When thinking about investing in any debt instrument there are multiple things that need to be considered. The most important metrics most investors are looking for are loan term and return, but in real estate there are a variety of other considerations that often cause investors to misprice risk. As RealtyShares rolls out its term debt product, the focus of this blog post is to educate potential investors on what we are thinking about when we’re looking at interest rates and how to price our term debt product relative to our bridge debt product.
Short Term Acquisition Financing (Bridge Debt)
The most popular product on the RealtyShares platform from both a borrower and investor perspective is the short-term bridge product. We launch roughly 2-4 short-term rehab loans per week and the investments are sold out within hours, if not minutes. The reason this product is so popular from an investor’s perspective is because of the high interest rate, short duration of the loan and the personal guaranty from the borrower. From a borrower’s standpoint, these are attractive deals despite the high cost of capital because of how difficult it is to obtain traditional financing and because the loan is outstanding for only a short period of time. He or she is willing to take the high interest rate in order to secure capital to close quickly and leverage the potential return.
High Interest Rate
Short-term acquisition and rehab loans are no doubt attractive investments, but they still come with a degree of risk. These assets are typically not producing cash flow from day one of the investment term and there is uncertainty on the ability of the borrower to A) complete the project successfully while paying interest, B) pay the loan back at maturity, and C) sell or refinance at a high enough value to cash out the lender. RealtyShares mitigates these risks by underwriting both the borrower and the property securing the loan, while investors are compensated for this risk with a high monthly coupon payment. The borrower will pay a higher rate because fix and flip projects are high margin and the biggest limiting factor for high volume fix and flip operators is access to capital and efficiency of capital.
Term Debt Product
While many borrowers are utilizing short-term bridge loans for a fix and flip strategy, there are equally as many repaying the initial loan by refinancing and holding the property in a rental portfolio. In a buy and hold scenario, borrowers are able to obtain a longer term loan at a lower rate after they have completed rehab and placed a renter in the property. The rate is lower because a majority of the risk has already been eliminated for several reasons.
Debt Service Coverage Ratio (DSCR)
When an asset has been stabilized and is cash flowing, there is a greater degree of certainty for a lender that the borrower will have the ability to pay the monthly interest payments using the cash flow that the asset is generating. When evaluating a loan, lenders are focusing on the debt service coverage ratio to determine whether the income from the asset is covering the debt service. The formula for debt service coverage ratio is simply the monthly net income from the asset divided by the monthly interest payment.
- Loan amount: $100,000
- Interest Rate: 6%
- Monthly Debt Service: $500
- Monthly Rent: $800
- Monthly Expenses: $200
- Net Income: $600
- Debt Service Coverage Ratio = Net Income / Monthly Debt Service = $600 / $500
- Monthly Debt Service Coverage Ratio: 1.20
The example above has a DSCR of 1.20. 1.20 is typically the minimum debt service coverage ratio a lender will accept before providing financing on the asset. The lender feels good about the loan because the property is generating enough cash flow to cover the debt while the borrower is still able to profit on the asset. The higher the debt service coverage ratio (say net income is $700 in the example above and the DSCR is 1.40) the more favorable the financing terms will be for the borrower.
After Repair Value (ARV) and Loan to Value (LTV)
The other reason a lender can get comfortable with a lower rate and a longer loan term for a stabilized asset is more certainty around the value of the asset that is securing the loan. When evaluating ARV before work is completed, there is uncertainty on the quality of the final product, which has a significant effect on the value. Once repairs are completed it is much easier to estimate value and typically a lender will not provide term financing without an appraisal, which includes a full interior and exterior inspection of the subject property and a thorough comparable market analysis. Once the value of the property is determined, in most cases, lenders will provide financing up to 75% of that value (75% LTV). At this point, the lender is betting that the market will not depreciate by more than 25% over the term of the loan and if the borrower isn’t able to make payments, the lender can foreclose and quickly sell the home at a significant discount to market in order to recoup the entire loan amount. In some cases, in a rising market, foreclosing can even be the most profitable outcome for a lender.
The last piece to the term loan that is significantly different from a bridge loan is that term loans typically include an amortization schedule; meaning part of the principal is paid down along with the interest each month. In a typical term loan with a 15 year amortization schedule, the lender is receiving part of the principal back each payment period mitigating the lender’s exposure as the loan matures and with payment a small portion of the risk is transferred from the lender back to the borrower. In the 15 year amortization scenario on a 3 year loan, the borrower has already paid back 1/5 of the principal by the time the loan comes due, while in a short term rehab loan that is typically interest only, the lender has the same risk exposure at month 12 as he does on day 1. As the principal is repaid, the default risk decreases as well as the lender’s exposure to fluctuations in the market because leverage goes down with every payment.
Risk Adjusted Return
Pricing risk is essentially based on uncertainty. Uncertainty around the borrower, uncertainty around the project or a combination of the two is driving the difference between a 12% interest rate (for a bridge loan) and a 6% interest rate (for a term loan). Depending on risk appetite an investor may be more interested in a higher coupon payment, however, in finance, just like anything else, you can’t have your cake and eat it too and depending on your risk preferences you may be better off putting your money to work in a low risk long term investment with more certainty that your investment will pay off in the end.