Mistakes Newbie Investors Make With Real Estate Debt: Part 1
“The only source of knowledge is experience.” – Albert Einstein
I think teenagers today have moved on to more advanced insults, but when I was a teenager playing online video games, a recurring verbal jab was calling someone a “noob”. The term Noob, an abbreviated form of Newbie, was used to communicate that a player wasn’t very good, and probably made some silly mistakes.
This is a recurring theme in life from starting to walk and talk as a toddler, to learning subjects in school as a student, to getting “owned” in video games by the older kids, and continues on into adulthood. As a newbie, you make mistakes that you’ll learn to avoid through experience.
Business and investing are no different. Experience is a teacher to be sought out. You’re going to learn from mistakes one way or another – better to learn from someone else’s mistakes rather than commit them yourself.
So read on, noobs, as we shed light on the mistakes that experience can teach us about arranging a loan for your commercial property investment.
Mistake 1: Fail To Prepare; Burn CredibilityCredibility is the currency in commercial real estate. To lose it is to lose your ability to raise funds and gain valuable partnerships.
One way new investors lose credibility is by failing to prepare for an interaction with a lender. No one expects an investor to have every detail about their property memorized. But if you fail to answer multiple common questions that a lender will ask you right off the bat, you’re burning credibility.
Likewise over email, if a lender asks for a reasonable piece of documentation, it’s much better to be prepared with all the docs ready to go in a folder, rather than scrambling to gather that same information yourself, and taking a long time to get back to the lender.
- Information you should keep on hand before engaging a lender:
- Historical operating statements (income statements, usually broken out by month) of the asset. Preferably 3 years’ worth if they are available.
- Basic property details (address, size in sq ft, zoning, construction type, year built/renovated, etc)
- A projected Sources & Uses of your investment.
- Pro forma (projected) operations statements.
- Personal financials (a Personal Financial Statement and a Schedule of Real Estate Owned)
The worst part about losing credibility is that it doesn’t just harm you now, but it harms you every time you could have gone back to that same relationship. People will mentally label you as either untrustworthy or just a waste of time. It’s hard to shake a bad reputation.
Mistake 2: Only Talk To One LenderUnderwriting standards, rates, and terms can vary widely from bank to bank for commercial mortgages. Different institutions have a different appetite for risk in their portfolio, so find the “right lender” is key. You cannot expect to get the best loan by walking into your local bank.
Not only that, but banks are far from the only commercial lending players around. There are also credit unions, life insurance companies, government agencies, and private debt funds that all offer very different types of loans. A narrow focus on those couple of lenders you already know at the start will be severely limiting, and you’ll miss out on the best loan that is probably available elsewhere.
Mistake 3: Focusing Too Hard On Interest RateInterest rates are important, but it’s easy to be myopic about them. In reality, an investor’s returns are often optimized by taking the higher interest rate loan if:
- Another lender can provide a longer amortization schedule, which increases cash flow.
- Another lender can provide higher loan proceeds, as long as the Loan Constant is positive.
- There is significant value-add potential in the short term, in which case refinance flexibility can help the investor cash-out more readily.
In the fortunate position of having multiple lenders who want to work with you, choosing the right loan comes down to financial math, and the interest rate is just one of the variables.
Mistake 4: Fail To Disclose Credit IssueSigning a term sheet for a loan before disclosing the “worst news” about your deal or credit profile is one of the worst and most common mistakes of a newbie investor. A lender will usually find out that key piece of information, the “hair” on the deal, eventually. When they do, you will have lost:
- Time – the lender may pull out entirely and now you’ve lost all the time you spent with them, thinking you would get away with it.
- Money – there are deposits and fees that get collected along the way from term sheet through due diligence. You won’t get them back if your deal falls apart, but worse, you may not be able to close your deal at all, and losing your earnest money with a seller is no joke.
- Credibility – darn, mistake #1, again.
Mistake 5: Misunderstanding LTVLet’s say you find a good-looking multifamily property and decide to analyze a potential acquisition. Your own underwriting indicates that it is worth $2 Million. It is currently listed for $2 Million – great! But of course, you don’t want to offer the full listing price, so you put on your negotiation hat and start bargaining with the seller.
After some back and forth the seller accepts your LOI at the lower price of $1.8 Million. Score! You’re getting a great deal!
As is customary with real estate transactions, an appraisal is ordered. The appraisal report comes back, and, would you know it, the appraiser pegged the current value at the full $2 Million based on income and market comps. The appraiser has now verified you’ve gotten a good deal, as the asset is worth $200,000 more than you’ve paid for it.
Does this also mean you have $200,000 more in “equity” according to the bank providing the commercial mortgage? Will they provide you more loan proceeds based on the higher appraisal value, thus limiting the cash you need to provide at closing?
Unfortunately, the answer is No. We see this time and again from newbie investors, thinking they can limit the cash required to close because they “have a good deal”. It’s just not how commercial mortgage lending works.
Regulated lenders, like banks, who limit their loan proceeds based on the Loan to Value ratio, have to decide what the “Value” is that determines the loan amount. That value, in practice, becomes the least of the purchase price, the appraised value, or the lender’s own underwritten value. Any of the three can act as a limiting factor to loan proceeds. Scoring “a good deal” through negotiation with the seller is great – but don’t expect it to boost the amount of debt you can garner.
Mistake 6: Asking Lenders To Underwrite a Deal You Don’t ControlUnderwriting takes time. Most investors wouldn’t look a property listing, and immediately send out an offer to the seller before performing any sort of analysis.
Loan underwriting takes time as well. Commercial mortgage loans require a thorough understanding of the property collateral, the historical income, comps, the borrower’s track record, and financials, and pulling it all together to project future income and risk. They don’t like doing this for an investor that just found an interesting listing but doesn’t have any sort of control over the deal, like a signed purchase contract or at least an LOI. It takes up their time to underwrite and quote deals, so quoting on deals that are earlier on and thus less likely makes their timeless valuable.
Asking for informal feedback about a market or a loan product is smart. Lenders can give you interest rate ranges and leverage constraints very easily. Asking for a full quote or term sheet on multiple deals you are just browsing can make a lender feel like you’re wasting their time.