Updated: Jan 9, 2021
As a passive investor, you are probably presented with multiple deals a year. Most investors focus on the returns, the business plan and the hold period (the length in which the property is being held before the syndicator sells it). However, many investors ignore one very important piece of the puzzle: the debt. Even though as a passive investor, you are not required to sign the loan, it is nevertheless important to understand the debt structure and strategy and make sure it fits your investment goals and criteria, and matches the level of risk you feel comfortable with.
Understanding the debt structure and how comfortable you are with it is crucial to your success as a passive investor. Before we discuss the best financing strategy, let’s start by looking into the basic types of debt.
Types of Debt: Recourse vs. Non-Recourse
With recourse debt, the investor who is borrowing the money is personally liable. That means that the lender can collect the money owed even after they have taken the collateral - the multifamily property. According to the IRS, the lender can garnish wages or even levy assets to collect their money.
However, with nonrecourse debt, the lender can only go after the collateral - the multifamily property. That’s why syndicators prefer nonrecourse debt. Even though there are instances where a lender can collect monies owed above and beyond collateral when there is fraud or gross negligence (which is called “bad boy carve out”), nonrecourse debt is the one that syndicators choose. The only caveat is that nonrecourse loans have a higher interest rate, and are available only to syndicators with a stellar financial track record.
The Two Financing Strategies: Agency Loans and Bridge Loans
Generally speaking, there are two main financing strategies: Agency loans and bridge loans. There are many more types of loan strategies, but we will focus on the main two. An agency loan is a loan that is backed by a government agency. Fannie Mae and Freddie Mac are the government-supported agencies that guarantee mortgages. They issue mortgage bonds and guarantee that the principal amount of the loan will be repaid. Because the loan is guaranteed, syndicators can generally get a lower interest rate.
The agency loan allows the syndicator to be more conservative in their underwriting. It has a lower loan-to-value (LTV) ratio than other loans and don’t allow investments to be over-leveraged. Just to clarify, loan to value (LTV) is a term that’s used by lenders to describe the amount or percentage that a buyer is borrowing against the appraised value of the property. For example, an 80% LTV means that the syndicator is borrowing 80% of the appraised value of the property from the lender, and is putting 20% of his or her own funds into the loan.
Today, most agency loans allow between 60%-75% LTV (which means that the loan will be 60% to 75% of the purchase price). This is actually a positive thing, because it keeps the syndicator conservative and disciplined. If you think back to the real estate crisis of 2008, the people who got into trouble were those who over-leveraged their borrowing.
Agency loans are usually a long-term debt, and the loans are given for 5, 7, 10 or 12 years. Many times, the lender will allow syndicators to receives several years of interest-only payments. Those loans are amortized for 30 years. Let’s say you have a 5-year investment property loan that’s amortized over 25 years. The syndicator would then make payments for 5 years at an amount that is based on a loan that would be paid off over a 25-year period of time. Once the term is reached, the loan must either be paid off, refinanced into a new loan or the property would have to be sold.
A bridge loan, also known as interim financing, is put in place until permanent financing (Agency loan) is finalized. Bridge loans are usually short-term loans, up to 1 or 2 years (though can be longer), and carry higher interest rates compared to Agency debt. Bridge loans are backed by collateral, usually the property that the loan is used to finance.
Bridge loans usually have a faster application, approval and funding timeline than Agency loans. However, the main advantage of bridge loans is that, unlike Agency loans, the building doesn’t have to be stabilized (85% occupied) to be granted a loan. In addition, may bridge loans have higher LTV.
Many bridge loans are interest only loans, so investors make interest-only payments for the period of the loan. At that point, the options are to pay off the loan, refinance with permanent financing, purchase an extension or sell the property. Because the loans are interest-only, the monthly debt service is lower.
Investors should be aware that bridge loans are riskier than agency loans due to their short term. Why? Because before the end of the loan’s term, the syndicator must refinance or sell the property. If the market is in a position where long-term or agency financing is hard or expensive to get, the investment returns might look completely different than initially projected. There’s no certainty in getting a short-term loan, since nobody knows what will be the agency loan interest rate when the bridge loan is due. That can significantly impact your returns.
Bridge Loans on the Upturn
While many syndicators and investors stay away from bridge loans, it appears that the bridge loan market is heating up. One reason for the surge in bridge loans has been explained in an article in National Real Estate Investor. According to the article, lenders are increasing the qualification standards for Agency loans, so the need for other sources of lending, including bridge debt, is on the rise. If a lender denies a loan when the deal is at the end of escrow, investors have limited options available because it’s too late to start the loan application process over again. A short-term bridge loan can provide the money needed until a permanent solution can be found. To avoid this situation, I always make sure to have an agency debt quote ready as soon as I sign the contract with the seller.
Why Agency Loans Are Better
Even when placing the more conservative agency loan, investors should take more precautionary steps to ensure their deal is safe. One of the biggest considerations of utilizing an Agency loan is the longer-term when compared to Bridge loans. The key is that the length of the loan should exceed the projected hold period. It will give you more flexibility in case of a market downturn. For example, if you join a syndication that plans to hold a property for 5 years and they have a 5-year agency loan, they will have to sell after 5 years, even if it won’t be the right time to do so because of an unfavorable market. However, if they placed a 7-yeal loan, then the syndicator can wait for a year or two so they can sell the property in a better market and get higher proceeds.
When I buy a property, I always choose a longer debt term than the hold period, to allow me and my investors the flexibility to sell in a better market. When it comes to a bridge loan, it’s even riskier because it usually comes due in the middle of the hold period, exposing investors to the risk of an unknown interest rate environment, which is why I tend to stick with Agency loans and avoid bridge loans.
Loan term is not the only major benefit of Agency debt. As mentioned earlier, Agency debt is more conservative, since its LTV requirements are stricter than Bridge loans, and it only applies to stabilized assets. You cannot be overleveraged with Agency debt, which will keep you safe.
When financing your property, you need to look at the differences between Agency and Bridge financing to determine the best route for your particular investment. An Agency loan is safer and more conservative, since it has a conservative LTV and a longer term. I find that if the deal works only with a bridge loan then it’s a risky deal and tend to avoid those type of deals. In today’s market, this strategy is not advisable and I stay true to my conservative nature.
About the author
Ellie is the founder of Blue Lake Capital, a real estate company specializing is
multifamily investing throughout the United States. She is also the host of a
weekly podcast called "That REllie Happened?! Unbelievable Real Estate
Stories with Ellie", a podcast that brings the true stories behind the deals,
from the most successful real estate investors around the globe. Ellie started
her career as a commercial real estate lawyer, leading real estate transactions
for one of Israel’s leading development companies. Later, as a property
manager for Israel’s largest energy company, she oversaw properties worth
over $100,000,000. Additionally, Ellie is an experienced entrepreneur who
helped build and scale companies by improving their business operations. She
holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.