Deal Structuring Series - Debt

This article on Debt is part of a 3 part Deal Structuring series. For part 1 see the article on Equity.

In a real estate deal, the debt component is arguably the most important of all. In reality it takes a number of services and resources to structure, close and run the SPE, but choosing the right debt instrument can make or break a deal. Why is debt so important? Which debt is best?

Debt leveraging gooses the equity return

As an investor, you want a good return on your equity with as little downside risk as possible. So how do you get a double digit return on a property with a single digit cap rate? Debt. That’s why they call it leverage - because that’s what it does. The illustration above shows how equity multiplies over the hold. It’s not uncommon to see a 2x equity multiple in real estate. It’s hard to imagine growing your stock portfolio 100%. I mean, it happens, but I hope that’s not what you’re banking on. A project unlevered equity multiple is typically less than the levered multiple, because debt is cheap capital relatively speaking. A 3% interest loan on a 5 cap property will add a modest bump to the equity return. That same 3% will add a sizeable return to the equity purchasing an 8 cap. The greater the spread between the cost of debt and the unlevered cash return, the greater the equity return. Adding debt to the capital stack conserves valuable equity capital and allows diversification and a higher return velocity. More money, more faster, or something like that.

Here are some common lending options in the CRE multifamily space. There are others, such as CMBS and special products, but I’ll leave those for another article.

Bank Loans

Traditional banks keep money on deposit and loan against their balance sheet. Both traditional and bridge products can be available, depending on the bank. High level common terms:

• Recourse mostly, though some offer non-recourse products

• No minimum loan amount, $5MM for bridge products

• 3 or 5 yr term

• Interest Only (IO) for 1 yr, up to 3 for bridge products

• Max LTV 75%, 65-75% LTC for bridge products

• 20-25 yr amortization

• Step down prepayment penalty

• Rehab budget can be worked into cost for bridge products, which is funded post-close through the construction draw process

Your local and regional banks are great sources to get loans done quickly. Comparatively less underwriting is performed, primarily due to the recourse nature of the loan. These loans might be a better product for an unstabilized property, but are typically more expensive (higher interest rate) than agency debt.

Agency Debt

Fannie and Freddie are government sponsored agency lenders. They offer great terms, but come with high underwriting requirements, including prior multifamily experience, stabilized assets, professional 3rd party property management, and reserve escrows. High level common terms:

• Non-recourse

• Minimum loan amount $750k (Fannie) and $1MM (Freddie)

• 5, 7, 10, or 12 yr term

• IO for 1-3 yrs

• Max LTV 80%

• 30 yr amortization

• Step down prepayment penalty or yield maintenance

• Rehab may be included with Fannie, but not with Freddie

The Agencies offer products that can help leverage equity gains a little more than the more expensive bank loans, but the terms - particularly maturity - must be underwritten correctly per the asset strategy. Additionally, these products are harder to qualify for as a newer or less experienced investor.