Debt: An Amazing Tool with Strings Attached
How loans work, what lenders charge, and how to use leverage wisely
Debt. Loan. LTV. Lender.
These are all terms relating to borrowing money to own a property.
If you own a home as your primary residence, chances are that you have a loan on the property.
Why?
Because debt allows you to buy something that costs more than you can afford at that moment in time. It relies on at least two things:
People want more stuff. A bigger house. A bigger investment. Better returns.
There are groups willing to lend people money to get that stuff in exchange for a promise of future payments.
Here are two examples:
First Time Home Buyer
You want to buy a $170,000 home, but you don’t have $170,000. You have built up $60,000 in cash, but you need another $110,000 to buy the home.
Enter the lender.
The lender, often a bank, will loan you the $110,000 in exchange for an agreed upon set of future payments over 5-30 years, inclusive of a certain interest rate and fees. The interest rate and fees are how the lender makes money.
They will do this based on your personal income profile (salary, bonus) and personalcredit score. This is how they determine how risky you are as a borrower.
Investor Buying an Industrial Building
There is a similar structure when you are buying a commercial building with two main differences: (1) how the lender determines risk and (2) how long a loan they will give you.
With a commercial building, the lender looks at the property (in this example the industrial building). They value (aka appraise) the property and look at the income the property generates to make the monthly debt payments. Additionally, they will only give you a 2-15 year loan.
Stay tuned. I will explain this in more detail.
We will cover the basics of debt including:
How a lender makes money.
The niches lender have - just like investors do.
The types of lenders that focus on real estate investment properties.
How a lender determines how much to lend and what interest rate to charge.
The typical timeline to close a loan.
The benefits and risks of borrowing money to own real estate.
Professor Bateman’s key takeaways.
Let’s dig in.
How a Lender Makes Money
Lenders make money in three ways: (i) fees, (ii) interest, and (iii) by getting paid back at the end of the loan term.
#1 Fees: Fees are one-time charges lenders make to the borrower. Examples include:
Origination Fee: To give you the loan.
When: At the time the loan is funded to the borrower.
Amount: A percentage of the loan amount. Ex. 1% of $110K = $1.1K.
Extension or Payoff Fee: A time of extension or payoff.
When: At the time the loan is extended or paid back.
Amount: A percentage of the loan amount. Ex. 1% of $110K = $1.1K.
“Processing Fee”: this is a catch all for the many fees lenders may charge such as underwriting fee, processing fee, application fee, credit fee, appraisal fee, legal fee.
When: At the time (or before) the loan is funded to the borrower.
Amount: These are normally specific dollar amounts. Sometimes they are to reimburse the lender for fees they are paying a 3rd party such as an appraiser or lawyer. Make sure to ask what fees the lender will be charging.
Broker Fee: this is when a broker helped find you the lender and the loan. The fee goes to the broker, not the lender.
When: At the time the loan is funded to the borrower.
Amount: Typically a percentage of the loan amount. Ex. 1% of $110K = $1.1K.
#2 Interest: Interest is the ongoing amount that the lender charges the borrower for the loan. Ex. 7% per year.
7% x $110K = $7,700 per year. Divide by 12 to get the monthly amount of $641.67.
There are two important factors to consider with interest rates, as there are different structures with different types of loans.
Fixed vs. Floating Interest Rate
Fixed: The interest rate remains the same for the entire loan.
Floating: The interest rate changes during the loan, normally based on a fixed amount (ex. 3.50% - known as the “spread”) over a publicly available benchmark such as SOFR or Prime. Ex. If SOFR is at 4.00% and the spread is 3.50%, then the interest the borrower pays is 7.50%. If SOFR increases to 5.00%, then the borrower’s interest rate goes to 8.50% (5.00% SOFR + 3.50% spread).
Why this Matters: You get interest cost stability with a fixed rate loan. With a floating rate loan, you are adding an element of risk (both upside and downside) to your investment based on what interest rates do.
Interest Only vs. Amortizing
Interest Only: Each month the borrower only pays the interest costs.
Amortizing: In addition to the interest costs, the borrower also pays down the principal balance (i.e. a portion of the $110K loan) each month. This makes the borrower’s monthly payment more than an interest only loan payment.
Why this Matters: If you are tight on cash each month, an interest only loan can help a lot, but you will have to pay the full loan amount back at the end of the loan. In an amortizing loan structure, you will “chip away” at the principal balance each month.
#3 Getting Paid Back at the End of the Loan: this one is fairly obvious. If the borrower doesn’t pay the lender back at the end of the loan, then the lender is not going to make money.
To summarize the three ways lenders make money:
Fees
Interest Rate
Getting Paid Back at the End of the Loan
Keep in mind that a lender is not an equity investor. They are not going to benefit from the property being a home run.
In exchange for a lower return, they have lower risk. If the property goes bad and the borrower can’t make interest payments, the lender can take over ownership of the property. This is called foreclosing and the investors lose all their money.
Low risk, low return, better protection. It is a fair trade-off.
Lenders Have Niches Just Like Investors Do
Just as investors pick a niche, lenders pick one or more niches to focus on. Let’s oversimplify a bit and say there are four niche criteria for lenders:
Asset Class: 1-4 unit residential, multifamily, industrial, retail, office.
Geography
Strategy: core/turnkey, light rehab, value add, development.
Recourse vs. Non-Recourse
We should be familiar with the first three as discussed in Stop Chasing Every Deal: Why Successful Investors Pick a Niche.
The fourth one is unique to lending: recourse vs. non-recourse.
A recourse loan means that you are personally responsible to pay back the loan. If you get a home loan, it is almost certain that it is a recourse loan.
A non-recourse loan means that you are not personally responsible to pay back the loan (unless you commit fraud or there is an environmental issue). If there is an issue with the non-recourse loan in the industrial building example, the lender can’t come after your personal assets (cash, home, stock, other real estate, etc.)
In an ideal world, as a borrower you would only get a non-recourse loan.
Why? Here’s an example of a recourse loan gone bad.
You buy a $500K property with $400K loan. The market crashes and the property is now worth $300K. You can't make payments. The lender forecloses AND can come after your personal savings, home, other assets for the $100K shortfall ($400K loan amount less $300K current value).
With a non-recourse loan the lender can only look to the $300K property value, not your personal assets.
So why do some borrowers get recourse loan? For several reasons:
Scarcity: It may be the only type of loan available. There is not a non-recourse option. This is almost always true if you are doing a new development.
Economics: The loan has better economics than the non-recourse option (fees, interest rate, loan amount/proceeds).
1-4 Unit Residential: Lenders view 1-4 unit residential investment properties as personal properties by relying on a borrower’s personal income and credit score. This can be helpful if you are a first time buyer.
Let’s do a quick sidebar to point out three characteristics of loans for value add and development deals, as they are the highest risk and lenders treat them differently.
Loan Term (aka Length): Loans for these type of investments tend to be shorter - say 3-5 years. They are often called “bridge” loans. The idea is that they are more temporary in nature as the property is in transition.
Floating Interest Rate: For the same reasons as the loan term, these are more likely to have a floating interest rate.
Reserve Holdbacks: These are funds the lender “holds back” from the initial loan funding to pay for future costs such as construction, leasing, and even interest rate reserves. This reduces the amount of the loan at closing and allows the lender to make sure you spend their money on what you said you were going to spend it on.
So who are these mysterious “lenders”?
Types Of Lenders
There are four main types of lenders:
Banks & Insurance Companies
Debt Funds
Securitized
Fannie Mae and Freddie Mac (Government Sponsored Enterprises)
Banks & Insurance Companies: These groups lend their own money. Both have excess cash they want to earn a return on: banks from deposits and insurance companies from insurance premiums.
Debt Funds: Debt funds raise money from various investors such as pension funds, insurance companies, and university endowments. Debt funds tend to do riskier loans than banks in exchange for higher interest rates and fees.
Securitized: Securitized lenders function differently in that they plan to sell the loan to one or more investors after the loan closes. They effectively act as a middleman earning a fee. Sometimes they are mainly concerned with how the loan will be viewed by the ultimate buyer of the loan. Watch or read The Big Short to see this go to the extreme.
Fannie Mae and Freddie Mac: Fannie and Freddie are government sponsored enterprises created by congress to support the U.S. housing market (residential properties only). Similar to a securitized loan, a lender originates the loan and then the lender sells the loan to Fannie or Freddie. This allows the original lender to have more money to make new loans. Don’t worry about the details. Just know that they exist.
Key Takeaway: If you are a first time investors, you will likely work with a bank.
With that covered, let’s get to the next big question of how lenders evaluate a loan.
How a Lender Determines How Much to Lend and What Interest Rate to Charge
So how do they do it? With a magic lender calculator?
Quite simply: by assessing risk and pricing accordingly.
More risk, more costs to the borrower.
Assuming the property fits in the lender’s niche, the lender will generally (a) charge more fees and a higher interest rate and (b) provide a lower loan amount for properties the lender views as riskier.
Here’s an overview of the financial tools a lender uses to assess risk:
Appraisal: An appraisal is an assessment of the fair market value of a property as determined by some combination of (i) replacement / construction cost, (ii) similar properties that have sold recently aka “sales comps”, and (iii) the capitalized value. It is completed by a licensed third party appraiser.
The lender will normally have some max amount of appraised value they will lend up to. Ex. 65%. This is referred to as the “loan-to-value” or “LTV”. Here are some LTV rough guidelines. More risk to lender = lower LTV = more equity/cash you need.
Primary residence: 80-97% (3-20% equity)
Investment property (1-4 unit): 75-85% (15-25% equity)
Commercial (turnkey): 65-75% (25-35% equity)
Commercial (value-add): 55-70% (30-45% equity)
Development: 50-65% (35-50% equity)
DSCR: This stands for debt service coverage ratio. Think of this as the lender’s “cushion” in the property’s ability to generate enough income to pay interest. Mathematically it is NOI divided by Interest Costs. Ex. A property generates $10,000 NOI. Loan is $110,000 at 5.5% interest = $6,050 annual interest. DSCR = $10,000 / $6,050 = 1.65x.
The lender normally wants this to be at least 1.20. Remember, they are in the low risk, low return business.
Debt Yield: Think of this a the lender’s cap rate. Mathematically it is NOI divided by Loan Amount. Ex. $10,000 / $110,000 = 9.1%.
The lender will have a minimum target.
Personal Credit & Income: If a recourse loan.
Each lender has their own special formula or hot buttons they use based on some combination of these criteria.
Side note: did anything stand out to you relative to the LTVs above? Even on the riskiest deals, they are all 50% or higher. This means the lender is funding 50%+ of the cost of each real estate investment. The real estate industry would be very different without their support. Thank you to all the lenders out there!
So how long does it take to get a loan? That is our next topic.
Typical Timeline
Finding the right lender (1-4 weeks).
Negotiating a term sheet (1-2 weeks).
Negotiating the loan agreement (1-4 weeks).
Closing the loan (1 week).
Total 4-11 weeks (plan for 6-8 weeks typical).
This can be tight if you don’t start the process until you are already under contract to buy a property, especially if it is your first deal.
Remember that your due diligence period may only be 30 days. You don’t want to be in position where you put your deposit at risk by going non-refundable without certainty on your loan.
Start early. Establish relationships with potential lenders that fit your niche before you have your first property. This will make the whole process much easier.
Now that we have a basic foundation, let’s zoom out a bit to talk about debt on real estate in general.
The Benefits and Risks of Borrowing Money to Own Real Estate
So should you get a loan to buy real estate?
The reality for most new investors is that they will end up getting one to be able to afford their first property. And most seasoned investors will see too much benefit to their returns and scale to not want to borrow.
There are two main benefits to real estate loans:
Benefit #1 - Lower Equity Requirement
You don't need to have or raise as much equity when you have a loan for 50% to 75% of the amount needed to buy a property. An investor may simply not be able to come up with the cash needed to buy a property without a loan or they may want to buy more with the money they have.
Benefit #2 - The Power of Leverage
Leverage is the mathematical and financial benefit of borrowing money at a cheaper rate than the rate of return for the equity investors. If you borrow money at 5.50% and can earn 9.0%, then you have positive leverage.
9.0% earnings is greater than 5.50% cost of borrowing.
Positive leverage is a good thing because you are earning more than the cost of your interest rate.
If you borrow money at 5.50% and can earn 4.50%, then you have negative leverage.
4.50% earnings is less than 5.50% cost of borrowing.
Negative leverage is a bad thing because you are being charged more than you can earn.
If you are a professional real estate GP raising money from LPs you will find it hard not to use debt to be competitive in the marketplace to raise LP capital.
When you believe your investment can earn a 9% total return (IRR) over the full 5-10 year investment, it is too tempting not to turn that into a 12%+ total return by adding positive leverage.
So what are the negatives of borrowing money?
Negative #1 - Increased Risk
Borrowing money increases your risk by (i) increasing your monthly costs in the form of interest payments and (ii) requiring you to pay back the full loan amount on a specific date. Things don’t always go as planned.
Did you know the Empire State Building was under construction at the start of the Great Depression of the early 1930’s? The developer was able to finish the development and keep ownership of the property partly because he built it all cash without debt. If he had a loan, he would have almost certainly lost it to the lender at some point.
Negative #2 - Reduced Control
Not only will the lender charge fees and a monthly interest rate, but they may also have certain approval rights for things like larger leases, major capital improvements, and other operating choices. You limit what you can do when you have a loan on the property.
So what do you make of everything I have discussed here?
Professor Bateman’s Key Takeaways Regarding Debt
Understand that debt and leverage can be a wonderful tool to boost returns, but come with added risk and costs.
Accept that you will likely need a loan on your first deal.
Start early and identify lenders in advance. Not all lenders are created equal. Take the time to find the lender that fits your property profile. Using a debt broker can help.
Form relationships with good lenders to do repeat business.
Become familiar with the lender’s perspective on DSCR, debt yield, and appraisals. This will help you speak their language.
Look beyond just fees, interest costs, and proceeds. These are the financial cost of debt, but there may be operational implications and restrictions. Think about what is most important to you on a particular deal.
Be careful with floating interest rates and short-term loans. These can lead to challenges.
Watch out for pre-payment restrictions or penalties if you pay the loan off early. These limit your flexibility.
Understand reserve holdbacks may reduce your initial loan amount. Ex. A $110K loan with $15K of reserve holdbacks results in $95K of initial loan proceeds. This could mean more equity is required up front to close the loan.
Become familiar with loan documents. Learn more on my downloads page.
Acknowledge the benefit of working with lenders that hold the loans “on their books”. Be eyes wide open on whether the lender will sell / securitize the loan after they make it. Challenges will happen during the loan term. It is a lot better to be able to work problems through with original lender than one that bought it from that lender.
Avoid recourse loans when you can. You may need to take on recourse for your first duplex, but set a goal to avoid it as soon as you are financially able. One bad recourse loan could personally bankrupt you.
In my opinion, owning a property debt free without any LP investors is a fantastic place to be. It gives you the ultimate freedom.
You may not be able to start there, but I encourage each of you to think of it as a goal worth considering over the long term.
Professor Bateman