Financing Secrets: Let’s Talk About Selecting the Proper Debt for an Asset…
For those looking to understand our financing process a bit more, and for those of you who have not read our e-book, we thought it might be helpful to talk through debt selection. That is, the how and why that goes into selecting a certain type of debt to complete the financing of a multifamily real estate deal.
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First, we determine how the property is operating in the current marketplace by reviewing the property financials. We work to identify potential upside through either physical reposition of the property and/or operational upside. From there we formulate a business plan that our team could potentially implement over the projected hold period of the property. A key piece of our business plan includes asking ourselves, “What are our debt options?” and ensuring that we marry the appropriate financing to the business plan and opportunity. Different business plans and objectives will require different types of flexibility and exit options.
Two Types of Debt: Categorized by Set of Lenders
In our case, we would be working with two different options for loans: GSE (Government-Sponsored Enterprise) and non-GSE.
GSE - A Government-Sponsored Enterprise, often referred to as an agency, in this context is what we know as Fannie Mae or Freddie Mac. For simplicity, these are the houses that would provide us a permanent loan that often has a fixed rate over a specific period of time. They also offer adjustable or floating rate loans, sometimes with flexible terms like an interest-only period.
Non-GSE - These can be life insurance firms, CMBS lender, regional or national banks, as well as alternative lenders (i.e. non-bank, third-party loan providers). Life insurance firms and CMBS options are typically longer terms and require more stringent terms than a loan originated under one of the above agency programs. These types of loan options will typically require lower leverage and longer lock out periods and/or larger prepayment penalties in return for attractive rates.
Alternatively, bridge financing options are short-term loans that “bridge a gap” while you reposition a property and wait for a permanent loan to become more achievable after a property has been stabilized (see below). Bridge financing would be leveraged by CF Capital to bridge the gap between the acquisition and reposition of a property allowing for a great deal of flexibility on when to sell or refinance. In most cases bridge loans typically have higher interest rates than GSE options, are interest only payments, and are for shorter terms ranging from 18 months to three years, often with an option to extend for one to two more years.
So what factors determine if we should choose a GSE loan or non-GSE loan?
Determining the Property Type
Within our investment criteria , there are two property types within multifamily real estate we could potentially look at: Stabilized and Distressed. One could take a guess what these types mean, in general, but when it comes to the more technical definition we must look at specific factors that might make a property categorized as stabilized or categorized as distressed.
The most important factors are occupancy and the amount of value-add (which can be operational and/or physical value-add).
To fit in the stabilized category, a property would need to have occupancy levels that are greater than 90% and needs a relatively low amount of value-add.
A property in the distressed category would be the exact opposite: less than 90% occupancy and/or a relatively high amount of value-add.
Why does the property type matter when choosing debt? Let’s talk through why.
Tying it Together: Debt Options According to Property Type
By identifying the occupancy and value-add factors, we are now on the right path in figuring out who to go to for a loan and what type of loan that is most appropriate for our investment.
Stabilized
Typically, a stabilized property would put us in a good position to work with a GSE lender for a permanent loan that might have fixed or floating interest rate terms.
Among the various market conditions that would allow us to determine the type of interest rate terms, one important area to look at is where the market rates are at the time of the loan relative to historical averages. If they are significantly lower, a fixed rate might be preferable.
An interest-only period in this loan might be an option, but it is not always a guaranteed part of the equation.
To receive a loan from GSE lenders, our property we need to meet the targets required by the GSE lender -- loan-to-value (“LTV”) and a debt-to-service-coverage (“DSCR”) of at least 1.25. Meeting these metrics and others, will tell us if we are in a position to be approved for a permanent GSE loan.
At CF Capital, we like to take things one step further and optimize these targets so that we are not over- or under-leveraging, as well as considering a more attractive break even point.
We would like to think that this reveals our partnership mentality with our investors. If we are cognizant of cash-on-cash returns by optimizing the key loan metrics, we believe we are best serving our investment partners.
Distressed
Back to our comment about the ability to choose the type of loan or not -- if the property does not meet the requirements by a GSE, then we may have no choice but to go the non-GSE loan route.
In the case of a distressed property, we would approach alternative lenders as well as local and regional banks to (typically) provide us with bridge financing. The lenders here understand that there is a need for a more significant transition, but may charge a higher interest rate in the short-term and require some sort of collateral. Often, these are loans with an interest-only period and may or may not have fixed or floating interest rates.
The goal with bridge debt from a non-GSE lender is to use this short-term temporary financing and switch to a permanent loan. That is, if the situation permits.
Main Takeaways
A stabilized property would typically require 90%+ occupancy and less value-add. In this case we would be more inclined to go with the GSE lender for a permanent loan, but we must factor LTV and DSCR into our decision-making. We also must be cognizant of cash-on-cash return metrics, as well as the risk factors of leverage and market conditions.
A distressed property would typically have less than 90% occupancy and significant value-add. In this case, we would most likely go with a non-GSE lender to provide bridge debt as a means to transition to a permanent form of debt. Interest-only provisions are more common here.
It is worth noting that each property is unique and specific, so choosing the form of debt should be treated as such. By partnering with the best lenders and brokers in the business, we should set ourselves up nicely for long-term success. But, ultimately, we (as the investors ) make the final decision.
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