If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book Stairway to Wealth available at LuLu.com.
As we’ve discussed before, interest rates on loans, even fixed rate loans, are the sum of two items: index and margin. Let’s talk first about the index.
Hypothetically, we’ll pretend that the ten year Treasury Note is 8%. That figure reflects the market’s opinion of the minimum interest that should be charged for an investment with no credit risk. There might well be risk in holding a Treasury Note for 10 years, but it’s not because you won’t get your principal and interest when due. You’ll get it, even if the government has to print more money to pay you. Briefly, if a loan is secured by the printing presses of a developed country it is judged to have no credit risk and its yield may become an index upon which other loans are weighed.
The margin is the premium that the lender adds to compensate for the additional risk of making that particular loan instead of just buying another ten year Treasury Note and going back to sleep. Margins vary with the borrower’s circumstances and the property’s marketability. A high borrower FICO, a low loan-to-value ratio, or abundant cash flows can all reduce lender imposed margins, especially in combination. A property that, upon foreclosure, will be difficult for the bank to manage or hard to sell will cause margins to enlarge.
These are only examples of a few reasons margins can be quoted higher or lower. There are lots more. From the lender’s point of view, increasing the margin tends to offset their risk in making that specific loan. The margin is added to the index to get the total interest rate. In our example, if 8% was the index and the particular circumstances of the loan required a 3% margin, the interest rate quoted would be 11%.
It is seldom discussed, but the bank is not the only entity accepting risk when a loan is made. The borrower, too, is faced with uncertainties. Both lender and borrower have to deal with the same risk issues, but the risks are asymmetrical. They don’t share the burden equally. Usually the lender carries the greater burden, but occasionally it’s the borrower. This is why it’s important for a prospective borrower to think through the consequences of borrowing money. ‘s not just the bank that’s taking risks.
The shared risks we’re going to talk about today are (1) non-sovereign credit risk, (2) liquidity risk, (3) systemic risk, and (4) interest rate risk (also called market risk). These are not all the risks that could be faced, but they are examples of the most common. Discussing these four items will give us a reference point when we contemplate refinancing. Note that they are not addressed in any particular order, except that interest rate risk is purposely placed at the end. That’s because, alone among the risks we’re going to talk about today, cyclical changes in interest rates are predictable long in advance and, if properly leveraged, can make large fortunes out of small.
Credit risk is the risk that a party “ either us or the bank “ may not be able to fully honor the terms of the loan contract. There are credible stories about lenders who take you right up to the closing desk and then refuse to complete the transaction. That probably happens sometimes, and that’s why you’d want to borrow from a credible source. Imagine everyone’s despair when they gather on the day escrow is supposed to close . . . you’re there, the seller is there, the escrow officer is across the desk opening another Snickers . . . and the lender tweets Loan cancelled. Sorry for any inconvenience.
But your risk of that happening is very small compared to the bank’s risk in not getting back the money they lent. Credit risk (the bank not funding or you not paying back) is shared, certainly, but your risk lasts only until you get the money at close of escrow. The bank’s risk lasts until you pay it back, maybe 30 years. They are not equal risks. If you don’t run your own printing presses there is obviously at least a minor credit risk in lending to you. That means the bank can reasonably weigh, as a qualification to the granting of the loan, whether or not you’ll be able to make the interest and principal payments in a timely manner. The borrower will probably have to establish that she can make the payments out of cash flows, either hers (personal loan) or the property’s (asset based loan).
Additionally, the lender has to satisfy itself that, if the cash flows don’t work out quite as everyone originally expected and the loan sinks into default, the bank will be able to recover their investment by foreclosing on the security.
It is seldom reasonable to expect that the lender could recover the apartment building, pay the costs of foreclosure, be made whole for the accumulated missed payments and still get back all the principal and interest owed if they had to foreclose on a 100% LTV mortgage. And that is why lenders require the borrower to have a substantial equity position in the security. Absent government loans, it’s real hard to find a bank that will lend 100% of the property’s value, but 60% LTV loans are much easier to get. That means that if you purchase a property you’ll have to make a down payment. If you refinance, you’ll have to leave significant equity in the building.
The down payment (or the equity remaining after your refinance) acts as a sort of non-interest bearing fund that prepays the costs of default if they have to foreclose. Think of it like the security deposit you require before you rent a unit.
Take-away: There’s nothing you can do about the index, but to minimize the margin try very hard to establish that you have abundant liquid assets to make the loan payments when due. Fill out a complete a balance sheet on yourself (the Individual Loan Application is useful here) as carefully as you can. Provide full details on the security you’re offering for the debt. And try to buy something other people might want.
Liquidity Risk is the risk the owner won’t be able to get full value for the security when it’s sold (or the loan doesn’t roll over). Could I offer a classic example? As this is written, cap rates have been low for a long time and many property investors are anxious to increase their cash flows. A lot of interest has been shown in buying triple-net investments (see my August, 2011, article) because they promise high returns secured by a long term lease by a well established tenant.
Imagine that a developer constructs a free standing building on a commercial, signalized corner and leases it for 30 years to an S&P 500 company at $20,000 monthly. The company pays all expenses of running the building (taxes, insurance, maintenance) in addition to the monthly lease payment so that $20,000 is NNN to the landlord.
The developer, at the moment the lease is finalized, has a stream of net income (the lease) of $240,000 annually that he wants to turn into a lump sum. At that very moment he sees you at the ATM. You and he agree that an 8% cap rate would be agreeable all around and you immediately turn back to that machine in the rear of the 7-11 and pull out another $900,000. Yes, $240,000 annually capitalized at 8% ($240,000 divided by 0.08) comes to $3,000,000 or thereabouts, but you know you’ll only be able to get a 70% LTV loan on this puppy, so you pull out all the $20’s the ATM has.
Escrow closes. The developer walks away with $3 million dollars. You have a stream of income of $20,000 a month (before loan payments) and $900,000 equity in the net leased building. The developer is happy. He gets a Mercedes. You are happy. You get your hair done.
Seven years go by and the loan is due. You have to refinance. Your rent is still $20,000 a month “ it won’t change until the 20th year “ but interest rates are no longer where they were. Now they’re 12%, with a debt coverage ratio (DCR) of 1.50 (Net Operating Income divided by DCR). That $20,000 a month, after adjusting for DCR, will only service a debt of $1,300,000. You owe $2,100,000: How are you going to refinance? You’re $800,000 short. Back to the ATM.
Take-away: There is no joy in borrowing short term (the 7 year fixed rate period) while leasing long term (the 20 years of flat lease payments). We really should try to match maturities. One way to do this would have been to buy a building that permits annual rent increases at least equal to inflation. Interest rates may go up every year, but so does your NOI. If you can raise your rents as interest rates go up you have, as much as possible, matched maturities.
Systemic Risk is the chance that the financial system might face a contagious failure. Some recent examples are the current housing collapse (by some measurements we’re now in the 6th year), and the EU market “ especially the southern European countries (Greece, Spain, Italy). At one time, it seemed that systemic risk wasn’t even worthy of discussion. Now, it’s one of the major things financial people worry about. In a systemic collapse there is no absolute safety, for either lenders or borrowers, but that doesn’t mean that all lifeboats leak equally.
Take-away: Buying diversified streams of income (as opposed to speculative investments) and matching maturities (see above) puts us in a lifeboat with fewer leaks.
Interest Rate Risk is the effect on value when interest rates (the cost of money) fluctuate. Whether you’re the borrower or the lender, being on the wrong side of interest rate risk can be disastrous. If, however, you’re on the right side, you’ll begin to wake up in the mornings thinking it’s so wonderful to be rich and wondering why others aren’t.
Try to find your notes on capitalization (or refer to the June issue), because cap rates are the key to understanding Interest Rate Risk.
There are three cap rate formulas, but we’ll only be using the first one: Net income divided by Purchase Price is Cap Rate.
Problem 1: Assume a perpetual stream of income of $300,000 annually . . .
Q: How much would that stream of income be worth if market cap rates were 4%?
A: $300,000 divided by 0.04 equals $7,500,000.
Problem 2: Still assuming a perpetual stream of income of $300,000 annually . . .
Q: How much would that same $300,000 per year be worth if cap rates, a little later in their normal cycle, reached 12%?
A: $300,000 divided by 0.12 equals $2,500,000
Notice that nothing happened except the cap rate changed. Problem 1 happened when cap rates (think: interest rates) were low in their cycle. Then the interest rate cycle reversed, as it always does, and later when you needed to sell the rates were high. What you bought for $7,500,000 you sold for $2,500,000. Well, never mind. At least you made two people “ the seller when you bought and the buyer when you sold “ deliriously happy. ‘s a comforting fact that you seldom bring more joy to the world then when you’re on the wrong side of the Interest Rate Risk curve.
Or, reverse the example. You bought at 12% cap and sold at 4% cap. Now you’re on the right side of the curve and the people that love you most are the commissioned sales staff at Graff Diamonds.
Notice that rents didn’t go up. Expenses didn’t go down. Your NOI stayed exactly the same. Nothing happened except . . . and here is the critical element . . . you did business at beneficial points on the Interest Rate curve. That is so-o-o-o important. Making your big moves at the right time in the cycle makes all the difference.
Take-away: Interest rates / cap rates will fluctuate. Their cycles are long, so long that the bell usually rings only three times in an investor’s lifetime. The first time you were still in nappies. The third time you’ll be in a rest home and unable to remember quite what you were waiting for. But the second time, that glorious second time, if you have the courage to act when others do not you can make life changing investments.
The second time is coming. Position yourself. And wear your red dress.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]