different debt options when considering investment decisions.
At Wildhorn Capital, we understand debt to be a critical piece of the equation when underwriting deals, as the debt product you use can define (and often drive) your business plan on an asset. You need the right tool for the job. We have experience with three different types of loan products–each a different tool used for a specific purpose. All of the debt we secure is non-recourse, meaning the lender can’t pursue collection on anything other than the property in question as collateral (as long as we don’t violate the “Bad Boy Carveouts”). To date, we have executed loans with Freddie Mac (Agency Debt), a big Regional Bank that focused on Multifamily assets, and a large Bridge lender. Because the debt product you choose is so important to your business plan, in today’s article we want to highlight the factors we think about when evaluating which option is best.
Our goal here is to highlight the elements we think about in order to educate investors and allow them to ask smart questions of their operating partners as they consider future investments.
- Duration of Business Plan.
Are you looking long-term or short-term? In this context, I would define short term as anything less than 5 years. If the business plan is short-term in nature, then you want to be thinking about how to maximize your exit scenarios, and be able to get out of the loan as cheaply as possible. You’d want to find things like low or no pre-payment penalties and would likely be best served to forego some loan proceeds and take on a higher rate if it allows you to get out of the loan quicker. Assuming you were short-term focused, then generally you want to look at Bridge or Bank-style debt, as those typically have 2-3 year terms before you need to sell or refinance. If you really prefer the Agency debt products, then you want to look for a floating interest rate as that will have the least expensive breakage fee when you go to sell in just a couple years.
If, like us, you are more long-term in your approach (5-10 years) then you will likely be looking for loan products that have 7-, 10- or even 15-year terms. These will usually be the Agency products from Freddie Mac and Fannie Mae, and you might even consider a HUD loan with a fixed rate for 35 years. With these products you can choose to have a floating interest rate or a fixed rate (see below) and offer very favorable terms.
- Fixed or Floating Interest Rate.
This is certainly a hot topic right now, as interest rates have come down over 100bps from where they were just last December, after they had steadily risen over the previous 12-18 months. Why would anyone choose a Floating Interest rate you might ask? Well, over the last two years if you had a floating rate you would have paid less in interest than if you had locked in a fixed rate at a certain point.
With a floating rate you can ride the market up and down. For us, the great benefit of a floating rate is the exit optionality (mentioned above)–with a floating rate product, you typically have a simple 1% exit fee if you get out of your loan early. If you think you’ll only have the loan for a couple of years, it might make sense to think about a floating rate. Note: on all floating rate products the lender will likely require you to buy some sort of interest rate cap–so the rate will only be able to raise so much before you are locked in to a fixed rate. Obviously, if you go down the floating rate path, you need to underwrite and expect for rates to increase some over time.On a fixed rate product, you’ve taken out any risk of rates going higher and can underwrite to a constant rate throughout the hold. The big concession you make with a fixed rate is that you now must factor in defeasance when thinking about selling prior to loan maturity. The more term that is left on your loan at the time of sale, the larger the pre-pay penalty will be. This ties in directly with factor number one above–you need to weigh the length of your expected hold with the loan term you’re signing up for. A 10-year fixed rate loan could be very expensive to break in year 3, as an example, and could be so costly it wouldn’t allow you to execute a sale.
- Interest Only or Amortize Immediately.
With most loan products, you can expect to get some amount of time of interest only payments whereby you don’t have to pay against the principal. This is great when you are performing value-add strategies where you might need some runway and produce some cash flow. Many syndicators we know (ourselves included) push for maximum interest only. If you want 5+ years of Interest Only payments, then you are looking at 10+ year Agency loan products.
We also know many owners and operators that don’t push for interest only periods. They prefer to start paying down the principal to capture and create more equity in the property. The other big benefit to foregoing any interest only is you will have a lower interest rate–the bank will cut you a break if they are getting principle back immediately. You need to weigh the benefits of a lower interest rate vs the needs for additional cash flow early on to determine how important Interest Only is to your investment and business plan.
As you can see, all of these factors are interrelated and none can be chosen or prioritized in a vacuum. Your debt decisions, and those decisions of the operator you are investing in, can make or break your investment. Make sure you understand all the components of the chosen debt vehicle, why those decisions were made, and most importantly how they support the business plan being described.