Real estate, like all other asset classes, goes through market cycles. As the market goes up, property values increase, and the ability to get a loan generally becomes easier. As the market goes down, property values decrease, and the ability to get a loan generally becomes harder.
When the loans get harder to obtain, you may begin to ask yourself:
- Why has it become so much more difficult to get a loan today, when two months ago it seemed easy?
- And most importantly, how am I going to fund my next deal?
Do I have your attention yet? Good.
Read on, and be sure to watch the video below for further information.
Now, in order to answer the above questions, we need to take a step back and see how lending has evolved in real estate.
Recent History of Lending
I started investing in real estate when I purchased my first duplex in 2004 outside Philadelphia. I used a $30,000 private loan. Since that first deal, I have seen four different lending markets.
From 2005- 2008, real estate went through its infamous “no-doc” period, which basically meant giving out loans with no required documentation. As you can imagine, this did not end well—it caused a collapse in asset prices not seen since the Great Depression.
From 2007-2010, the pendulum swung the complete opposite way, and getting a loan became extremely cumbersome. This period was famous for the ample amount of deals to buy—but no capital to buy with.
For the last nine years, the process of getting money for a deal can be summarized in one word: easy. When I talk about getting money, I’m referring to the debt of the deal.
For example, say an apartment building costs $1 million. For simplicity purposes, I have to raise 25% (or $250K) for the deal from my investing partners, leaving the remaining 75% (or $750K) to be funded by a debt provider, such as a bank, agency, or private lender.
Obtaining that 75% debt has been “easy” up until COVID-19 hit. Now we enter what I call the “corona crazy” environment.
To put it simply, the world has changed—in almost every way—in the last two months. These changes have drastically affected an investor’s ability to get loans on deals.
Where Can You Get Money for Your Next Deal?
The first place to look to get money for your next deal is your own network. I talk about the different ways to cultivate your network in order to raise capital in my BiggerPockets book Raising Private Capital.
But even if you could raise all the funds needed for a deal, you probably wouldn’t. Why? Because real estate’s greatest asset is leverage.
The ability to put down a 20- 25% down payment in order to obtain a large leveraged asset is a great wealth creator. (A word of caution here: the opposite is also true—too much leverage is a great wealth destroyer.) So after you raised your initial funds—usually consisting of your down payment, closing costs, capital expenditures, and operating expenses—you turn your attention to the debt market.
While it may be difficult to get a loan, the investor’s reward is that debt is currently experiencing historically low interest rates. As I write this article, the rates are between 2.5- 4%. Those are impossible to beat!
Not all banks are lending these days. In fact, most aren’t. To understand which are, you need to know where the banks get their money.
Balance sheet lenders use the money that’s been deposited with them to fund loans. They lend it out and earn interest on the loan. Since the funds are staying on the balance sheets of the bank, the bank can hold onto the loan for as long as it chooses. These balance sheet lenders are typically smaller, regional banks.
The alternative to a balance sheet lender is a warehouse lender, where an enormous bank or a large institution like Fannie or Freddie provides, in essence, a line of credit for small intermediaries to originate loans. The main goal for a warehouse line is to originate loans and package them up to sell in order to pay back the warehouse line of credit and then repeat the process.
So, how do you know which banks to go to?
It’s simple, ask them if they’re a balance sheet lender. (You’re speaking their language now!) Again, if you’re unfamiliar with the term, it just means that the bank is loaning their own money and does not plan on collateralizing or selling the loan.
If they are a balance sheet lender, you will have a better chance of them funding your deal. If they’re not, then there’s a very good chance they are not lending at this time.
And if they are lending, you may have another problem…
Why Is It Much More Difficult to Get a Loan Right Now?
Two months ago, it seemed so easy to secure a loan. But because of COVID-19, these warehouse lines have dried up. Some of it is due to the fact that Wall Street funds were backing these lines of credit, but the main reason is the unpredictability of today’s environment. Large institutions are taking a pause and shutting off the spigot.
The second major reason is that when the debt providers underwrite your deal, they look at the income available to pay down the loan. This is commonly known as the debt service coverage ratio (DSCR).
Up until the corona craziness, residential real estate has been fairly stable from an income perspective. When people decide which bills to pay, rent is usually given the highest priority in the hierarchy of expenses. Because of this factor, banks were always able to make certain assumptions on income projections—which in turn made underwriting easier for the banks.
However, in the tumultuousness we’re currently living in, underwriters have no way of projecting what the future income for a property will be. Compounding this issue, the numbers are looking worse and not better in the near future, as unemployment approaches Great Depression levels.
With this bleak outlook, a lender’s best chance to underwrite your deal is if the current month’s rent collection is strong. This can be a saving grace for current loan applicants or a death blow if the collections weren’t so hot.
The Gorilla in the Room
And now it’s time to talk about the big gorilla in the room: Fannie and Freddie, who collectively are commonly referred to as agency debt. Agency debt is insured by the federal government and provides lenders the funds needed to loan on everything from a single-family all the way up to hundreds of units.
Given the vacuum created by the warehouse lenders stopping their loans, Fannie and Freddie have changed their terms. Fannie and Freddie are now requiring anywhere from six to 18 months of operating expenses. While they do give back the funds if your deal performs, it requires the investor to raise an enormous amount of escrow just to close a deal.
So, how are YOU going to fund your next deal?
In short, this article is a snapshot of today’s lending environment. You need to be aware of who you should go to for the best chance of securing a loan.
There are two main options in funding a deal right now: a balance sheet bank lender and agency debt. Without strong income in the current month, a balance sheet lender most likely won’t lend you the money, and without strong reserves, agency debt won’t lend you the money.
But then again, getting into a deal without strong income and reserves may not be the best thing for you anyway.
As mentioned, if you want to hear the full discussion on this, be sure to watch the video here.
Have you applied for a loan and been denied recently? Do you know why?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.