Now that we’ve covered the wrong way to leverage a property, let’s get into how we do it. Once you see how good your returns can get when you finance and refinance an investment property correctly, you’ll understand why we maintain such close relationships with as many banks and credit unions as we can.
First, let’s make one thing clear regarding the last blogcast, Finance and Refinance Wrong – we don’t use bridge debt because we don’t need to use bridge debt. I don’t know any multifamily owners who look at a property and say “I’d prefer a loan that comes to term in 12 months over one that comes to term in 60 months for that deal”. All else being equal, you don’t want to put your back against the wall any sooner than you need to (with anything, but especially) when it comes to financing. So why would an investor use bridge debt? There may be more answers to that question, but I guarantee the full story includes one of the following:
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- They’re not buying a great deal.
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- They aren’t speaking to the right lenders.
For the multifamily owners out there who are top-notch property and construction managers, this is your wake up call to (a) start taking bankers to lunch, or (b) add someone to your team who will. If you’re a passive investor, and a friend or syndicator brings you a great-looking deal, don’t put your money in until you ask them about the financing terms. The terms we like include:
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- 3+ year fixed rate term (to date, we haven’t done one below 5)
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- 5+ years before balloon payment (to date, we haven’t done one below 7)
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- Low interest rate (obviously)
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- 12+ months of interest only payments (to date, we haven’t done one below 24)
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- No or low prepayment penalty
There are plenty of other ingredients, like a construction budget; early rate lock; long amortization schedule; low loan fees; and more, that make the perfect recipe for a loan (and are negotiated for by any diligent and savvy investment property owner); but the five in the bulleted list, above, are the most important for our business plan.
You may be asking “why the no or low prepayment penalty?”. Well, as soon as we close on our first loan, we’re working toward the second (aka refinance); so we want to avoid a penalty that will cut into our profits. On our path to the second, we know we’re likely refinancing into a loan with a 1.3 DSCR requirement, which means we’ll need to increase NOI $130,000 for every extra $100,000 we’re given in debt service. If we add $390,000 in NOI, that’s $300,000 of debt service. At a 4% interest rate and 30-year amortization, that’s an extra $5.25MM in loan proceeds that we can return to our investors. Why does that matter?
Well, let’s assume we truly knock a deal out of the park; and 24 months after closing, we’re able to refinance into a new loan which is big enough to pay back our first loan and also return all of our invested capital. You now have your full investment back, which means:
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- You are de-risked from this investment (you very likely will not lose money)
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- All of your returns from this point forward have an infinite rate of return (money divided by $0 = infinity)
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- You can now reinvest that money elsewhere (maybe a new deal)
So, how do we do it? Well, simply put, there are two rents that are important when we buy a property: (a) where they’re at now, and (b) what the market rate neighbor is at. While there’s nuance to the game, let’s use the following statement as our mostly-true heuristic: we want to take our rents to market rate as cheaply and as quickly as possible. The following exercise is an oversimplification, but let’s use it to get the basic understanding of the decisions we make in the race-to-refi.
Here are some theoretical (a) costs and (b) monthly rental premiums earned by projects:
| Project | Cost | Rent Premium |
|---|---|---|
|
1. Proper advertising & marketing: |
$1,000 |
$500 |
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2. Exterior paint and signage: |
$40,000 |
$100 |
|
3. Landscaping: |
$15,000 |
$25 |
|
4. Exterior Lighting: |
$5,000 |
$25 |
|
5. Community BBQ Area: |
$20,000 |
$40 |
|
6. Laundry Room: |
$15,000 |
$50 |
|
7. Dog Park: |
$10,000 |
$25 |
|
8. Cabinets: |
$140,000 |
$50 |
|
9. Countertops: |
$100,000 |
$50 |
|
10. Appliances: |
$100,000 |
$50 |
|
11. Flooring: |
$150,000 |
$75 |
|
12. Backsplash: |
$30,000 |
$10 |
|
13. Replace Doors in Unit: |
$40,000 |
$15 |
|
14. Add Washer/Dryers in Unit: |
$140,000 |
$75 |
Let’s say your rents are $900 below market. Mathematically, the ROI (rent premium ÷ cost) of the projects are, in order: 1, 4, 6, 2&7, 5, 3, 14, 9&10&11, 13, 8, 12. To get to market, you might think the fastest way would be to hit the list in order; but let’s assume that $900 is our ceiling, and spending any more money beyond that point will not get us to $900.01. So, the cheapest way to $900 is actually to (1) advertise and market properly, (4) install exterior lighting, (6) install a community laundry room, (2) paint the exterior and install signage, (7) build a dog park, (5) build a community BBQ area, (3) landscape, (14) add washer/dryers in the units, choose to install (9) countertops or (10) appliances, forego (11) flooring, (13) doors in unit, and (8) cabinets, and then (12) install backsplashes in the kitchens instead. Easy. Well, not really. You wouldn’t install a community laundry room and install washer/dryers in each unit, would you? Does the exterior lighting make as much of an impact without paint, signage, and landscaping? Do you get the same returns on countertops without also doing cabinets?
Also, what if that neighbor at the top of the market has a pool and you don’t? Do you need to assume you’ll always be $50 behind his rents; or can you install a community BBQ area and dog park to close the gap? What if that neighbor’s units are 40 ft2 larger than yours? Can you make your units slightly nicer, or add an amenity that they don’t have to achieve the same rents?
These are the questions that make multifamily properties such a beautiful combination of art and science; and unless you have two properties of the same vintage and in the same neighborhood, no two deals are truly the same. We use our past experience, knowledge of the property, and knowledge of the location to assemble the best budget to bring our rents to market. Then, we pay close attention to the feedback we get as we try different strategies, and adjust accordingly. For example, going into a new deal, we may think we can get an extra $250 in rent with the right interior renovation strategies. If we budget 5 different renovations, and get there in 2; we may decide to scrap the remaining 3 if we feel like we’re hitting our ceiling on apartment quality. We can then use the remaining budgeted items toward exterior/other projects.
An obvious question would be “how come we don’t try to push rents above market?” Well, we’re not saying we wouldn’t. What we are saying, though, is that we buy properties (a) with cheaper rents than our neighbors, and (b) for cheaper prices than our neighbors paid for theirs. If we paid less for our properties and we’re making just as much money, that means our returns our higher than theirs, and they’re the ones in the hot seat to test the market. Catching up to the neighbors is like running downhill, but passing them begins the incline. By the time we catch the market rents, we’re probably already in refinance territory, making some serious money. We’re much more likely to light this money on fire when we’re trying to push market rents than when we’re catching up to them. So, once we’ve caught up to the market, our NOI improvement strategy will typically shift more toward cutting expenses, or finding means to add other non-rent income streams (like adding more apartments or income-generating amenities), rather than increasing rents.
So that’s it in a nutshell, with about a million other details that we didn’t get into. When we’ve increased NOI enough, and the market is ready for it, we refinance into a long-term loan with the right terms. At that time, we return as much invested capital and profit to investors as we can. Since we buy in great and growing locations, we ride the wave of the increasing market, and hope that neighboring properties sell to new and hungry owners for high prices. When new owners spend a ton to buy our neighbors, they’re forced to increase rents to hit reasonable returns. And you guessed it, we’re here to draft right behind them as they work hard to make both of us more money.
“Ok, this all sounds good, and logically I get why refinancing and getting my money back sounds like a good idea.. but how exactly do I make more money?” I’m glad you asked. Find out in blogcast article 6.
1. Financial Disclaimer: The financial figures shown above are intended for illustrative purposes only to explain general real estate concepts and are not guaranteed by Raven Real Estate Acquisitions, or any of its affiliates. Real estate investing involves many risks, variables, and uncertainties. No representations or warranties are made that any investor will, or is likely to, attain the returns shown above since hypothetical or simulated performance is not an indicator or assurance of future results.
2. Investment Advice Disclaimer: This content is for informational purposes only. Raven Real Estate Acquisitions and its affiliates do not provide legal, tax, investment, financial, or other advice. All content presented is information of a general nature and does not address the circumstances of any particular individual or entity.
3. Investment Risk Disclaimer: There are risks associated with investing in real estate and securities in general. Investing involves risk of loss including loss of principal. Some high-risk investments which use leverage may accentuate gains and losses. Past investment performance is not a guarantee or predictor of future investment performance.