Peter Pays Paul

The LA Times is reporting that a Record number of California homeowners default on mortgages in 2nd quarter.

Year over year the actual number of homes being foreclosed on has increased 261%. The percent increase is dramatic. However the total number is only 63,061.

Based upon the U.S. Census Bureau Data California had 13,174,378 household units and 56.9% of those are owner-occupied. If these statistics are correct, there are 7,496,221 owner-occupied homes.

Though the increase is dramatic, the total number is still a small percentage of the total owner-occupied homes. This means that at most 0.84% of the owner-occupied homes are being foreclosed upon, or 8.4 out of 1,000.

However, my statistics do not breakout condos or home that were owned by speculators or investors. Many investors will stop making payments on their investment before they will stop making payments on their own home.

Likely, a lower percentage of owner-occupied homes are being foreclosed upon. A larger number are likely investor and speculator homes that were bought during the run-up in the real estate market.

Does the small increase from last quarter to this quarter signal that the damage is coming to an end? My crystal ball is broken. We will just have to batten down the hatches and ride out the storm.

Head over to Yahoo! Finance to take a look at an interesting article by a former subprime lender.

Richard Bitner was an owner in a mortgage shop that made subprime loans and sold them to investors. He is writing a book about his experience from “behind the curtain”.

In the article he details 3 loans that cost his company thousands of dollars.

The article also describes how investors’ desire for mortgage related securities drove the market to make loans to borrowers with riskier and riskier profiles to satisfy the demand.

Confessions-of-a-Subprime-Lender-3-Bad-Loans: Personal Finance News from Yahoo Finance

Michael Stoler of the New York Sun has written an article about our industry. (HT: The Dirt Lawyer)

Mr. Stoler accurately states that for new or inexperienced developers the sources of capital are few and far between. He writes:

“The answer for a growing number of these borrowers is alternative, or specialty, lenders that provide financing at higher rates and with stricter conditions.”

Still Lending

While the credit crunch has decreased the supply of funds, specialty lenders are still willing to lend on the right deal. Specialty lenders can be hard money lenders or hedge funds.

In order to obtain a loan from these specialty lenders, borrowers should have lots of cash and a solid project grounded in reality, not the past boom market. Mezzanine lenders and joint venture funds help borrowers with limited cash acquire the necessary equity to gain financing.

Borrowers should expect a rate in the double digits and higher fees to pay for the speed that specialty lenders provide.

If you need specialty financing, please feel free to call me at (925) 280-5388.

Part of my job is to take incoming cold calls. We advertise in a commercial lending industry magazine that generates a good deal of call traffic.

On a regular basis I get requests for “construction” loans. After asking some questions to determine the nature of the loan, I usually find out that the broker/borrower is actually searching for what I would call a “development” loan.

What’s the Difference, Who Cares?

Why does it matter if you call it a construction loan rather than a development loan?

First, it reflects on the broker/borrower. If a lender has to educate the person requesting money, it sets a bad tone for the deal.

Second, some lenders offer construction financing but don’t offer development financing. Asking the right question allows you to get a correct response and save you time.

Finally, loan to value and equity requirements may vary depending on whether the loan is for development or for construction; I know ours do. This information helps the lender determine if the loan is within their parameters.

Construction vs. Development

Construction by definition has the connotation of putting things together. In my mind, moving dirt for roads or infrastructure does not meet this definition (no offense to those in the fields of civil construction).

The definition of the word develop includes the idea of being made usable. This is perfectly suited for the installation of roads, pads, and infrastructure; as the land has now been made usable for a building.

Defining Loans

Consequently, I would recommend that if you are asking lenders for a construction loan, a building should be in place when construction is complete.

Loans to improve land should be titled as development loans.

There are ways, even in a down market, to make money with distressed properties. The key to succeeding with distressed properties is to focus on “buying right“. Warren Buffett is quoted as saying, “Price is what you pay. Value is what you get.” Buying right is ensuring that that price you pay is congruent with the value you are receiving.

In any market, good or bad, there are those properties that are under-performing or distressed. Usually through physical repairs or through prudent management practices a poor performing property can increase in value.

The key to successfully investing in distressed properties is finding, controlling, and repositioning these assets. We will not deal here with controlling and repositioning distressed properties. The purpose of this article is to help you find them.

Distressed Does Not Equal Foreclosed

Foreclosures are the hot word in the media these days. However, distressed property does not mean that it has to be in foreclosure. Some websites that sell you information on foreclosed homes would like to have you think otherwise.

Divorce, death, illness, or absence can all lead to a properties disrepair and decrease in “apparent” value.

Pay Attention - Method #1

Have you ever driven the same route home and noticed a store for “the first time” that may had always been there? This seems to happen with new cars also. Once you buy a car you suddenly notice that everyone has the same model.

Your brain now aware of the specific model of car, can identify the characteristics that distinguish your model from all the others. The same is true for distressed properties. Once your brain is trained to look for them they will stand out in your mind.

Train your mind to recognize the signs of a distressed property. These signs will vary depending on if you are investing in multi-family, single-family, office, retail, or industrial properties. Each property type will have different tells that can tip the savvy investor off that the property is distressed and may be a good investment.

The Alphabet Game

On long car trips my parents taught us to play “The Alphabet Game”. The game is simple enough: each person tries to get through the alphabet sequentially by spotting letters on passing billboards or vehicles. The first person to spot a “Z” wins.

As kids “The Alphabet Game” taught us to be attentive to our surroundings and to notice what it was we were driving past. The same can be done for finding distressed properties.

It is very likely that on a regular basis you are driving past property that is in some sort of distress. It could be a house with absentee owners or an office building with a high vacancy rate. Unless you pay attention you would probably drive right past it and never know that it could be an opportunity.

Listen Up!

There are opportunities in the daily conversations around us as well. Listening for specific reasons that a property can become distressed (divorce, death, taxes, marriage, complaints about tenants or landlords, etc.) might tip you off to an investment opportunity. I would never advocate taking advantage of another’s misfortune. If you can genuinely help the current owner to a win-win solution, you are not taking advantage. Avoid becoming a carpetbagger.

Conclusion

Remember that distressed properties are not always in foreclosure. Most of the time distressed properties are easily noticeable if you know what to look for. Pay attention to your surroundings and to the events that are happening in people’s lives to locate distressed property.

Buying right is disciplined work.

The work is not so difficult that only an elite few can do it.

However, it does require a meticulous and detailed approach that most people lack the discipline to perform.

At a recent conference I attended, this bit of wisdom slipped out:

“You cannot tell if a property is a good deal by looking at the price the last owner paid for it and the discount you are receiving. If the last owner overpaid by 20%, are you really getting a good value with a 20% discount from the last price?”

Buying with the End in Mind

In order to be successful at buying real estate for the right price, an investor needs to have a defined strategy - What is the purpose of the property? Cash flow? Appreciation? Rehab? Conversion?

Knowing the end goal allows you to work from that goal back to the present and to determine a price point at which you can reasonably achieve your goal.

In order for a property to cash flow, the rental rates must be higher than all of the combined expenses including the mortgage, taxes, maintenance, vacancy factor, and reserves.

For rehab properties the Acceptable Purchase Price = Sales Price – [Sales Costs (Marketing + Closing Costs) + Rehab Costs (Construction + Carrying Costs) + Desired Profit].

Details

The devil is in the details they say.

Details are the reason that most people fail to make wise buying decisions. Investors often fail to have the patience and discipline to crunch the numbers.

Many new real estate investors are like my wife at the department store. “Honey, it was 30% off! Do you know how much money I saved?!” No, but I do know how much you spent.

Many of the factors that go into determining the right purchase price are learned only with time and study. Estimating repair costs, knowing market rents, market growth rates, and projecting expenses are not innate to human knowledge.

Fortunately, they can be learned or ascertained over time. A wise investor will invest first in their own education.

The factors to determine a correct price can also be “borrowed” from a real estate agent with experience buying investment properties and knowledgeable in the target market. Only choose an agent that is going to listen to your goals, evaluate your present financial situation, and formulate a plan that fits your goals and financial abilities. Investors are not “one size fits all” and no one type of investment property is appropriate for all investors.

Understanding what your money is doing and how it is working for you is vitally important.

Buying right in real estate is not dependent so much on the discount from sales price; it’s dependent upon knowing what price will allow the investor to accomplish their investment goal.

My wife and I like to go on “dates” to Barnes & Noble Booksellers. Most of the time we do not buy anything. We will just spend hours finding and perusing books that we find interesting.

The last time we were there I picked up Mega-Producer Results in Commercial Real Estate: A Blueprint for Success. I only leafed through the book on my way to other books, but I noticed the author had a section on specialization, a topic I had been thinking about for a while.

Working with an Expert

The author recommended that new agents focus on becoming a specialist in a single type of property. The benefit of this approach is that you become an expert. Now you are adding value to clients because you have studied and know more about the subject than they do. They call you when they want an answer to a problem.

The author detailed an experience he had as a new commercial sales agent after moving to a new city. He was given a camera and the task of creating a “comp book” of all the shopping centers in the city. It took him a while to cover the entire area, but he was able to know the area and to know the product. He also began documenting which properties had vacancies, were sold, were in need of repair, and the property’s sales price.

The author’s knowledge allowed him to interact knowledgeably with potential clients. He could tell them if their building needed repair or the sales price of the property down the road. These interactions established him as an expert, and who doesn’t want to work with the expert?

Financing Specialists

So how does this all apply to the financing side of the equation? Why not become an apartment financing specialist or “The Shopping Center Loan Gal”? Choose not to be “a mile wide and an inch deep”. Choose to have a narrower focus, but a deeper knowledge of that focus.

A narrow focus targets your marketing. You no longer advertise to apartment brokers only to retail brokers. It also refines the list of lenders that you need to know. If XYZ Bank doesn’t do retail loans or doesn’t offer competitive rates, you don’t need to deal with them on a consistent basis. I know an experienced broker that had a handful of clients and only dealt with five lenders but closed over $100 million in loans annually.

Benefits of Specialization

1. Deeper knowledge of available financing options.
2. More efficiency underwriting loans. Well practiced tasks will become easier and easier.
   
3. Higher closing rate due to understanding lenders and what they prefer.
4. Greater likelihood of referrals and repeat customers because of your knowledge and skill.

Disadvantages of Specialization

1. The possibility of greater startup time while gaining market knowledge. It will take time to become an expert.
2. A smaller “pool” of deals to draw from. You must become a bigger fish to survive.
3. If your area of specialty slows, transitioning to other property types may be difficult.

Differentiation by Specialization

Being a specialist allows you the advantage of differentiating yourself from the competition. You will stand out like a shiny penny when you are an expert. Truthfully being able to say, “I have the perfect lender for that” will build confidence with clients and put you on the way to wealth.

For further reading check out: Riches in Niches: How to Make It Big in a Small Market

When I am reviewing a loan file one of the first things I look at and look for is the executive summary or loan summary. A well written executive summary speaks to the quality of the borrower and the value of the project. The goal of well written loan summary is to give the underwriter enough information to understand the commercial loan and to determine if the loan will fit within the lender’s lending guidelines.

Below are items that should be included in a well written and complete executive summary.

Salient Facts

Lenders want to know the details of the commercial real estate loan. Property location, property type, number of units, lot size, and the square footage are all important in the underwriting process.

Also include the loan amount and property value. I am always amazed when a loan summary is missing the loan amount or the property value. If the property is being acquired, include the purchase price.

You might also include useful ratios such as loan-to-value (LTV), loan-to-cost (LTC), and the debt-service coverage ratio (DSCR). Rounding these ratios to the nearest 5 or 10 integer can appear deceiving. I personally prefer that these ratios be expressed to two decimal places.

Project History

Include a project history for commercial property that is currently owned by the borrower. This should include the date of acquisition, acquisition costs, and any improvements or monies spent on the project.

Exit Strategy

Owens Financial Group is a bridge lender. Consequently, we are looking to see what the borrower’s strategy is to repay our loan at the end of the loan’s term. The exit strategy may be less important to permanent lenders than to short-term sources of capital.

Sponsor Summary

The sponsor or borrower summary should give relevant facts about the sponsor, but should not be their life story. A more detailed description of the borrower or borrowing entity can be include in a borrower’s resume.

A good summary might look like this:

Fictitious Development Company was started in 1989. Since it’s inception it has developed 32 properties with over 1,000,000 square feet of retail space. With combined sales of $120 million.

Or:

Fictitious Properties Group began acquiring multi-family properties in 1993. Fictitious currently owns in excess of 4,000 units in 7 states with rental revenue of in excess of $3,000,000.

Sources and Uses

This section details the utilization of the loan proceeds as well as the source of any other funds needed for the project. A table or spreadsheet format is most helpful and looks cleaner. If you are seeking a construction loan, this section is vital for the underwriting process. Cost information should only be a summary, because this is the executive summary and not the supporting detail, . The detailed costs should be included with the rest of the packet.

Property Financials

Relevant information regarding the current or projected rental income of a building should be included. The value of income property is determined by dividing the property’s net operating income by a capitalization rate suitable for the market location. Gross Income, total expenses, and vacancy are needed to determine net operating income.

Conclusion

Keep an executive summary short, no more than two pages. Include enough detail for the underwriter to understand the deal and to determine if it will fit in the lender’s parameters. Never mislead or lie on an executive summary. A well written commercial loan summary is often a reflection of the professionalism of the commercial mortgage broker submitting the loan.

What is a Daisy Chain?

I field phone calls from commercial loan brokers all day long discussing the different loan scenarios that come across their desks. Our company advertises in the Scotsman Guide and this generates some “cold” incoming calls.

Frequently, we will get a phone call from a Broker A that received a loan file from Broker B. Broker B received the file from Broker C who received it from Broker D who knows the borrower. This is what we call a broker “daisy chain”.

Merriam-Webster defines a “daisy chain” as “1) a string of daisies with stems linked to form a chain, 2) an interlinked series”. One broker linked to another broker linked to the next broker, etc.

Problems with Daisy Chains

Human nature dictates that every broker involved in the transaction feels entitled to a piece of the pie. Each will often demand their own “fee” for services rendered. Often this is a deal breaker. If there are four brokers in the deal each charging a 1% fee the borrower is now paying a fee of 4% just to brokers! As Brian Brady writes , “what value does the agent bring to a transaction” to demand a fee?

If the borrower balks at the fee, Broker A is likely to say to Broker D, “I know the lender, you know the borrower, if we cut out B & C the fee is only two points and the borrower gets his loan closed.” Now Broker D is in an ethical dilemma, because he plays golf with Broker C on Wednesdays. Does he get the loan closed and burn Broker C to earn the commission?

Let’s imagine that this is a perfect world and all of the brokers in the deal lower their fee to an amount acceptable to the borrower. However, they are unwilling to give up their contact in the chain for fear of a future “circumvention”. So every piece of information needs to be passed from the borrower to Broker D to Broker C to Broker B to Broker A to the lender. (Did you ever play the game Telephone as a kid?)

How to Avoid Daisy Chains

Ask if the hard money lender lends their funds. Or you may ask if the hard money lender brokers their deals. Both of these questions should give you a better insight into the lender’s business model and how they make loans. If a “lender” brokers all of their deals, you may get caught in a daisy chain. Ask enough questions to get a straight answer and to understand the lender.

Remedies for a Daisy Chain

The smart broker that finds herself in a daisy chain situation will take control of the situation and work as the main point of contact for both the lender and the borrower. For example the chain of brokers lowers their fee to 2% of the loan amount. Broker D volunteers to coordinate between the lender and the borrower for a larger share of the commission, say 1%, allowing the other three lenders to split the remaining 1% without having to do any additional work.

Cutting out a broker from a deal, because they do not have a “signed agreement”, is a bad idea. This is a quick way to ruin a reputation and to never receive a referral again.

Summary

Daisy chains should be avoided at all costs. However, if you find yourself in the midst of this situation, take control and work to bring the deal to completion. This is an opportunity to gain a reputation as a broker that gets things done in the eyes of the borrower, other brokers, and the lender.

As a commercial hard money lender I have to be good listener. The reason is that everyone has a story to tell about their need for money. Some stories are better than others.

What should you include in your story?

Introduction

A good literary story introduces you to the characters, the setting, and any history relevant to understand the narrative going forward. A good lending story will include some of the same attributes. Most of this information should be included in a easy to read executive summary.

• Who are the main characters? This includes the loan sponsors, and any borrowing entity that may be involved.
• What is the setting? The setting would include the property location and property type. Details are important in this section and should include: unit mix, income details, and tenant information. This would also include the loan amount and the current property value.
• What is the property’s history? This should include the property’s acquisition date, acquisition cost, repairs or construction, current liens, and any other items that set the stage going forward.

Body

The “body” of a commercial loan story should contain all the details that support the loan amount and property value. Not all hard money lenders will lend on the “appraised” value alone. Unfortunately, an appraisal is an opinion of value and not necessarily the price that the market will bear. Hard money lenders desire to protect their investment capital and want to be assured that the property can sell for more than their loan amount.

Property information and borrower information is very important in this section. The lender may ask for tax returns, income statements, balance sheets, rent rolls, leases, appraisals, operating statements, and other relevant facts to justify the loan. It is best to have these times beforehand from the borrower and be ready to provide them to the lender when they ask for it. Hard money lenders require different documents depending on their underwriting criteria.

Conclusion

When I review a deal, I want to have all the facts that are relevant to the deal. Market surveys, comps, and demographics are helpful to understand the project. The conclusion of your story should be the reason that they are searching for hard money. Is time a problem? Is the credit poor? Do they have unseasoned funds? Are there vacancy issues that will be corrected? Are they short on capital?

How to tell your story?

First, if you are a commercial broker don’t pass on a loan file that you received from someone else without reviewing it. This is the epitome of laziness and a lack of professionalism. It is frustrating to call a broker with questions, after reviewing a loan file, only to find out that the broker has no idea what the deal is because they just glanced at the package and passed it along.

Second, organize the data. Sorting through pages of data is frustrating and may mean that the borrower is trying to hide something. It is like an episode of “Law & Order” where the defendant sends over 15 boxes of documents in order to hide the document containing incriminating evidence.

Third, be as brief as possible. You may be very eloquent, but time is money. Also, a pig in a dress is still a pig. An ugly property with pretty words is still an ugly property. The executive summary should be a summary, not a life history.

Fundamentals are Still Fundamental

What do I mean? The value of a property is largely going to be based on income and cap rate. A lender is going to base their loan on the value of the property. The value may be today’s value or it may be a future value, but it will be based on a reasonable expectation of the property’s value. Property doesn’t generally appreciate at 400% or even 100% per year so take this into mind when you “estimate” your property’s value.