What is so scary about commercial loans? Well, interest rate adjustments for one thing. Here’s how to reduce risk of adjustable rate real estate loans.
I wrote a post a couple of weeks ago for the BiggerPocket blog entitled Are Nothing Down Real Estate Deals Risky in which I discussed the essence of risk as it relates to leverage and addressed some of the basics of transfer of risk in a real estate deal.
One of the follow-up comments on this article posed the question of what can be done to off-set the risk posed by rate adjustments on commercial real estate notes. Let’s see what we can do here – and I hope your sense of humor easily accessible at this time…
Before Commercial Loans, Let’s Talk About Sex
Yep – you read it right; let’s talk about sex. Why – because commercial notes with adjustable interest rates are very much like sex, which likely explains why I like them so much 🙂
The thing about sex is that it’s a sword that cuts both ways. Think about it – sex is fun, it’s necessary for emotional and physiological health, and while this might be news to some of you, sex is how babies are made…
At the same time, though, sex can be dangerous to your health, and while fun it can lead do consequences that are at the very least inconvenient and can be detrimental if you are not ready for them…
The final point that I need to make is this: while abstinence can save you the headaches and keep you away from danger and/or inconvenience, this is just not realistic – are you with me? At the end of the day, the best advice is to really be positioned well (no pun intended), and act smartly as it relates to when, how, with whom, and why you have sex!
Now, Let’s Talk About Commercial Loans
OK – they are never fun, but most everything else I described above is applicable to commercial loans:
Commercial Loans are Necessary for Real Estate Investment
While not necessary for your physical or spiritual health, commercial loans are indeed necessary if you intend to grow your real estate investment portfolio. Understand, the secondary market guidelines as set by Fannie Mae and Freddie Mac stipulate that a well-qualified individual can borrow up to 10 mortgages (4 for Freddie Mac) in their name. This money can NOT be borrowed with a corporate entity as the borrower, and the type of property that can be financed with one of those residential notes includes SFR, Duplex, 3-plex, 4-plex – that’s it. Furthermore, the borrower must meet all of the qualifying standards including Debt to Income ratios. This means that even if you do manage to get up there to property number 9, you better be bringing home some serious W2 or 1099 bacon, because that’s the kind of income they want to see on the residential side…
Commercial Lenders for Real Estate Investment
Guess what – I haven’t qualified for years. For one thing, I’ve got too much property; 10 loans was never going to do it. But more importantly, the entire reason for creating income through investments is so that you don’t have to earn money with a job. Yep – my job is to invest in property and collect rent checks, which, incidentally, comes with two very happy consequences. First is that my commercial lenders like rent checks coming in and couldn’t care less if I have a job or not. They understand that I am not the one paying on the commercial loan – the asset is. In fact, thy know that I could not afford to carry the debt I’ve got if I had to do it with earned income. As a consequence, they don’t expect me to and don’t bother to qualify me based on earned income – commercial lenders look at the asset!
And the other meaningful benefit of doing things the way I do things is the very attractive effective tax rate. You see, the income I generate via an asset is not subject to FICA taxes such as the Social Security Tax and the Medicare Tax. This is precisely why I don’t flip or wholesale – the resulting income is considered Earned Income by the IRS; thanks, but I’ll do without…
When Residential Lending isn’t Enough for Real Estate Investing
Well – if you ever want to buy a 5-unit, a mixed use property, a strip mall, a storage facility, any other commercial or industrial space, or if you simply want to grow big, then you are going to have to look past those vanilla residential notes. While you’ll get some mileage out of owner-financing and other creative tools, you will certainly have to get comfy around commercial financing with all that it entails.
Question: Do you want to be a real estate investor, or do you want to dabble in real estate? This might be news to some of you, but just like sex facilitates expansion of humanity, financing which transcends 10 lines facilitates expansion of a real estate portfolio!
However, most people are terrified of some of the terms which come with the territory when we begin to look at commercial financing, and the item that concerns people the most is the fact that unlike the residential loans which are structured on a fixed interest rate (this is what most people like to use), in most cases the interest rate on commercial notes changes at predetermined time (1,3,05 5 years are all common).
Now, here’s the question…
How do you offset the risk of rate adjustment?
Rate Adjustment Risk and Commercial Real Estate Loans
Well – inherently there is certainly risk which comes with ARMs; this is a fact of life. But, there are a few things that we can do to mitigate the effects – here are a few ideas:
PROTECTION #1: Force Appreciation
Buy only those assets that exhibit elements of expandability which allow you to force appreciation. Forcing equity in the deal creates options of refinancing, selling, or exchanging prior to the rate adjustment.
PROTECTION #2: Cash Flow Reinvestment
Buy only those assets which exhibit stronger than average Cash Flow. This allows you to re-invest Cash Flow on monthly basis in order to positively amortize the note faster than amortization schedule. If the interest on the note goes up, but the outstanding principle balance goes down, you may be able to offset all or part of the increase to debt service.
PROTECTION #3: Negotiate a Cap
Try to negotiate CAPs on your loans. A CAP will guarantee that the interest on your note will not adjust by more than a pre-determined margin. For example, if you start out with a 5% loan which is due to adjust every 5 years (meaning there will be 3 adjustments on a 20-year loan), and you negotiate a 2 point CAP per adjustment with no more than 6 points throughout the life of the loan, then you’ll know that the highest your interest will be in 5 years is 7%, and the highest it will be by the third adjustment is 11%.
With this knowledge, your goal becomes to follow steps 1 and 2 on this list. You can try to force appreciation and sell/exchange for Capital Gains and roll the money into a bigger deal. Or, if you are committed to keeping the building, you will utilize your Cash Flow to positively amortize the note and bring the underlying balance on the note down to a level at which even at a higher interest rate of 7% your debt service remains more or less the same. That’s the goal – debt service remaining the same, because that would mean that your Cash Flow will remain the same as well.
Now – please understand that CAPs are something that you’ll need to pay for, and not every lender will agree to this with every client. You’ve heard me say many times – real estate is a relationship business; go find a portfolio lender that will work with you. Finally, for a CAP such as I described you can expect to pay 2-3 points, which is not cheap since on a $500,000 note you’ll spend $10,000 – $15,000 on CAPs as part of your closing costs. Therefore, you must consider the larger economy and make a determination in your own mind as to what the interest rates are going to do.
PROTECTION #4: Work with a Smaller Bank
Let’s understand a basic reality – even though it’s a little cynical. Understand – when you borrow a little money, you become a slave to the lender; why – because if your loan goes bad, it wouldn’t cause much trouble to the bank, and as consequence of this you are very much expendable.
On the other hand, if you borrow relatively a lot of money, specifically if you borrow at a relatively small community bank with only a few locations, then your default is liable to indeed hurt the bank’s bottom line in a substantive way. As a consequence of this, if you borrow a lot of money from a smaller bank, you essentially become a partner – an asset manager contributing to the bank’s returns to their shareholders, so to speak.
Why is this important – because while it’s not possible to say definitively how a bank will behave at any given time since this is very much a function of where the bank is relative to its portfolio (how many defaults are in the portfolio), but on balance there is reason to think that you are more likely to have the opportunity to work things out in some way that benefits both sides if you are dealing with a lender who views you as a partner; if for no other reason than by the virtue of realizing that your pain would cause the bank pain. Naturally, in exchange for working with you to stabilize things now, you should be open to re-paying in some way, shape, or form when things get better for you. The point of all of this is to salvage the investment and the relationship – it may not be great for either, but better than the alternative for both. But believe me when I tell you that a big 5 bank cares about your relationship about as much as they want an outbreak smallpox…just sayin.
Conclusion on How to Reduce Risk of Adjustable Commercial Loans
I trust I haven’t offended your sensibilities by either drawing a comparison to sex or commenting bluntly on some of the realities of commercial lending as I see them. Let me mention one other thing before wrapping up:
It’s true – debt financing can be avoided all together by pursuing equity partnerships instead. However, you’ll find it impossible to attract capital until your intellectual worth is of a certain caliber, and you can’t get there by reading articles and forums on BiggerPockets. At some point, having learned the basic steps to this dance you will need to take a chance and ask a good-looking girl to join you on the floor.
“Courage is not the lack of fear. It is acting in spite of it.” ~ Mark Twain
Hopefully this gives you some perspective on how to reduce risk of adjustable rate real estate loans.. What are your thoughts?