This is the presentation deck from Real Estate Investing 101: Financing, PeerRealty's fourth in a series of on-demand educational videos. In this series, PeerRealty Head of Investments Jeff Rothbart takes viewers through the fundamentals of real estate investing, and discusses some of the key metrics that real estate investors should consider. This Financing course analyzes the different types of debt instruments that investors can expect to find in real estate deals. It also discusses common loan agreement provisions, and explains how they can affect your real estate investment.
You can view this webinar at http://resources.peerrealty.com/real-estate-investing-101-financing
3. COMMITMENT LETTER
Generally, upon review of the contemplated transaction, the
lender will issue a Commitment Letter setting forth the terms
under which they will provide debt financing.
The Commitment Letter will generally state:
– The Parties – The Borrower and the Guarantor
– Loan Amount and Rate
– Dates / Amounts of Repayment
– Security (Real Estate, Guaranty or both)
– Commitment Fee
– Timeframe
4. TYPES OF DEBT
• Fixed Rate Financing – Typically, fixed rate debt is based off the
Ten Year Treasury (2.25% on 3/23/11).
– The Ten Year was at 4.7% (2/2007). 3.5% (4/2008), 2.6% (2/2009), 3.6%
(3/2010) and 2.86% (3/2011).
• Floating Rate Financing – Floating debt is traditionally based off
LIBOR (0.24% on 3/23/11).
– LIBOR was at 5.4% (2/2007). 2.7% (4/2008), 1.8% (2/2009), 0.4% (3/2010) and
0.25% (3/2011).
– Depending on which type of financing is used, either the Borrower or Lender will
assume the interest rate risk.
• Fully and Partially Amortizing – The Borrower pays the interest and
reduces some or all the principal over the life of the loan.
• Interest Only (IO) – The Borrower only repays interest not principal.
5. FLOATING RATE DEBT
• Floating rate debt usually has a LIBOR floor and ceiling which
states that in no event can the rate be more or less than X%.
• Floating loans without caps should never be accepted.
• Caps can be measured annually, at time of payment or over the
life of the loan.
• Floating rate debt can also come with the option to covert to
fixed rate financing at some point.
– Long term floating debt should be avoided or the Borrower
should maintain the ability to close down the credit facility
and refinance to obtain a better rate.
6. LOAN AMOUNT AND RATE
The loan amount (or LTV) is a percentage of the real
estate’s value, adjusted for the risk involved with the
asset(s).
– The LTV is usually stipulated in the commitment
letter and states that the lender is required to lend X
% off the appraised value.
In a healthy market, the rate on fixed financing is generally
100-150 bps over the ten year on fixed and 200-300 bps
over 6 Month LIBOR on floating rate debt.
7. DEBT YIELD
• Debt yield is the lenders cap rate.
NOI 100,000$
Price 1,000,000$
NOI 100,000$
Loan Amt 650,000$
10%=
Cap Rate
Debt Yield (65% LTV)
= 15%
•Generally, debt yields are 9% - 12%.
8. DEBT SERVICE COVERAGE RATIO
• In general, it is calculated by: DSCR = Net Operating Income / Total Debt
service
• The debt service coverage ratio (DSCR) is the ratio of net operating income
to debt payments on a piece of investment real estate. It is a popular
benchmark used in the measurement of an income-producing property’s
ability to produce enough revenue to cover its monthly mortgage payments.
– The higher this ratio is, the easier it is to borrow money for the property. The phrase is also
used in corporate finance and may be expressed as a minimum ratio that is acceptable to a
lender; it may be a loan condition, a loan covenant, or a condition of default.
• Typically, lenders look for a DSCR of at least 1.5, but at the minimum, the
ratio should be over 1.
– If a property has a debt coverage ratio of less than one, the income that property generates
is not enough to cover the mortgage payments and the property’s operating expenses. A
property with a debt coverage ratio of .8 only generates enough income to pay for 80
percent of the yearly debt payments. However, if a property has a debt coverage ratio of
more than 1, the property does generate enough revenue to cover annual debt payments.
9. LENDER FEES
• Lenders love fees.
• Borrower’s usually have the ability (given decent credit) to
have some of the fees waived or reduced.
– In the event of excessive fees, try and negotiate them
down.
• Origination /Commitment Fees – Fees for originating the debt
and the commitment of the same.
– Remember, once the debt is committed, the lender has
foregone the use of those funds for something else.
• Inclusion Fee – Inclusion fees are commonly associated with
credit facilities and are a fee to cover the lenders cost of
underwriting the transaction.
10. AMORTIZATION
• Full Amortization – At the end of the loan’s term, all of the principal
(borrowed funds) and interest will be paid back.
• Partial Amortization – At the end of the term, some of the principal
will have been repaid and the Borrower will still be responsible for a
balloon payment to cover the then remaining principal.
• No Amortization / Interest Only – At the end of the loan, no principal
has been repaid and a larger balloon payment (often called the
“bullet”) is due.
11. ZERO CASH FLOW FINANCING
• Zero Cash Flow Financing is a fully amortized loan whose term
expires at the expiration of the lease.
– THIS MEANS THERE IS NO CASH FLOW FROM THE REAL
ESTATE EVER!
– At the end of the lease term, the Borrower owns 100% of the fee
simple interest in the property free and clear.
• These are popular with single-tenant net leased investments,
particularly CVS Drug Stores.
• Zero’s are often used as estate planning techniques for fiscally
irresponsible children/beneficiaries.
12. BORROWER LIABILITY
• Recourse Loans – If the loan is recourse, then the Borrower (and if
the Borrower is a legal entity most likely the principals behind it) are
personally liable for repayment of 100% of the loan and interest
amounts.
• Non-Recourse Loans – No Borrower liability other than “Bad Boy”
and environmental.
– “Bad Boy” Acts – Fraud, misrepresentation, breach of
representations and warranties.
13. LOAN PREPAYMENTS
Prepayment
• Terminate Credit Risk
• High Risk Loans Prepaid at
Full Value
• Minimize Interest Rate Risk
• Reinvest at Higher Rates
• Prepayment Penalty /
Premium
No Prepayment
• Lower Interest Rates on
returned funds.
• No prepayment penalty.
• Refinance at lower rates.
14. LOCKOUT PERIODS
• Lockout periods prohibit repayment of the loan for a stipulated
duration.
• More common on shorter term (3-5 year) loans.
– Typically, Borrowers push back if the lock out period is greater
than 5 years as this will limit their ability to dispose or refinance
the asset.
• After the lockout period has expired, prepayment is allowed. If the
loan is securitized, then defeasance is the only option.
• On “second’s” or mezz debt, the lockout period is usually shorter,
around 12-18 months.
– The reason for the shorter lock out period is that the these loans
typically come at higher than standard interest rates and the
lender does not want the borrower to be able to refinance out in
a short period of time.
15. DEFEASANCE
• Defeasance is the process whereby the collateral or
security for the loan is replaced with other collateral,
typically bonds or securities.
• By defeasing, rather than prepaying loans, the
securitized lenders are able to still retain all of their cash
flow and return versus getting cashed out of the deal.
• www.defeasewithease.com
16. REAL ESTATE FINANCE
DOCUMENTATION
• Loan Agreement – A lender's agreement to make a loan on particular terms, including
interest rate, fees and charges.
• Mortgage - A mortgage is a promise in which the borrower agrees to put up the real
estate as security for a loan. The mortgage is the instrument which secures the
Promissory Note, in which the borrower promises to repay the loan at a certain date.
The mortgage document allows the lender to force a sale of your home (foreclosure)
if, for example, the borrower fails to make payments, to pay property taxes or
insurance, or keep other promises. In some states the mortgage document is called a
"deed of trust.“
• Promissory Note - A legal contract in which the borrower promises to pay back the
loan. The "promissory note" sets forth the terms and conditions that apply to the loan
repayment, such as interest rate, when payments are due, where payments are
made, what happens if payments are not made, etc.
• Guarantee(s) – Even in non-recourse loans, there is typically a guarantee of some
kind and typically it’s a guarantee of the recourse obligations (carve outs, typically
environmental).
• Cash Management Agreement – An agreement which details how cash will flow from
tenant to Lender and then on to the Borrower.
17. MORE FINANCE DOCUMENTS
• Assignment of Rents and Leases – These documents force the Borrower to assign its
interest in the rents and leases (getting at the cash flow) to the Lender to ensure that
the loan is repaid.
• Environmental Indemnity – In addition to guaranteeing the recourse carve outs (as
mentioned before), the Borrower will typically have to indemnify the Lender from all
environmental liabilities incurred.
• Equity Pledge – The equity pledge gives the Lender the right to control, access or
apply the Borrower’s equity in the real estate against any unsatisfied loan obligations.
This usually comes into play when there is a forced sale of real estate.
• Interest Rate Cap Agreement – Sometimes, real estate loans have interest rate caps
(this is more common when you have a line of credit than with individual loans).
Interest Rate Cap Agreements will stipulate how to calculate the maximum interest
rate that can be applied and is most common in floating rate loans.
– Had more residential loans had interest rate cap agreements in place, the
subprime crisis could have most likely been minimized or averted.
18. MBS LOANS
• As we have discussed in previous classes, CMBS and RMBS loans were a
very popular method of financing real estate transactions.
• MBS loans were made on an individual basis, then, per FASB, were moved
off-balance sheet, placed into pools and syndicated.
– The largest problem with the off balance sheet nature of these loans
was a lack of liability, on the part of the issuer, for the quality of loan
and/or initial underwriting.
• The MBS loans were then cut up into slivers, based on risk profile, and sold
as a security.
• While great in theory for the real estate industry, the end result, as we can
see by the current economic crisis, wasn’t great.