Loan Characteristics and Their Effect on Your Prospective Investment Project (Part 1)
Most real estate investors acquire income properties by obtaining a loan. As you are probably aware, maximizing loan funds (or OPMâOther People's Money) maximizes leverage and, thus, maximizes returns. The right loan product can easily make or break a real estate investment deal. As such, exploring various loan characteristics is more than warranted.
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Regarding lender recourse, loans fall under one of two broad categories: "recourse" or "non-recourse." The former refers to loan products that require the borrower to accept personal liability for the repayment of a loan. The latter, however, is a loan for which the borrower is not personally liable; if the borrower defaults, the lender's only "recourse" is to seize the collateralâthe property in the case of real estate.
This is important because not every investor will qualify for a recourse loan. Likewise, an investor might only qualify for a limited amount of loan dollars that may prevent him from obtaining the money necessary for a particular property. This investor may be able to secure a non-recourse loan and the coveted property in the process. Keep in mind, however, that non-recourse loans are not only much rarer than recourse loans, they also take much longer to secure since the lender thoroughly inspects (read: qualifies) the subject property.
A pre-payment penalty is a fee that must be paid to the lender if the borrower prepays a loan within a certain time frame. Lenders do this to guarantee some specific yield on the loan they are making. Prepayment penalties can be "soft" or "hard". A lender offering a "soft" prepayment penalty allows the loan to be paid off without penalty if the property changes ownership, but applies the penalty if the loan is refinanced. A "hard" prepayment penalty will kick in regardless of the source of repayment.
It is crucial for the real estate investor to understand the specific terms of the prepayment penalty because it directly affects the investor’s exit strategy and return. Be sure to take the prepayment penalty into account when performing your analysis.
If a loan agreement includes a "due on sale" clause, the associated loan is referred to as a "non-assumable" loan. An "assumable" loan, on the other hand, does not carry a "due on sale" clause. Once again, the assumabilty of a loan affects the investor's exit strategy. After all, a low-interest, assumable loan is much more attractive to potential buyers than a property with existing financing that must be paid off upon the property’s sale.
Fees and Costs
This one is fairly obvious, but don't forget to take it into account since it directly impacts your initial investment. These also vary greatly from lender to lender and loan product to loan product. As a rule of thumb: the more unique the loan, the higher it's associated fees and costs.
Stay tuned because next week we'll explore some other loan characteristics. Until then, happy investing!
Updated 11/9/09: PART 2 – Other Loan Characteristics is now live on the site.