Now that we’ve covered Cap Rates & NOI and Construction Execution, you have the foundational understanding of how we’re able to generate great ROIs at our properties. Now, let’s dive into a subject which can crush a deal when used incorrectly; but which takes our deals from great to outstanding: financing.
In this blogcast article, you’ll learn the great power of great financing. The bursting of the real estate bubble in 2008 (due, in large part, to irresponsible lending practices) reminded us that with this great power comes great responsibility. You’ll learn that we utilize substantial leverage to maximize our return, but never at the price of unreasonable risk. In fact, when we negotiate loans, we make sure to structure them in a way to mitigate risk; and only once we have the proper structure do we begin to negotiate the loan amount. Today we’ll cover, in order, the following topics:
- DSCR, or Debt Service Coverage Ratio
- The WRONG way to finance a deal
- The RIGHT way to finance a deal
So, let’s begin.
DSCR
The Debt Service Coverage Ratio is exactly what its name implies: it’s the ratio of a property’s NOI to the amount of it’s loan payment at any given time. So, if your property brings in $150,000 of NOI in a given month, and your monthly loan payment is $100,000, you covered the debt at a ratio of 1.5; so, you have a debt service coverage ratio of 1.5.
Now that you know what it is, it’s time to understand how it’s applied. First, let’s understand how it’s NOT applied. Multifamily investors who haven’t bought a deal yet often have the mistaken assumption that the financing process works like this:
- Find a deal.
- Ask the bank for the biggest loan possible.
- Check to see if the deal will cash flow with a bank payment of that size.
- If it doesn’t cash flow, (a) ask the bank to lower the loan amount, or (b) risk it and cover any losses out of pocket.
Spoiler alert, it’s the bank who decides the loan amount, not you. Actually, that’s incorrect – it’s the bank and your deal that decide the loan amount, not you. Actually, that’s not correct, either – it’s the bank, your deal, and your business plan that decide the loan amount. Let’s review each, in order.
The Bank
There are many variables that affect the financing that a bank is willing to offer for an investment property. The ones we’ll focus on are the DSCR, amortization schedule (the time period over which the loan is being paid back), and interest rate.
The DSCR is pretty self-explanatory – based on a bank’s current appetite for lending money, they’ll create a DSCR as a means to protect them from risk. So, a bank who has recessionary market expectations and who has low capital reserves may require a DSCR of 1.35, meaning that they’ll offer you a loan with an annual payment of $100,000 only if your property brings in $135,000 of NOI:
$135,000 NOI ÷ 1.35 DSCR = $100,000 debt service
A more optimistic bank with tons of reserves may only require a DSCR of 1.20, meaning that your property only needs to bring in $120,000 of NOI for the same $100,000 loan.
The amortization term is also dependent on a number of factors – two primary ones being (1) the bank’s risk tolerance and (2) the amortization term of the money that the bank borrowed. So, if the bank borrowed its money (from another bank, probably) on a 20-year term (like the 20-Year Treasury), it’ll usually offer loans to finance a multifamily property on that same 20-year schedule.
Finally, the secret about the interest rate: a bank will lend based on the interest rate of the money they borrowed, plus some spread that provides them profit. So, if a bank:
- has no reserves
- can currently borrow money at 5.5%
- wants a 0.5% spread on their loan
…then they’ll offer you a loan at 6%. But, a bank right down the road may have $50MM of reserves that they borrowed 6 months ago at 4.5%; and if they’re hungry to lend on great properties, their spread may be only 0.3% – giving you an interest rate of 4.8%! This is why we maintain close relationships with dozens of banks – the bank that offered the fourth best rate in town three months ago may offer the best one today.
Your Deal & Your Business Plan
For the wrong deal or the wrong bank, the property as it stands today is the only thing that matters – not the plan for the future. So, if you’re buying a deal where there’s no potential for growth, the bank will only invest in it to the extent that it’s been making money lately. Likewise, for a deal where there’s tons of upside (for example, if 12 months from now, the property will be making double what it is today), the wrong bank will still only lend based on how much money the property has made in recent history – and pay no consideration to how much money the property can make. So, if a deal has made $130,000 of NOI in the last 12 months and the bank’s DSCR is a rigid 1.3, they’ll make a loan that requires a $100,000 annual payment.
But, if the right business plan comes together with the right bank, something truly special can happen. The right bank, for the right deal, for the right buyer, may do something like offer 12 months of interest-only payments (meaning, for the first 12 months you don’t pay the loan principal off, only the interest on the loan – which is a considerably smaller payment) for that same deal. Even better, they may only have something like a 1.0 DSCR for the first 12 months, and then a 1.3 DSCR starting at the beginning of year 2 (to reduce their risk from that point forward). So, if that property will only make $130,000 on an annual basis today, but will make $260,000 in year 2, that bank will make you a loan that requires $130,000 of annual interest-only payments (based on their 1.0 current DSCR requirement) during the 12-month improvement period, and $200,000 ($260,000 NOI ÷ 1.3 DSCR) of conventional (principal + interest) payments during the amortization term (which starts after the first 12 months).
That may have been a lot to digest. But you can quickly see how the right deal with the right business plan can be bolstered by the right bank who believes in the project. The bigger the loan from the bank, the less money out of your pocket. When that money is cheap (the interest rate is low), your ROI can benefit substantially.
And now that you understand how value-add multifamily financing works and how it turns great deals into outstanding deals, you’re ready to learn how refinancing can make outstanding deals… extra-outstanding. In the next blogcast article.
- 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.
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