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.
The other day I was trying to explain how helpful it is to the borrower when a bank performs due diligence before making a loan. The fellow on the other end of the line wasn’t having any part of it. Can I try one more time?
The only person who does something for you even if it hurts is Princess, your cocker spaniel. Who else would run to lick you when it means tripping over their ears? Not even your mother. Forget her ears, your mother hasn’t run anywhere for years. She’s watching the Kardashians on the kitchen TV when a random thought suddenly occurs to her. As always, she knows your father needs to hear it *right now*. She yells to him. He’s in the garage waxing the water heater, but he learned long ago to always listen for her bellows. He dutifully plods into the kitchen, but no longer joyfully, like Princess, with his tail wagging. That’s because he no longer gets treats as often as Princess.
Money is the treat of the commercial world. We want lenders to respond to us like Princess, not like Harold. Lenders act like Princess when they are confident of getting a treat. They get treats from (a) performance fees and (b) bonuses resulting from reduced loan losses. To be assured of fees and bonuses, lenders perform due diligence on every loan application. The purpose of due diligence is to assure the next owner-of-the-stream-of-income (think: a future buyer of the mortgage) that they are very likely to get paid when due.
When you think about it, isn’t that what you want, too? To be assured that your investment is secure enough to pay for the costs of ownership as they become due? To put this another way, lenders aren’t the only ones who benefit from strict due diligence. The borrower does, as well.
Can’t the buyer / borrower do his own due diligence? On smaller mortgages which are bundled with many other similar loans and then sold as collateralized securities, yes, the borrower can and often does do most of his own due diligence. The buyer of a mortgage backed security chooses diversification (he is buying a tiny piece of hundreds of loans) to offset the risk of an individual loan going south. ‘s like stocks: if you can do security analysis you can buy individual stocks. If you can’t, it’s probably better to buy the market (index fund).
Large property loans are auctioned to individual buyers on Wall Street. The buyers don’t want to acquire a multi-million dollar loan that subsequently defaults. To minimize the likelihood of default, they demand that large loans be thoroughly third-party diligenced.
The lender has been doing due diligence for years. They can provide guidance if you listen keenly. You kind of have to hear between the stops, because lenders are not formally in the guidance business. Listen “ or get your loan broker to listen “ for something that you would expect to be in the symphony, but somehow isn’t there. Try to hear, as Dr. Watson once wrote, the dog that doesn’t bark. ‘s Princess, again. What you’re listening for is the Lender’s institutional memory. It usually comes in two forms: Descriptive and Abbreviated.
Do you remember in middle school, when you went to your first prom? Your mother would waltz happily into your room and “ you personally observed this several times “ instantly shape shift into something you didn’t recognize as human. Her tongue would grow long and forked. It would flicker in the twilight, seeking your body heat as her head approached your throat and she hissed, No-o-o-o-o-o, you’re *not* wearing that dress! Her hissing was brief and focused. She was employing the Abbreviated approach.
Things always begin with the Abbreviated approach, which consists only of the interest rate and the loan-to-value ratio. You tell the lender a few (it’s almost always the same six or eight) things about your building. He runs your credit and reflects a moment before looking at you, his eyes like cold wet pebbles at the bottom of the stream, as he quotes you an interest rate and an LTV. Although there is no warmth to the Abbreviated communication, the data is useful. You learn immediately what the experts think of your proposed purchase just from the price and terms quoted for the loan.
What if the lender says he’ll approve the loan but requires an unexpectedly high margin? (The interest rate is the sum of two figures: the Index (which fluctuates with the business cycle) and the Margin (the surcharge above the base Index that reflects the initial risk of this specific loan.) Doesn’t an unexpectedly high margin tell you that the lender thinks you’re proposing an unusually high-risk adventure? Ignore this warning at your peril. If the lender has to foreclose its really unlikely that the value of the building will go to zero, so the lender will always get some-to-most of their money back. But you will lose everything. This is important to remember: you have to lose your entire down payment before the lender loses a dime.
When you make a down payment you are guaranteeing the top 30 or 40% or so of the investment’s value with your own cash. The down payment is insurance against the lender taking the first loss. He’s making the loan, but he’s moved the risk of first loss to you.
After further review, what if the lender indicates that the proposed purchase is so risky that even after your down payment guarantees the top third of the price, and even after you’ve agreed to pay a premium interest rate for the loan, there is still an un-hedged risk that will have to be offset by a lower loan to value ratio? The lender suspects that, in the event of foreclosure, the resale of the building might net less than 70% of the purchase price. It might only bring half of the purchase price, or even less. He announces, You’ll need to bring another $300,000 to escrow.
Now you have to make a much higher down payment, in effect prepaying the lender’s possible loss to 50% or more of the appraised value. Part of your building’s greater risk profile is offset by the higher margin. The margin premium reflects the greater operating risk. And part of the building risk profile is offset by the lower LTV ratio. The lower LTV reflects greater resale risk. You’re getting hit for both. Aren’t those clues that maybe we should rethink this?
THIS IS NOT WHAT WE MEAN – Interest rates fluctuate day to day. When you first discuss getting a loan with your mortgage broker you will naturally ask about current interest rates. Those are rates valid at the moment you inquire. It will be awhile before the lender permits you to lock the interest rate on your apartment building loan. When you lock the rate may be higher (or lower) than when you first discussed the matter. Does this mean the risk profile of your investment has changed? ‘s probably due to normal market fluctuation and not a change in risk profile. If you trust your mortgage broker, ask her. She should have significant insight in the matter.
OK, so the Abbreviated approach consists of the LTV and interest rate, and you accept the lender’s quotes. Suddenly you are no longer a price-checker. You have elevated yourself into the client category. The lender begins to think he might have a deal, so his attitude changes and everything is different. You are now past the Abbreviated portion and into the Descriptive approach. Maybe he’s not yet Mother Teresa, but he’s sliding away from Voldemort.
Do you remember when your mother used to lovingly give you the benefit of her experience? This was before you started wearing prom dresses. You knew she’d be in the kitchen when you got home from school so you went there straightaway. The air was redolent with fresh baking. She’d sit down with you as you were having your cold milk and still-warm-from-the-oven cookie with the M & M smiley face, and tell you how it was when she was growing up, how she handled the little problem you were having. Then she’d kiss you on the forehead. That’s the Descriptive approach.
You can tell when the lender’s being Descriptive: he gazes upon you with soft eyes and vows to protect your mutual interests by requiring the seller to prove every element of value to your mutual satisfaction. The lender thus brings institutional memory to the transaction. That’s important. I mean, maybe you’ve done one or two similar transactions before, but the lender’s institution has done thousands and all the data is available in their computers. That resource, the lender’s institutional memory, should be indispensible to the confidence you have in the investment.
Everything the lender does to protect the security if his mortgage benefits you. Because you take the first loss, it could be said that due diligence benefits you even more than the lender. Be grateful.
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].