It all started about three weeks ago when my son Aaron took ill with the flu. Within days it was my wife Patrisha’s turn, followed promptly by Isabella, Aaron’s twin sister. It has been fun indeed around the Leybovich household…
So here I am, at 1:30 in the afternoon on a cold, I might even say nasty, winter day in Ohio. I am in bed sick as a dog, and as I lay here I am suddenly overcome with the notion that I am a thirty-seven year old man and I LOVE MY BLANKET…
Before you determine that besides having the flu I am also nuts and move onto another article, let me clarify that this particular thirty-seven year old man also happens to be a passionate real estate entrepreneur, and the blanket that I love so much is, of course, is the Blanket Note – a valuable tool in the world of real estate investing.
Allow me to remind you of a basic principal that I adhere to:
I believe that in real estate investing every technique and every negotiable term exists for one of two reasons – to improve investment returns or to facilitate the transaction in the first place; to make it possible. With this in mind, the primary function of a blanket note is to facilitate a transaction, and here is how:
Accessing Capital by Liquefying Equity
One of the most basic requisites to the majority of real estate purchase transactions is access to capital to cover the down-payment requirement. Most people fulfill this requirement by writing a check from their savings. However, in case you happen to own significant equity in another piece of real estate, you can gain access to capital by liquefying this equity, which can take several formats.
The simplest way to liquefy equity, of course, is to sell property. However, while this generates capital gains, the sale often carries undesirable consequences with regard to taxation, which is why sophisticated investors turn to a “loophole” in the tax code commonly referred to as 1031 Tax Deferred Exchange, which provides for the taxation of capital gains resulting from the sale of real property to be deferred so long as this gain is applied toward a purchase of another asset of like-character. The IRS puts forth very strict guidelines as to how this process is to be administered, so consult your advisors if you are thinking about doing this.
Ultimately, however, sale of a cash-flowing asset is akin to slaughtering the golden goose in my mind. I mean, if it’s working for you, why sell it? I, and a lot of others, prefer to “pull” equity out through means other than selling, which allows us to gain access to capital without destroying a cash-flowing asset. This has to take the route of either some type of refinance, or the sale of shares in a corporate entity which controls said real estate.
The latter falls outside of the scope of this article, but relative to financing, most people are familiar with options such as equity line of credit, equity loan, or a cash-out refinance. All of the above achieve the basic objective of liquefying equity. However, investors with larger portfolios are sometimes able to use a technique we commonly refer to as Equity Bridging, which allows us utilize equity locked in a property, or multiple properties we own, to collateralize lending for the subject property that we are purchasing.
The tool that is used for this is the blanket note, which results in an umbrella mortgage. This type of a note cites multiple pieces of real estate as collateral for lending, which in effect pulls or “blankets” leveragable equity of multiple assets together.
Now, it is important that we agree on a basic philosophy, and some of you may not, that equity which is “locked” in real property does nothing for us in terms of cash flow. Therefore, whenever we can unlock this equity and trade it for additional cash flow – this is a good thing. Cash flow pays the bills, while equity just looks good on paper! Any time I can create more cash flow by acquiring additional assets than the debt service associated with bridging equity – it’s a go…
Caveat – 100% leverage and 100% financing are not at all the same thing. If the building is reasonably worth $410,000, and the transaction incorporates elements of expandability which will allow me to improve the value to $475,000 within a reasonably short time, then by financing 100% of the purchase price of $375,000, I am not leveraging 100% of the equity. I am leveraging 100% of the purchase price, but I sleep fine at night as I am reasonably sure that if I needed to sell quickly – I could. Thus, whenever I speak to you about leverage I never mean that 100% of the value should be leveraged. Be reasonable and safe.
Having said this, it just kills me how many investors look at a down-payment as a means of generating cash flow. As in – if the building is not cash flowing enough, just put more money down. NO! A good deal needs to cash flow comfortably under 100% financing. If it does not, then either you are paying too much, or some other of the negotiable terms are way off the mark – go get a better deal! You should NEVER buy cash flow with down-payment!
What are the Benefits?
The obvious benefit to utilizing a blanket note is that we are able to avoid needing a cash down-payment. Instead, we are able to utilize equity to collateralize the down-payment. Also, by doing a blanket note as opposed to setting up a bunch of equity loans or lines of credit for individual properties, we can keep the costs down in terms of origination fees and closing costs.
There Are Risks
There are risks associated with using blanket notes. First of all, blanketing several buildings as collateral for a single note exposes each one of those buildings to the performance of the rest. In other words, if things go badly and you default on the note, the lender will have rights to all of the property in the blanket. This may not be an acceptable risk for some people.
Also, selling one of the buildings within a blanket may not be simple – you will need to have it released by the lender. The lender will want to ensure that the remaining balance on the note is sufficiently collateralized by the equity which remains in the blanket after you sell one of the pieces of collateral.
Pay attention guys – this next part is important: In this situation the lender will likely order an appraisal. What do you think happens if it turns out that your buildings are worth less than you thought? The painless answer is that the lender will refuse to let any collateral out of the blanket. But, and this is a painful but – you could also be asked to compensate insufficient equity with CASH, or else they foreclose. It’s happened before!
It’s not fair, but:
He who has the gold makes the rules!
This is why I suggest that you do your homework before you shake that tree. And obviously, only consider blanketing those assets that you plan to hang onto for a long, long, long time.
Blanket notes can be an advantageous tool in our bag, but as is the case with most things in the world of investing, you must be cautious and well educated before attempting to use this tool.
What do you think – will you be using a Blanket Note on your next deal?