Secured note vs. equity syndication

5 Replies

Hi all,

I'm buying my second 4 unit in Wash Park, Denver with a small group of investors and am hoping to get feedback on two different approaches to structuring it.

Approach #1 is to buy the home in my name with a 75% conventional loan. I fund the down payment, quit claim title to an LLC post-close and fund the investor equity at that time. I have an Operating Agreement with my equity investors that dictates distributions, etc.

My concerns with Approach #1 are two risks: (1) having the loan called as a result of the due on sale clause (which I've read the BP posts and spoken to lenders about the likelihood of that) and (2) the challenge of refinancing. I'm more focused on a solution for the refinancing, and it seems I could either (1) refinance with a commercial loan or (2) transfer title back to my name, refi, and transfer back to LLC. The former would dilute returns with a higher rate and more closing costs and the latter seems to be sketchy in terms of moving title around.

Approach #2 is to buy the home under my name with the 75% LTV conventional loan and finance the down payment and any renovation budget post-close with a secured note from private lenders. These would be the same investors I currently work with, but they would make a debt investment instead of equity.

I like Approach #2 at first glance - avoid the risks of Approach #1, claim all of the depreciation, increase my levered return while providing a strong debt investment to investors - but am surprised that I haven't heard more about on BP or elsewhere. I know hard money is common for flips and cash deals, but this would be more of a buy and hold investment for me and my debt or equity investors.

SO the question to those who have bought 3-4 unit deals with investors, do you have a favorite between the two approaches?

Are there any fatal flaws (eg, could I refi it if there's a secured note that's subordinated to the first mortgage?) with Approach #2?

My goal is to scale my small multi-family portfolio with my investor group and optimize the financing of these smaller residential multi-family deals. I'm buying 5+ units and don't have to worry about this with commercial financing, so this question is specific to the <5 unit niche.


Thanks in advance!

Ben

Hi Ben. First of all, congrats on securing a value add 4-plex in Wash Park. I live in West Wash Park. Would love to connect and chat about your projects and goals.

As for your financing question, it seems you’re set on getting a conventional residential loan. Any reason for that other than better terms?

The reason I ask is two-fold. First, from a liability standpoint, I would recommend setting up a multi-member LLC specifically for the property. If it's done right, this will protect your personal assets and place the 4-plex in its own ‘business model.' You can take that model to local banks and shop for mortgages. If it's a good model, someone will lend to you.

Second, from a goal standpoint, you said you want to grow your portfolio, but if you're putting these in your personal name, you're going to run up against your debt to income threshold. Banks like to see a number less than 40% or so. The problem with rentals, is even when you cash flow, your mortgage and expenses get get divided by your income and your dti ends up really high. Depending on your ‘day job,' you may be able to do a few of these deals, but you will need to use LLC's sooner rather than later.

@Ben Sowers , the other issue with a conventional mortgage is it is common to be asked about the source of your down payment, which both of these options could create a problem for both the purchase mortgage, and if you are recording the secured note, it will appear as a lien on the property and create issues with the refi.  If you are not recording the note, it likely won't come up in a refi, but you are typically signing off on documents stating there are no other known liabilities tied to the asset.

@Steven Tawresey thanks for the response! I'll send you a separate message so we can grab a coffee or beer in the neighborhood.

Regarding the conventional vs. commercial, I did Approach #1 for my first 4 unit in Cap Hill and it seems easy to replicate. I'd have an LLC for either approach. The reasons I like the conventional loan are (1) security of 30 year fixed rate to hedge against increasing interest rates over a longer term buy and hold period (2) a lower interest rate and (3) less closing costs. Regarding closing costs, FirstBank's 1% origination fee plus ~$12k in 3rd party reports crushes my returns, but I've heard that they have lower closing costs on a residential property so will look into that today. I'll be curious to hear more about the financing options you've used as I'm sure there's a better way.

Regarding scaling the portfolio, my lenders take into account the rent income from the investment properties, so as far as I can tell the rental properties actually help my debt-to-income ratio. Regardless, I don't plan on staying at the 4 unit level for too long, but it's a good entry point and place where I can be more competitive. I've bid on 10-20 unit buildings but I haven't found any great buys based on my conservative underwriting. I'll look into this more though to make sure I'm not missing something.

@Evan Polaski thanks for the feedback!

On the down payment, I'm bringing my own equity at closing to meet the lender's requirement that it has to come from me. My investors fund their contributions before close, and I reimburse myself for fronting the down payment. Is that what you were getting at?

On the refi and lien issue, that's good to know. Would a recorded secured note that's subordinate to the primary note prevent a refi?

Broader question on Approach #1 vs #2, have you seen many private debt deals (#2) or is private debt mostly used for acquisition and renovation financing? I haven't gone out to investors yet, but would think I could find around 10% to 12% long term debt for this.

Quick update after taking into account @Steven Tawresey and @Evan Polaski 's advice and chatting with another lawyer and lender, I've decided to go with a commercial loan from a regional bank (FirstBank).

I think the benefits - higher leverage (80% vs 75%), finance the reno budget, avoid due on sale risk, build track record with the bank - outweigh the drawbacks of higher interest rate risk (7yr fixed vs 30yr) and a slightly higher rate. 

Thanks for the help. Now the challenge is finding a good GC to partner with on a quick timeline post-close. If anyone in the Denver area has referrals, I'd appreciate a message!