The #1 Things Passive Investors Can Learn From The TX Foreclosures

If you’ve followed our podcast, blog, and social media for a while now you’ll know we always preach the #1 thing to vet for when investing as a passive investor is the operator, but, I don’t want to use this post to beat a horse that everybody else has already trampled on (myself included).

Quick Notes:

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I want to talk about another item that killed this deal, which was the debt, and how passive investors need to understand their deals debt.

Debt is the most common killer of real estate deals.

A Quick Recap:

For a quick recap of this story a group is getting foreclosed on 3,200 units in Texas when the rate on their $230M loan went from 3.4 to 8%.

That means they went from a monthly interest expense of $790k to $1.85M!

There were a few red flags that investors could have caught that could have prevented them from investing in this deal, those 2 things are…

Fixed or Floating (And if floating…)

Understanding if the rate was fixed or floating. If this property had a fixed rate of 3.4% that means that rate stays, and regardless of what the fed does this property is locked in at 3.4%, something that could actually make the property even more desirable at sale if the loan is assumable.

But, that’s not the end of the world if the product is floating, around the time of this loan almost all lenders were offering very attractive terms for floating debt and even we used floating debt for some acquisitions. But, if you know the debt is floating then you have to understand if there’s been a rate cap purchased.

This would do exactly what it says and cap the rate at something significantly more reasonable. And once you find out what that rate cap is, you have to understand if the deal was underwritten to that rate.

If the deal doesn’t work at the maximum rate allowed in the cap, then the deal doesn’t work.

Debt Terms

Another aspect of the debt that investors should understand is the term of the loan.

Forced sales are another big item you want to avoid at all cost when investing, if there’s a balloon payment coming due within a few years, we want to understand what the extension options are for that loan.

A popular format might be 2 + 1 + 1 which means the initial term is 2 years with the option to extend for 1 year twice.

There are typically fees associated with exercising these options, but the fees are significantly cheaper than being forced to sell when you or the market isn’t ready.

Having rate caps, underwriting the deal to those rate caps and confirming they still work, and having loan extension options are 3 things that great operators should put in place to prevent catastrophic deals, and something you should vet for as an investor.