March 26, 2019

Real Estate Debt Financing 101

Time to talk about leverage!

In part one of this two part series, the BxB team discusses the essentials of real estate lending, including industry terminology: LTV, DCR, DTI, NOI, and more!

We also talk pricing, terms, and additional variables to ensure that you match the right loan with the right project.

 

(Transcript below.)

 

Ben Shelley: [00:00:00] Welcome back to the Brick x Brick Podcast. Today's episode is part one of a two part topic on debt financing. Part one is focused on terminology surrounding the financing process. Enjoy.

 

Ben Shelley: [00:00:21] Welcome back to the Brick x Brick Podcast. I'm Ben and I'm here with John and Ryan. And for today's episode we're going to talk about debt financing. Now if you've been a avid listener of the show which I'm sure many of if not all of you are you know that we've already done a sort of overview episode about real estate financing more broadly today. We want to hone in a little bit more specifically on the debt side. And why we want to do that is so that you both the everyday intermediate and expert investor have a sense of the landscape and know where to go and what to look for when you're negotiating and talking with lenders. And so some of the types of financing in lenders you may be dealing with are conventional lenders portfolio lenders FHA lenders hard money privateetc. So our experts are going to take you through it. Nobody knows it better than John and Ryan and so I'm going to start by throwing it over toMr. Wells Fargo himself. Ryan Goldfarb where do we want to start this?

 

John Errico: [00:01:13] Ryan quote Wells Fargo quote Goldfarb.

 

Ryan Goldfarb: [00:01:17] Together Wells Goldfarb so far has really come. It's one of my friend's jokes. I want to try to get him right here. I think it's Neal. Okay.

 

John Errico: [00:01:26] And about 50 years when you acquire Wells Fargo you can.

 

Ben Shelley: [00:01:30] You don't want that kind of publicity.

 

John Errico: [00:01:32] So just over set big goals and then try to achieve. And that's you know that's just put it out to the world see what's gonna happen.

 

Ryan Goldfarb: [00:01:38] Interesting too. It's interesting to think about where these banks will be in 50 years from now.

 

Ryan Goldfarb: [00:01:42] Any who because.

 

John Errico: [00:01:44] They keep loaning money to us. I mean they might say.

 

Ryan Goldfarb: [00:01:48] Well we in Ben's eyes are the experts on this.

 

Ben Shelley: [00:01:51] Now of course my only goal is really to convey every episode that you guys are experts at fill in the blank topic of that episode should I cut that.

 

Ben Shelley: [00:02:00] I don't know.

 

John Errico: [00:02:00] Well we're always there's like the point 0 0 0 1 percent of the Earth's population that we listen is like these guys go to the bank for 40 years. Well they set it on the by podcast. It must be true.

 

Ryan Goldfarb: [00:02:12] Well sir I worked at one for three years.

 

John Errico: [00:02:14] I want to make sure that we accommodate that person. What incentive do that person who's like five people enter.

 

Ben Shelley: [00:02:20] We are way off the rails.

 

Ben Shelley: [00:02:21] We didn't even get started yet more sidetracked.

 

Ryan Goldfarb: [00:02:24] Anyway. Taking us back to square one.

 

Ryan Goldfarb: [00:02:26] The way that I've been thinking about this is in the context of buying let's say a car. There's so many different places where you can start and there are so many things to think about. You'll walk into a dealership and they'll start throwing all these terms out at you both pertaining to the car itself and to the different ways that you can obtain the car. You can buy it outright. You can lease it and you can finance it. And in a lot of ways I think there are parallels to buying property. You can buy it outright. You can buy it with financing.

 

Ryan Goldfarb: [00:03:00] You can lease iti.e. rent it as as many of us do for our own purposes.

 

John Errico: [00:03:05] Steal it buy adverse possessing defective squatters.

 

Ryan Goldfarb: [00:03:10] That be an interesting episode that is going to anyway.

 

Ryan Goldfarb: [00:03:14] So that's kind of how I think about this high level. There are I guess to start any number of ways that you can buy it. As I alluded to before it can be through all equity or in the case of you know just buying a property for 100 percent cash or the more common way to do it would be to put down some money in the form of a downpayment and then obtain a loan for the remainder.

 

Ryan Goldfarb: [00:03:44] That loan is what is classified as debt.

 

John Errico: [00:03:47] And usually just to clarify that the loan is secured by a lean on the property. So that's what classifies this type of financing from me. You could also get other types of debt I suppose that aren't secured by leans like you can get a personal line of credit or something like that that's secured by your personal credit. But these are all secured by the actual asset. So that distinguishes there's a category of thing. Right.

 

Ryan Goldfarb: [00:04:12] So under that umbrella of debt some of the options are conventional financing which is what most people think of when they're going to buy a home. It's you go to the bank and your banker says we can get you into this new house for 20 percent down while we're on your credit. It's oftentimes the loans are guaranteed by Fannie Mae or Freddie Mac and they fall into this bucket that allows them to be offered to you at pretty attractive rates. And so that's that's generally more applicable to the owner occupant class of purchasing which is what you would use to buy a primary residence on the investment side. There are also a litany of other options including commercial portfolio lenders hard money loans private lenders each of which have many similarities but also some key differences that are important to be aware of before you dive in and pursue any one of these paths. John, am I missing anything here.

 

John Errico: [00:05:12] Well I think we'll get into it. But part of the the skill of being a real estate investor is knowing when and how to use these different financing options. So oftentimes with the home you'll you might buy a home with a certain type of financing or no financing and then obtain financing for that home at a later time or you might start with one type of financing change or a different type of finance in Exeter et cetera it be known as a refined refinance right. And depending on your goals of the property and the type of the property that may be very advantageous or not so we can run through some examples. I mean just very high level of you if you're familiar with reading say BiggerPockets or that community of thing you've probably heard of the Byrd strategy which is buying renovating renting refinancing and then repeating and refinancing is sort of the key word or what we're talking about which is normally in a BR technique you might start with could be conventional finance and could be FHA financing whatever and then you got to refinance that into a conventional loan and take money out of it. So even like very beginner like house hacking type strategies you're going to have to know knowledge about financing and how it works.

 

Ryan Goldfarb: [00:06:23] Then I guess before we get too deep into the weeds here it's probably good to start with some definitions or with understanding some of the key components of what these different loans will offer. The first one is leverage. That's often referred to as the loan to value or in some cases loan to cost. So if you're buying something for two hundred thousand dollars and your lender is offering a loan product with an 80 percent loan to value that means that the lender so long as they support that two hundred thousand dollar value via an appraisal or some other type of internal valuation they're willing to loan up to one hundred sixty thousand dollars on that property for that purchase. Which means that you as the owner investor whatever you want to call yourself. Need to bring the remaining forty thousand dollars to the table plus allocations for all the closing costs that you that you will incur. Plus any holding costs that you will have for any period of time thereafter up until you are fully stabilized with your rental property and have tenants in place who are going to cover those holding costs. So.

 

Ryan Goldfarb: [00:07:38] Leverage. Most commonly I think the most common benchmark that you'll see is generally 75 to 80 percent loan to value for investment property. The more risky an investment can be generally the lower loan to value that a lender will offer out because it's true.

 

John Errico: [00:07:58] That's that's a victory for the world of residential loans properties for commercial loans.

 

John Errico: [00:08:03] You can get a lot lower or higher whatever you want to call it requirements so you might be a little like 70 percent loan to value 65 so a lot of other things that graduate.

 

Ryan Goldfarb: [00:08:11] As you get into as you get into say commercial property like a strip mall or a standalone office building or something akin to that you may find lenders that are a little bit more averse to lending and high leverage because the secondary market for that kind of mortgage is a little bit different. There aren't as many means to securitize and sell off that paper which means that the lender themselves often has to hold on to the loan for the lifetime of that loan whereas when you're buying a residential mortgage through Wells Fargo or through ABC lendingCorp. in your town that is a well known mortgage broker. They're originating alone but within a few months that loan will get bought by an investor generally as part of a pool and that investor will be the one who's essentially clipping the coupons and earning the interest on that.

 

John Errico: [00:09:06] Yeah. So the banks are like recycling cash. That's how these big originators are able to do so much volume because they're not at any given time loaning out like a hundred million dollars of cash they're loaning out X amount they're selling it to an investor or securitizing it or whatever and then they're recycling that money that they got back to re lend it out to more people. So right. So it may be worth noting sorry to cut you off right but that for primary resident if you're living in the home that's generally the most leverage that you can obtain. Actually no. I mean I could fathom exactly why.

 

Ryan Goldfarb: [00:09:41] Well I think I'll do that but I don't think it's necessarily a business play. I think the reason for it is because the so if you if you think about the existence of Fannie Mae Freddie Mac FHA FHA I think about it. FHA is is a government agency Fannie and Freddie are quasi government institutions so they are effectively the Federal Housing Administration right authority administration authority for monetary Administration FHA and Fannie and Freddie meanwhile are technically private entities but they are kind of under the oversight. Yeah they're under the oversight of the of the federal government. And the reason that those institutions are in place are for a few different purposes. One of which is to make homeownership more accessible to the everyday American. We've actually discussed this in the past. The idea of through and through government trying to catalyze good behavior or sound behavior in this case buying a home is probably better than spending that same money on a car or a or an asset that is under any circumstances going to depreciate. Home at least has a high chance of retaining its value and potential even increasing value.

 

John Errico: [00:10:59] So if you're living in the home as your primary residence you can get loan products that are as low as even zero percent down or maybe even pay you closing costs. But for most people it's more like three and a half percent down 5 percent down or conceivably possible depending on your credit in the home at Exeter cetera.

 

Ryan Goldfarb: [00:11:14] But then the other reason why these institutions exist is to promote liquidity in the marketplace. And that's mostly for the health and longevity of of the real estate markets. Anyway getting back to leverage. So as John alluded to they're actually somewhat products out there. I believe the conventional ninety seven still exists store something in that realm and then there's an FHA loan product as well that can provide access to or access to a mortgage with as little as three or three and a half percent down.

 

John Errico: [00:11:49] Is there evidence of a loan at zero percent interest rates on other things.

 

Ryan Goldfarb: [00:11:53] And then there are also some sometimes in addition to these attractive loan products there may be some down payment assistance programs and through different grant programs or other subsidies.

 

John Errico: [00:12:04] So you get anywhere between over 100 percent loan to value ratio to 60 percent 50 percent depending on the type of building asset that you're buying your personal creditetc. so that we'll get into that. Right.

 

Ryan Goldfarb: [00:12:15] And then another offshoot of the leverage question is that is the fact that some loans allow for the ability to borrow renovation proceeds. So there is still some calculus in there pertaining to to leverage limits. They generally won't let you borrow something in excess of what the property is going to be worth. At the conclusion of renovations I think two or three K may actually have an exception for that but generally any kind of investor focused loan will not. So if you're buying something for a hundred thousand dollars and plan to put twenty five thousand dollars into it you may be able to finance both a portion of the purchase and a portion of the renovation so long as your value upon renovation or upon completion is in excess of the value might be a minimum of one hundred fifty thousand and might be a minimum of 175 or 200 but depending on the loan program that will be that would generally be considered loan to appraised value or as stabilized LTV.

 

John Errico: [00:13:17] It can be enumerated so that you can wrap multiple loan products into one loan depending on the banks. You can get like a construction loan construction to purchase Russian to permanent something all sorts of things.

 

Ben Shelley: [00:13:28] To what extent do you have influence when you're talking with I know we'll get more into the process of of what is the give and take between you and a lender when you're offered terms. Can you play a part in the process of determining that after renovation value for example. Is that purely on the banks assessment or are you able to have some say in what you think that is and where you think the fairest terms are. Well.

 

Ryan Goldfarb: [00:13:52] If you're talking about just with respect to what the appraised value is on the back end that's generally gonna be driven by some kind of internal valuation by the bank or more than likely driven by an appraisal which is supposed to be done by an independent third party. So you may be able to make the case that based on something you know or some kind of substantive experience that you have that you know this property is gonna be worth six hundred thousand dollars when it's done because you just renovated and sold the one next door which is identical and you got six hundred thousand dollars for it. Generally on the residential side it's gonna be driven by mostly by comps sales comps that is on the commercial side. On the investment side it's generally gonna be driven by the what's called the income cap approach which is it's a valuation methodology driven by capitalizing the NOI on a property. So you go through an income and expense pro forma something out arrive at an NOI and then apply a cap rate to that NY to arrive at a value. That's something that we've gone into and a little bit more detail in in prior episodes but high level that's that's how it is.

 

John Errico: [00:15:02] Cap rate is usually from the market with market cap rate red is for that area.

 

Ryan Goldfarb: [00:15:08] Right. For that area for that asset class.

 

John Errico: [00:15:10] Appraisers I mean it's a whole nother different episode.

 

Ryan Goldfarb: [00:15:15] We can I guess move next to the loan term. So that's always going to be a big factor in weighing different investment options or loan options. The standard again in the in the residential space nowadays at least is the 30 year fixed rate loan. 30 years is advantageous to the borrower because it spreads out the principal payments over a longer period of time which means that your monthly payment is able to be kept within reason and it ultimately gives you more buying power.

 

John Errico: [00:15:51] So 30 years amortized and fully and so that the passive barely fully advertising loan correct advertising would mean in this case that you're not paying only the interest on the money that you lend you're paying back the principal interest for all time.

 

Ryan Goldfarb: [00:16:03] And that's and that's governed by an amateur nation's schedule which if you look into is is quite unfavorable to borrowers.

 

John Errico: [00:16:10] So you're paying mostly interest at the beginning of your loan. You're paying mostly principal at the very end of your loan.

 

Ryan Goldfarb: [00:16:15] Even though your payment might be the same. Twenty five hundred dollars a month for the duration of the loan. So the loan term again 30 years is common in the residential space but when you get into the commercial space it's more common to see maybe a five seven or 10 year loan. Oftentimes there's variable pricing within that. So you might have a certain period of a fixed rate loan and then it adjusts after the fifth year every year until the end of the term so you might have five years of the fixed rate loan and then after starting year 6 you will have a new rate that maybe cannot increase more than a certain amount but that will generally be pegged to the prime rate or live or perhaps the Treasury although that's a little bit more common on fixed rate loans. The loan term is is important to keep in mind as an investor for a variety of reasons but probably the most important of which is you don't want to be caught. If you're looking at. If you're looking at a five year loan and a 20 year loan and you decide to go with the five year loan because the interest rate is significantly lower it's important to bear in mind that there's risk associated with that if you're buying. If you bought in two thousand four and you put five year financing on your property and your price and your loan came due at the end of your five you were. Your loan is coming due at a time when property values were at maybe not an all time low but we're at a low for a significant period of time preceding that.

 

Ryan Goldfarb: [00:17:47] So you are going to be the reason we saw so many foreclosures during that time in part was because people who were in that situation and we're seeing their loans reset or we're seeing a pending maturity they couldn't purchase or they couldn't sell at a number that would allow them to pay off their loan and they couldn't refinance based on current values at a number that would make it. That would make it feasible for them to hold onto the property.

 

Ryan Goldfarb: [00:18:14] So that kind of fed this vicious cycle of increasing supply which further suppressed property values and just kept the spiral moving downward.

 

John Errico: [00:18:25] If in the short term if you're flipping for example and you have a non amortizing loan like an interest only loan you might have the term the length of time of that loan is gonna be very important because that sort of determines the amount of time that you have to sell or refinance out the property to give a six month hard money loan that gives you essentially six months is other property which is not a very long time versus a year versus 18 months. And those are usually interest only as we were talking about before they're not fully amortizing so you're only paying the interest you haven't paid the principal and at the end of the loan terms you need to pay back the entire loan in one go.

 

Ryan Goldfarb: [00:18:59] On the flip side of this there are also investors who use this on the more conservative side of things but they will really take a long term view view towards this and they'll say look my retirement goal is in 15 years and all I'm really looking for this property to do is to serve as a source of income for me during retirement. So they might buy a property knowing that they're going to be putting 15 year financing on the property and they might amortize that loan only over 15 years. So they're paying back a lot more principal during those 15 years than if they had spread that out over 30 years so their monthly payments are going to be higher and their cash flow is going to be lower because of that. But their goal is to have this source of income for retirement so they'll have in theory a fully paid off property at the end of year 15 no mortgage which will mean more more cash flow down the road at the expense of cashflow in those first 15 years.

 

Ben Shelley: [00:19:56] Good point.

 

Ryan Goldfarb: [00:19:57] John alluded this before but the flipside of this is when you're talking about. No pun intended flips. When you're looking at a much shorter time horizon and this is another area where investors can get a little ahead of themselves and they'll think that they can complete a flip in six months. No problem but they underestimate the scope of the work. They underestimate the obstacles with zoning or the building department. They get screwed over by a contractor and they get left with a project that's going to take them a much longer to finish than just 12 months. But I think in the hard money space it's very common to see twelve months as a typical loan term and what that loan term means is that at the end of it you were loan is due and if you can't pay off that loan then you are in default and that's that's not a road you want to go down.

 

Ben Shelley: [00:20:46] That's bad that's bad in the words of bench expert opinion.

 

Ben Shelley: [00:20:50] But I think it's probably fair to point out from a hard money perspective too that it's it can be a good option for people who may not either qualify for two reasons either.

 

Ben Shelley: [00:21:00] If you're looking to flip in a short term period or for investors who might not initially qualify for conventional loans for whatever reason as almost like a bridge to that conventional loan via refi we'll get into those strategies right.

 

John Errico: [00:21:12] Yeah well I guess I should go. Just leave particulars.

 

Ryan Goldfarb: [00:21:18] What other one other subset of the of the term is that you can have a different amortization period than what your loan term is going to sound very confusing. And it took me quite a while to grasp fully but you may have a 10 year loan that is due at the conclusion of 10 years and you may have an amortizing loan but it may not fully amortize over that 10 years. So you may pay off that loan as if it's a 30 year loan in which case you after 10 years you've maybe paid off 20 or 20 or so percent of the principal. But at the end of that 10 years your loan term and maybe up so your you may either have to sell or refinance or pay it off in cash if you are so inclined. The reason that this is done is because it gives lenders a little bit of cushion. And frankly borrowers as well but it gives lenders a little bit of cushion and lessens the risk on their side of things. Because if you're doing a 10 year loan as a lender if you offer it as interest only that's super risky because your borrower is not paying anything down and if they're buying it at the height of the market when they go to refinance there's a high likelihood that the valuation that they arrived at on day one will not be the same at the end of year 10 in which case they may be it's it's more likely that they will be unable to refinance the property. That's that's what we would call refinance risk. So to allay that concern to an extent they will build in some amortization into the loan schedule so that 10 year loan might amortize over 30 years which means that the principal payments are going to be embedded in every monthly payment. So it's a little bit more expensive for the borrower on a monthly basis but it's far less expensive than it would have been had that 10 year loan be fully been fully amortizing and if you if you just kind of play around with a mortgage calculator. I mean I do this all the time. If you go into Google this is what I do in my free time ladies and gentlemen if you go into Google and just type in mortgage calculator Google has a built in mortgage calculator right there and you can kind of play around with some of these things so you can see a million dollar loan at 5 percent on a 10 year term versus a 30 year term. That assumes that these loans are loans are fully amortizing so you can kind of get a sense of how that impacts the monthly payments.

 

Ben Shelley: [00:23:47] I mean I think it's a lot of fun when we do a lot of something that we talked about at the beginning which is interest only hard money cash purchases and refinance now we're going to talk about it later on and refinance to conventional mortgages but to to to Ryan's point I think one of the most the things that gets my blood going is playing around with the numbers in such a way to see just how much we're reducing our interest. You like playing around with those numbers. I love playing around with those numbers. Talk dirty to me. When we refinance right the whole purpose is to make your debt less expensive in essence. And sometimes that means along getting your amortization periodetc.

 

Ryan Goldfarb: [00:24:24] That's great.

 

Ben Shelley: [00:24:26] Like I didn't really I don't care at all. I'm sure you know I'm just trying to do my part. I'm sorry that I'm sorry. And we value you here. That's very clear. And the interest in the interest

 

Ryan Goldfarb: [00:24:43] of time. I just want to highlight some quick definitions so that we can get a little bit more into the strategy of things. But it will be useful for the details of the later conversation. So amortization we discussed on DSC RR is the debt service coverage ratio. You may also see it abbreviated as DCR and the formula for that is NOI divided by annual debt service payments. The sum of those effectively what it is showing you is the cushion between your net operating income and your debt service obligations.

 

Ryan Goldfarb: [00:25:18] So it's the lender's way of saying okay they're paying us ten thousand dollars a month on their mortgage. That's one hundred twenty thousand dollars a year they're projected NOI is one hundred fifty thousand dollars. So the form the math is one fifty over hundred twenty thousand which I believe is a one twenty five DCR one point to five which is oftentimes is an arbitrary threshold.

 

Ben Shelley: [00:25:42] I know at least federally backed financing I got rent high.

 

John Errico: [00:25:45] I don't know. Yeah.

 

Ryan Goldfarb: [00:25:48] So there's been a little duel that we'll discuss that a little later but one twenty five is a pretty common benchmark in this maze. All right. So beyond the DSCR we have the mortgage constant or debt yield. I think this is actually more of an internal metric that banks use. But the formula for this is pretty simple. It is the NOI divided by the loan amount. So for if a bank's a 10 million dollar loan on a property with eight hundred thousand dollars I know I.

 

Ryan Goldfarb: [00:26:15] That's a debt yield of an 8 which is another way of saying it's another way of gauging the bank's return. If they had to take over this property next we have interest rate. That's pretty straightforward though it can get a little bit more complex when you get into some some more unique deal structures.

 

John Errico: [00:26:36] You talk about interest rate versus EPR.

 

Ryan Goldfarb: [00:26:39] Yes. Would you like to do that?

 

Ryan Goldfarb: [00:26:42] Well no I would not like to talk about interest rate versus you. I don't I don't either. I don't know all the technical.

 

John Errico: [00:26:49] I mean APR is just like your interest rate. So an APR is inclusive of like additional fees or other things that might be wrapped into the loan. So you might have an interest rate of you might be quoted an interest rate of say 5 percent but then you're effectively paying five point to 5 percent because of various fees and other things that are that are wrapped into it so like it doesn't like a credit card. So you see like a credit card APR it's sort of like the effective rate that you're paying even though the your set interest rate might be below that.

 

Ryan Goldfarb: [00:27:20] Thank you John.

 

Ben Shelley: [00:27:22] Notice Ryan's different reaction when John speaks. Then when I speak out how should we feel sorry for Ben. Is trending on Twitter right now.

 

John Errico: [00:27:31] Anything we hear like the voice of God kind of man. You know a deep sonorous mass where he wears a voice whereas George I need Joe. Thirty two years of life pulsing over my veins.

 

Ryan Goldfarb: [00:27:42] All I want is for this episode to consist

 

Ryan Goldfarb: [00:27:45] of more than just a few definitions. All right so under the umbrella of interest rates we have a few different benchmarks that are used to determine when interest rates are some different ones that you'll hear our library which is the London Interbank Offering Rate. I believe the Treasury rate which is based off of the Federal Reserve or the Treasury Department's current yield on bonds and that's over different timeframes you have a you might have you'll have a five year treasury a seven year treasury and a 10 year Treasury and there's a yield curve that's a pricing curve that is generally accepted in that space and so you'll see a little bit of a difference between the 5 7 and 10 year pricing as a result of that. And then there's the prime rate which is I think it's actually pretty murky or unclear as to what the actual science is behind the prime rate. I don't know if John has any more.

 

John Errico: [00:28:36] I don't know if you're into that but it's a good question. I do know that the primates are only 1 2 3 5 7 13.

 

Ryan Goldfarb: [00:28:44] Yes prime no jokes ladies undergraduate Rob it's like a dad Joe our graduate. Thank you.

 

Ryan Goldfarb: [00:28:53] Well that's like a very specific type of bad joke that's a dad joke for a dad who's a math teacher I know.

 

John Errico: [00:28:58] I'm neither of those. It's unbelievable. Thank you so much. You're welcome.

 

Ryan Goldfarb: [00:29:02] But prime rates I believe are published publicly but I believe they're determined based on like a survey of banks and their current.

 

John Errico: [00:29:13] Yeah I think that's great thing it's maybe a survey of the Fed Reserve Bank. Something like something like it's a it's a it's like small sample size of banks and it's a it's it's a said obtainable number but I don't know how it's obtained.

 

Ryan Goldfarb: [00:29:27] But the primary it's actually important because a lot of a lot of loans are priced off of primes. You're your pricing might be prime plus 1 which would mean 1 percentage point over what the prime prime rate is of primes 5 your price that your interest rate is going to be 6. That's also adjustable rate mortgages are commonly priced as a in relation to prime.

 

Ryan Goldfarb: [00:29:49] Other things that you will see when shopping around are prepayment penalties which can take the form of defeasance or yield maintenance.

 

Ryan Goldfarb: [00:30:00] Sometimes they're in a step down pattern after a certain period of time but essentially it's just the the banks way of protecting their downside because they don't want to spend three months underwriting a loan for five million dollars and have you come back day two and just pay it back with any. Yes Ben we have a question.

 

Ben Shelley: [00:30:21] Yes I do. Thank you.

 

Ben Shelley: [00:30:22] Just curious actually so I know obviously for for hard money generally there is either no or very minimal prepayment penalties given the term but is it a direct one for one. Generally speaking that the quote unquote shorter your term the shorter the prepayment penalty will be or what is your experience.

 

Ryan Goldfarb: [00:30:40] I'm just curious. I don't necessarily think that's the case. I believe unconventional financing conventional loans for a home. I don't know if there's any prepayment penalty built in

 

Ryan Goldfarb: [00:30:50] whatsoever. I've never seen it before. I think I do. I think lending you might burn some goodwill with your lender. But I don't think there's any monetary. But again the lender is probably selling your letter. They really don't care. I think there is a minimum amount of time that they have to hold. I could be wrong but made so in order for them to articulate your views.

 

Ryan Goldfarb: [00:31:04] I mean maybe the 30 60 days like that but so the answer I would say is no on.

 

John Errico: [00:31:12] And your question is this is this episode to turn into the roast of Ben Shelley.

 

Ryan Goldfarb: [00:31:19] That's like the like you really really like the chocolate factory. Like you get nothing. You are awarded no points and then God have mercy on your Exactly.

 

John Errico: [00:31:28] Yeah.

 

Ryan Goldfarb: [00:31:29] So sometimes I'm like a hard money loan you may see that the lender wants like a guarantee of three months worth of interest payments. Other times you might see a loan prepayment penalty of like 1 percent of the loan amount. So it varies loan term amortization. We talked about that. Interest only has been alluded to before. It's pretty simple it's a loan on which there is no amortization and you're paying only interest. So it's a lot easier to calculate the rate on that if you have a hundred thousand other loan and your interest rate is 12 percent. That's twelve thousand dollars a year or 1000 dollars a month. That's your interest. That's your mortgage payment. That's all you pay on a monthly basis outside of your holding costs interest only loans are only really comment on investment property I've never really seen them offered on at least conventionally on owner occupied either.

 

John Errico: [00:32:21] It's either for hard money flips or for like commercial or he locks are like what he likes are often interest only but that can be advantageous because they may obviously allow you to have a lower monthly payment than men if you are paying decades as well shall we say.

 

John Errico: [00:32:38] Juice somebody returns you you have to buy and hold property if you really wanted to cash flow and you have an interest only loan.

 

Ryan Goldfarb: [00:32:45] If you're and if you're working with a more sophisticated lender or a lender who is willing to get a little bit creative oftentimes one way that you'll see these structured is that you'll have an interest only period so you might have six months 12 months two years of interest only payments and then it goes to an amortizing schedule and that's all.

 

Ben Shelley: [00:33:05] Now that's fun to underwrite.

 

Ryan Goldfarb: [00:33:06] Yeah that's generally done for the purposes of giving the owner time to get their operations up to par. So if you have a big repositioning or if you have a development occurring it's a way to say like OK we understand that your cash flow is gonna be tight for the first six months or twelve months or two years but we understand that there's upside in that and we'll work with you to to create something that's gonna work for you. The one last thing that we can touch on are that we should just highlight now as the DTI or debt to income that's a common metric for conventional financing because that's underwritten on an individual level versus against the property. So your debt to income is it's the ratio of your debt to income.

 

John Errico: [00:33:50] It's important to consider that the debt to income ratio and that's thrown around a lot particularly in the residential world too could be inclusive or exclusive of the debt that you're about to assume. So oftentimes the minimums are inclusive of the debt. So if you're buying a home your debt to income ratio has to be a certain number including the debt you're about to assume which is often quite substantial. So just as a very high level overview and we should talk also about what underwriting is. I know that that might be very obvious but we've just used the word underwriting many times. Underwriting is essentially like the call analyzing like you're just like running the numbers and seeing like do the numbers make sense. So a lot of people in the finance world say I'm going to underwrite a deal it sounds very fancy but just means that I'm going to take like three numbers together and see what they are.

 

Ryan Goldfarb: [00:34:35] So my first title was underwriting analyst and it took me a while to understand what that even like what that even meant analyzing I think is redundant.

 

Ben Shelley: [00:34:45] I think it is fair to say that in previous episodes we've alluded to a very basic form of underwriting this idea of underwriting or analyzing for the common investor or rental properties. I was an underwriting analyst for a mortgage debt lender.

 

Ben Shelley: [00:35:00] You were an underwriting analyst for a mortgage debt lender.

 

John Errico: [00:35:03] Do you ever underwrite the La Brea Tar Pits which is the tar tar pits.

 

Ben Shelley: [00:35:08] This is so over my head at this point I just don't even know that's not involved in it.

 

John Errico: [00:35:12] It doesn't matter because you can't. I just made a very common joke. I didn't I mean it's like no complexity.

 

Ryan Goldfarb: [00:35:18] No. I made a unique joke.

 

Ryan Goldfarb: [00:35:19] It just wasn't that funny.

 

John Errico: [00:35:21] Laughing very hard it was. Cut it out actually. We're moving further and further away.

 

Ryan Goldfarb: [00:35:26] Nobody laughed harder at Ryan's joke that Ryan himself.

 

Ben Shelley: [00:35:30] Point being that if you listen to some of our previous episodes you hear some of also the assumptions that we draw from our quote unquote analysis and underwriting cash on cash, IRR, etc. That's all part of this and I definitely recommend listening to previous episodes to make sure you have a firm sense of the concepts. For the folks listening at home make sure you subscribe to us wherever you get your podcasts. You can find us on the brick by brick. That's Brick X Brick. Facebook and Instagram. Thanks so much for listening.

 

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