Lenders are risk adverse and have long memories. By now they’ve pretty much learned that there are some places where they have more loan losses and some places where they have fewer. Loan losses are minimized in “preferred” areas where there is the expectation of continued high demand. That means that if (in lender’s terms, “when”) the borrower gets into trouble, the building can (historically) be sold quickly at a price that pays off the underlying mortgage and makes the lender whole (see below). That’s all lenders are concerned about. Nobody at the bank cares if the defaulting owner gets any of her down payment back. There’s no end-of-year bonus money riding on that.
Mortgages in low risk areas are generally granted Tier 1 pricing. That’s the loan that has the most favorable rate and terms. Given a qualified borrower, it’s important to understand that much of the final credit decision rides on where the apartment building is located.
Rates, as we’ve discussed before, are the total of some type of index plus a margin. In my memory there have been 19 indexes, but don’t ask me to list them all off the top of my head. Most, as you would expect, have fallen into disuse. Currently, two indexes underlie well over half of all adjustable loans. If you get a loan, the index will almost certainly be either LIBOR or CMT. Here are some of their characteristics:
The London Interbank Offering Rate is calculated in ten currencies, allowing investors from all countries to match their cost of lending to their cost of funds. That suggests that LIBOR based loans are favored by investors that seek international diversification with lowered currency risk.
LIBOR is currently probably the most common index, although several European banks have been reported as having manipulated the index to the disfavor of borrowers worldwide.
The yield of a Constant Maturity Treasury index is estimated from the daily closing yields of actively traded Treasuries. Depending on the lender and the mortgage, these yields could be from short term bills, medium term notes, or long term bonds. The most common is the 1-Year CMT which adjusts annually based on the one-year T-bill.
Margin: In addition to an index, the interest charged on a loan includes the “margin”. The margin is the difference between the rate you’re quoted and the index. Margin is the risk premium that customizes that loan on that property to that borrower at that time. With major banks, the Law of Large Numbers applies so that the margin can be generalized over all current loan submissions. For example, the lender may require that all brick buildings have a margin 0.5% higher than a corresponding stucco building. There’s no private negotiation; you have a brick building, your margin will be higher.
Where a property is located can be described by three general terms:
Primary: The two components of property are (a) land and (b) improvements. The income generated from these two elements – dirt and anything that isn’t dirt – is capitalized and added together to determine the value of the property as a whole. If we wanted to, we could separate the income attributed to the land from the income earned by the improvements. For example, assume two buildings identical in every way except the low rent building is owned by Billy Bob who, you remember, liked to tell people “Yep, ma and me own this building for mor’n forty years and we ain’t never done squat!”. Although Billy Bob’s property is still generating a little income from parking fees, the improvements are pretty much at the end of its economic life and will collapse right after lunch.
Its sister building, right across the street is owned by a childless couple whose hobbies are cleaning (her) and maintenance (him) and landscaping (him). It started when the doctor told her that even mild exercises could help fitness, like gardening. She naturally assumed the doctor was referring to her husband, who was sitting in the car drinking coffee and listening to bluegrass. That afternoon, for his own good, she assigned her husband to the landscaping chores. He got better at it and eventually their landscaping started to win local awards. Soon afterwards she got her husband into the preventive maintenance side, and he’s done equally well there. Their building is in pristine condition and will last for at least another 50 years.
Clearly, we would expect these buildings to generate different income, with Billy Bob’s tear-down earning less and the trophy building earning more. In one building the improvements are worn out and nobody will pay to live there so any income it gets is attributed to the land it occupies, in this case parking fees. It gets that money because of its favorable location.
The otherwise similar but pristine building earns rents not only due to its location but also its superior condition. You take the income from the trophy building (income from land and improvements) and subtract the income from Billy Bob’s shack (income from the land only) and what’s left is income attributed solely to the improvements.
A primary area is one where land appreciates at least as much as inflation. Generally, in these areas half or more of the building’s income can be attributed to its location, to the land it occupies. What that means is that historical inflation rates you could theoretically buy a new building, let it fall into disrepair until it crumbles into dust several years from the day you bought it, and at that time you could expect the value of the land itself to exceed your original loan amount. The fact that land appreciates and improvements depreciate is enormously important to the investor. Blocks of land in primary areas are normally quoted on a price per square foot basis; in secondary areas it’s often “so much” per acre.
Secondary: A secondary area is where the cost of the land (historically) can’t be sure to appreciate with inflation. There’s just so much available land around that values are quoted in acres or even sections (a section is a square mile and contains 640 acres). In secondary areas land values are less than half, sometimes much less than half, of the value of the property. Because more than half the value of the property is improvements and improvements depreciate, the security of the loan depends on the maintenance ethic of the owner. Primary lenders won’t go there because that’s an unwanted layer of risk. You can still get loans in secondary areas, but you will probably be limited to property loans structured like business loans. These are characterized by short term amortization (not to exceed the buildings remaining economic life, as determined by the appraiser), higher margins, greater fees, and balloon payments. If you had a choice, you would not choose a mortgage like that. Such loans tend to make financing in secondary markets difficult. Reduced loan opportunities depress prices. If prices are depressed, property appreciation is limited. The major benefit of buying in a secondary market is cash flow. Any appreciation you may experience will be a function of capitalization due to declining interest rates. But . . . but . . . but didn’t banks lend way out past Ft. Mudge back when the bubble was still expanding? Yes, but land values in the area were much higher then. See above.
Tertiary: Some places exist simply to hold the rest of the world together. They are neither Primary nor even Secondary banking areas. In these locations most financing has to be provided by the seller or the government. Banks won’t touch it. If the banks won’t touch it, probably we shouldn’t either. If we did buy in an area like that when the time came for us to sell we’d probably have to carry back the paper for the next guy, just like the old owner did for us. Now what do we do? All our equity is tied up in a dumpy building way out past the old Alvord gold mine in San Bernardino County. The guy we hope would make the payments can’t be reached. And nobody’s going to take our trust deed as a down payment on a decent property in a reputable area. We can’t even borrow against the carried back paper. We’re stuck.
But . . . but . . . but didn’t sellers carry back a lot of paper in the early 1980’s when interest rates were so high? Yes, and the sellers were still unsure if payments would be made as agreed, and it was very difficult to get someone to accept the old paper as partial payment for a new purchase. But it was occasionally done back then. My husband did it a couple of times. He says it was like pulling teeth.
SUMMARY: Primary areas are where big banks will loan on the best terms. They are characterized by appreciating land values. Secondary areas are serviced by business loans (even if in the form of a mortgage). Properties in secondary areas are characterized by the existing value of the improvements being more than half of property value.
Importance: In our field, the big money is made at the intersection of leverage and growth. Folks often buy their first home with a little down payment and high loan. If the location was wisely chosen, the home appreciates over time at a rate greater than inflation. Eventually, the owner refinances and uses the proceeds as a down payment on a small apartment building. If that location is favorable the apartment building will probably appreciate equal to or even faster than inflation. Eventually that building is refinanced and the cash-out applied as the down payment for another building. This process is repeated as necessary.
The entire process of developing significant wealth in real estate is predicated on the value of the owner’s equity increasing faster than inflation. In a secondary market this is possible when you buy a “fixer” at a price below the value of a similar but habitable building. You then restore the fixer to be competitive in the local marketplace, forcing the value up. You’ve earned “sweat equity”. Your rate of wealth accumulation is dependent on how many junky properties you can find and whether or not they are financeable. It’s a tough process, but it’s a beginning.
If you started in – or transitioned to – a primary market, your wealth grows through controlling (a portion of the) supply in a high demand area. You probably paid a premium for the trophy property, because the seller’s mama didn’t raise no fools. You buy and rents eventually go up. The more desirable the area, the faster your rents go up. And the more desirable the area the more another buyer will pay for your stream of income. Your rate of “refinance – buy another – repeat” is dependent on how many rich folks want to live in and around your property. If you buy where both population and income is increasing, you should do well.
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].