Three Financing Traps that Borrowers Need to Avoid at All Costs
In the first part of this series, How to Get the Best Possible Loan for Your Property, I explained the importance of selecting a competent commercial mortgage broker to guide you through the process of financing your rental properties. Employing the services of a commercial mortgage broker has four distinct advantages over shopping the mortgage market on your own. If you didn’t read the previous article, I suggest you do so by clicking on this link: Four Advantages of Using a Commercial Mortgage Broker. Bottom line, they will substantially increase your chances of getting the best possible loan for your property.
But you also need to be knowledgeable about financing. It’s not all on their shoulders to find you the best financing for your property. In Part II of this series, How to Get the Best Possible Loan for Your Property, I explain that one of the most common mistakes that real estate investors make is focusing too much on one loan parameter to the exclusion of all other loan terms. Most borrowers make the mistake of focusing on one of three loan parameters. Avoid these financing traps.
Three Common Financing Traps to Avoid
Financing Trap #1 – Focusing on Getting the Lowest Interest Rate
For many borrowers, their hot button is getting the lowest interest rate. I understand their reasoning but as you can see in the following example, what they really want is the lowest mortgage payment, not the lowest interest rate. I recently had a client who told me that he had decided to proceed with another lender than what I had presented to him because this other lender had quoted a lower interest rate. When I asked him how many years was the loan being amortized over, he initially didn’t know, and he would get back to me. He discovered that the lender had quoted a 20-year loan amortization. The loan quote I presented to him was amortized over 30 years and my lender’s mortgage payment, even though it had a 1/4 point higher interest rate, had a substantially lower mortgage payment than the other lender’s quote. Once I explained this to my client, he quickly understood that the longer amortization made a huge difference on the monthly mortgage payment and he chose my lending source.
Financing Trap #2 – Attempting to Minimize the Down Payment Needed to Close
I understand why investors would focus on minimizing their down payment: They only have so much money to invest! I get it. But minimizing the down payment results in maximizing the debt needed to finance the property. And having too much debt does not come without risk: Highly leveraged properties are more susceptible to downturns in the real estate cycle. Those properties that are the most leveraged are at risk of not being able to generate positive cash flow. As market vacancies continue to climb, at some point a highly leveraged property will not be able to pay its mortgage payment. That is what happened during the Great Recession resulting in many properties being foreclosed upon by lenders for getting behind on their mortgage payments. Are you sure you want to minimize your down payment?
Financing Trap #3 – Choosing Non-Recourse Financing over Recourse Financing
A recourse loan gives the lender the right, in the event of default on the loan, to recover against the personal assets of the borrower. For example, let’s say an investor purchases a property for $1,000,000 and finances it with a $750,000 loan. Time goes by, and the real estate market goes into a deep recession causing vacancies to rise significantly at the property. As a result, the cash flow generated by the property is no longer sufficient to make the mortgage payment. The lender forecloses and sells the property for $650,000. The current loan balance has been amortized down to $700,000 leaving a deficit of $50,000 that is still owed by the borrower. The lender has the right to recover the $50,000 deficit by going after the borrower’s personal assets. That is an example of the downfall of a recourse loan.
The Advantage of Using Non-Recourse Financing
A non-recourse loan bars the lender from seeking a deficiency judgment against a borrower in the event of default. The borrower is not personally liable if the value of the collateral for the loan falls below the amount required to repay the loan. So in the example above, the lender sells the property for $650,000 and takes a loss of $50,000 with no recourse to go after the borrower to make up the difference.
So which loan would you prefer? A recourse or non-recourse loan? It seems like a no-brainer doesn’t it? We would all choose a non-recourse loan because there is less risk to the borrower when things go bad. In a worst case scenario with a non-recourse loan, the borrower would hand the keys of the property over to the lender and not have to worry about the lender being made whole by going after other personal assets of the borrower.
Why Non-Recourse Financing May Not Be the Right Choice
Unfortunately it’s not that simple, and here’s why. In most instances, a non-recourse loan is paired with an onerous prepayment penalty, typically yield maintenance. And as we’ll discuss in the section below, you want to avoid prepayment penalties that prevent you from selling or refinancing your property when you think it’s best time to do so. So maybe, just maybe, recourse financing is not so bad after all.
Another way of looking at it is this: In the example above, the investor purchased the property for $1,000,000 and the bank eventually sells the property for $650,000. That represents a 35 percent drop in the property’s value. What are the chances that we will ever experience a recession that results in that significant of a drop in a property’s value? During the Great Recession, we experienced a 10 percent decline in apartment values and maybe as much as a 20 or 25% drop in some property types. I shudder to think what type of recession/depression would result in a 35 percent or more decline in property values.
Why I like Recourse Financing
So in most instances, I will gladly accept recourse financing to avoid being locked into a loan with an onerous prepayment penalty. I want the freedom to choose when I want to refinance or sell the property and I will gladly accept the additional risk of recourse financing in the unlikely event that I lose the property to foreclosure due to not paying the mortgage payment.
There you have it, avoid these three financing traps and you will have a much better chance of getting the best possible loan for your property.
These are my thoughts. I welcome yours. What financing traps do you see that borrowers make?
Doug Marshall, CCIM is the award winning author of Mastering the Art of Commercial Real Estate Investing. Check it out on Amazon!