What we learned about lending for real estate – Part 3 of 3
This is part 3 out of 3 of a longer article, “What we learned about lending for real estate”. We explore some often used loan products for financing real estate purchases. For this part, we’ll talk about the types of loans available for different kinds of real estate properties.
With the FHA and VA loans described, we are leaving the area of conforming loans, which forms a significant percentage of total mortgage lending in the USA, and are entering the realm of custom, or “portfolio loans”.
These loans are not written to be sold to any of the government agencies. They are kept on the lender’s books (hence: portfolio loan), which means that the lender remains the owner and the servicer of the loan.
It is of course always possible that the loan gets sold for various reasons to a different owner and/or servicer, but when that happens the loan terms will not change. I do not see that the servicer address makes a difference to the borrower for the lifetime of the loan.
The loan terms that you will see in portfolio loans are starting to become more varied. The government lending programs still set the benchmark for other loan programs, so you will tend to see a menu of options for fixed rates loans–as a reminder, still a very US American thing.
Before we go into the territory of “esoteric” loan programs, we’d do well to mention the humble seller financing. This is exactly what it says on the tin: the buyer makes an agreement with the seller to finance part of the real estate purchase. In a way, the lender becomes the bank. For elaborate, and especially unusual properties, it is worth inquiring about this option. Some sellers are open to it, and are willing and able to write up a promissory agreement that allows them to collect money with interest from the buyer-borrower.
There are a few reasons why sellers may be open to seller financing. One is that the property has unusual qualities, making it ineligible for regular financing. In this case, the seller tries to sweeten the deal for the buyer by offering a way to finance the deal without going to a bank and going through an underwriting process. Another reason why the seller may be willing to do so is if they are wanting to convert their asset into a fixed monthly income. This is sometimes attractive to sellers who are looking to retire from the investing career, and prefer a steady stream of cash flow to a lump sum payment. They also get to collect interest on loan payments which would otherwise have gone to a bank. Sellers that expect to be in a low tax bracket can split their sale proceeds across a long time period, placing them into a lower tax bracket compared to them receiving a (large) lump sum payment in a year. This trades off the availability of money for a longer time to repay, so it is something that not all sellers would be open to. But it is always reasonable to ask.
Assets that are usually sold this way are mobile home parks. My understanding is that they are otherwise difficult to finance (although I do not have first hand experience, so take with a grain of salt), and seller financing may not only be the only way for a non-cash buyer to buy into the property, but may also be the only way for a seller to attract prospective buyers. However, with the eyes of large financial institutions and funds turning from high end to all aspects of real estate, the landscape here is changing too.
Jumbo loans are loan products that look like government backed loans, and quack like government backed loans, but are actually portfolio loans. Jumbo loans are all too familiar to investors or home buyers living in geographical locations with notoriously high real estate prices–coastal cities like New York, San Francisco and Seattle being typical examples. These loans are typically available to high net worth professionals for buying–to some opinions overpriced–homes in expensive coastal cities. The qualification criteria for jumbo loans are by and large similar to those of conventional loans, with the obvious exception of very different loan limits.
Adjustable rate mortgages (or ARM)
A popular loan product is an adjustable rate mortgage (ARM). This loan product is somewhat more similar to the loans one can typically get in Europe. ARMs usually have a period of fixed rate (sometimes called a “teaser” rate since those are usually lower than competing fixed-rate loans), usually 3 or 5 or 7 years. Thereafter, the rate is adjusted in regular intervals, usually in 1 year increments. This is usually denoted as 3/1 or 5/1 or 7/1 ARM. When rates are adjusted after the expiration of the initial period, a number of limitations apply to the interest rate. The initial adjustment cap limits the initial adjustment of the interest rate. The subsequent adjustment cap limits each subsequent increase. And the lifetime adjustment cap limits the total amount of interest rate increase over the lifetime of the loan.
This label includes a vast swath of portfolio loans, originated by private companies: banks, lending houses, funds, and the like. Commercial loans can be used to finance pretty much any real estate purchase, provided that the parameters of the deal conform to the lender’s underwriting standards. Different lenders place different weight on various parameters of a deal depending on the intention of the borrower. Parameters that enter the lender’s deliberation process (usually called “underwriting”) include: the borrower’s income, creditworthiness, past financial performance, personal financial statement, and past experience with the type of business plan proposed in the acquisition. The parameters that concern the property itself are: the purpose of the property, the geographical location, past performance–usually proven through the so-called T12 or the “trailing twelve” months financial statement as well as rent roll (list of tenants, evidence of vacancy, rent amounts and contract begin and end dates)–the profit and loss statement (or P&L, which represents the account of the income and expenses on the property for usually at least the past year, sometimes two).
With commercial loans, almost any parameter is negotiable. This is in contrast to conventional loans, where parameters are by and large determined by the FNMA selling guidelines. Although there also is some play, as lenders have some leeway to adjust the rates and other loan costs, based on how much they want you as a customer. Your desirability as a customer depends not only on you and your project, but also on how close the lender is to achieving their lending goals for the current period. This means that it pays to shop around for the best deal for a loan, just as you would be inclined to do this in case of any other purchase. This is called competitive bidding, and it sometimes helps in negotiations to make it clear to the lender that you are asking multiple lending houses to compete for your business.
What documentation is required to back up the borrower’s application. This includes a number of document types, depending on the type of loan and intent:
- Guarantor experience biography
- Proof of income
- Credit scores
- Bank account statements for the past few months
- Brokerage and retirement account statements
- Personal financial statement
- W-2 forms for the past few years
- Payslips, for salaried persons. Other proof of income for self-employed persons.
- Tax returns for verifiable company financials.
- Profit-and-loss (P&L) statements of the property to be purchased
- Trailing 12 (T12) monthly financial reports for the property. Sometimes T24 is required, or T3/12, which is trailing 3 months projected to a full 12 months.
Commercial loans are usually recourse loans, and are in many cases the only way to finance 5 or more units of residential real estate that requires less than $1,000,000 to finance. The upside is that the paperwork is usually less than the conforming loans, the lender contact points are more efficient and business oriented–but also expect you to be too. The lenders are usually fine to close in the name of a company, but will require personal guarantees, and will want to know the debt service limitations for your property. An upside of closing the loan in the name of a company is that the loan never appears on your credit report–this way you can extend your creditworthiness as much as needed to support your real estate business plan.
Once your investment acquisitions go over about $1M of debt, another source of financing becomes available to you. For amounts starting from about $1M to over $100M, there is a big variety of non-recourse loan programs. In non-recourse loan programs, the property itself becomes the only collateral for the loan. That is, the personal financial situation of the borrower becomes secondary–though not entirely irrelevant.
These loan products are again underwritten by government agencies, allowing the lenders to offer unusually good terms despite the large amounts of debt involved. This web page offers a detailed overview of these loan programs, and there are at least a few dozen of them.
Let us line up a few typical characteristics of non-recourse loans:
- Non-recourse: the property is the collateral.
- Attractive interest rates. May be as low as 3% or 4% even nowadays.
- Long terms and maturities. Loans with terms up to 40 years are available, though there is a great variety in specific terms.
- Long closing times. Be prepared for 45 to 60 or more days to close.
- High fee amounts. Expect to be out $50,000 or more to close one of such loans. The fees are also based on a certain percentage of the loan amounts, but since we’re talking large amounts of money to begin with, this necessarily means high loan fee amounts as well.
- Distressed properties are not eligible. Blighted properties or properties with high vacancy rates (15% and up typically) will not qualify. When the lenders loan large swaths of cash, they want a safe haven for the money they give you. A distressed property is not such a safe haven. Financing a distressed property usually requires some form of a bridge loan (see below).
- Personal guarantees are required. While the loans are non-recourse, they usually come with carve-outs (a.k.a “bad boy carve-outs”). That is, a set of circumstances under which a loan may convert to recourse: typically in cases of gross neglect or criminal behavior by the operators.
- Loan amounts starting from $1M going to over $100M.
- Separate loan programs for different types of properties. For example, there are dedicated “small balance” loans ($1M to $10M). Or, dedicated loans for student housing.
- Requires a certain minimum DSCR. The proven net operating income must be a certain fraction above the yearly debt service.
- Business plan is required. You must prove your intention for the property
- Prior experience required from the property operators. Experience levels may affect the loan terms. This is informally referred to having a “golden ticket”, i.e. being known as credit-worthy by the agencies underwriting these loans.
- Assumable loans, sometimes for a fee.
- Liquidity required from the guarantors. Typically 6 to 12 months of debt service in cash reserves, after all acquisition expenses are paid.
- Net worth required from the guarantors. Amount is usually a certain high percentage of the amount of the loan, e.g. 90% to 100%.
Loans such as these are a critical tool for financing large acquisitions, by single investors, an investor group, or a syndication. Having at least a rough idea of the options available adds to your real estate investor toolkit and opens up options for making various kinds of deals work.
Bridge loans are short-term loans (typically 12 to 24 months) taken out if for whatever reason the property is not eligible for long term financing. A typical example would be a “rehab” acquisition of an apartment complex. When the property requires extensive renovation, or is distressed, it is ineligible for long-term debt. This is where bridge loans come in. They take more risk, but allow you some breathing room to rehabilitate and turn a property around, and then refinance into long term debt. Bridge lenders have a variety of options and will tolerate risky properties, in exchange for appropriate relatively higher fees and interest rates compared to long term debt.
In short, this is debt that you take on from private individuals that are willing and able to lend to you. The terms here are basically whatever you agree with your lender, subject to some regulation, such as usury laws.
The upside of private money is that, depending on the relationship you have with your private money lender, the lending process can be relatively uncomplicated. If your private money lender knows you and your abilities well, they might be prepared to lend to you based on the relationship alone, regardless of the parameters or the risk levels of the deal.
The downside is that the private lender needs to be motivated to lend the money to you (vs investing it somewhere else). This usually means that such loans will charge high points and higher interest rates when compared to institutional loans.
This has been a quick tour of the lending landscape that you may be seeing when looking for appropriate financing for your real estate acquisition. Main takeaways are:
- Check loan parameters first. Be sure you find a lender offering loan parameters that fit you.
- Conventional loans. Use conventional loans to finance 1 to 4 unit residential properties.
- Commercial loans. Use commercial loans to finance smaller 5+ unit projects, or other commercial real estate.
- Non-recourse loans. Use non-recourse loans for large acquisitions of commercial property, typically starting at $1M, going up to $100M and even more. Though, chances are that if you regularly take out such loans you do not need to read a lending guide written by me.
- Bridge loans and private money loans help with unconventional and distressed situations.
Good luck in your real estate endeavors!
Check out the other parts of this series in our blog: