100% Financing: Feeding the Desire to Acquire
by Ray Alcorn
At least once a week, someone posts to the commercial newsgroup seeking a way to
finance 100% of the acquisition cost for an income property. I suppose it is
fueled by the late night infomercials touting no money down deals and using
pictures of Class A apartment buildings, never saying the one describes the
other, but leaving a strong impression that that is the case. The way it comes
across, one would believe that all you have to do to become a millionaire in
real estate is to acquire the properties with “OPM”, meaning Other People’s
Money, and then just sit back and collect the big fat checks they like to flash
on the screen. Television is a wonderful thing. After the story is told and the
product is sold, no one in the TV cast has to stick around and collect rent.
The quest for 100% financing in real estate reminds me of that joke about a dog
chasing a car... what's he going to do when he catches it? I wonder, has he
thought this through? I laugh every time I see a dog chasing a car, and think
how much he is just like an investor high on the “desire to acquire.” That’s the
peculiar state of mind that surfaces when the target of our desires looks so
good that we’ll do anything to get it, with no regard for the consequences.
The Desire to Acquire
In real estate, the “desire to acquire” is present when the investor is willing
to do anything to get a deal, any deal. Convinced that once you own real estate
you’re on your way to the good life, they tap their home equity, or find a
seller that will owner finance, and get a bank loan on the bank’s terms, not
theirs. Now they’re in a deal, but have they thought it through? Let’s take a
look at what happens when you “catch” the 100% leveraged deal.
The infomercial gurus teach that if you find the right seller, then you can
structure the deal so that there is no money out of your pocket, and leave the
impression that there will be plenty of money in your pocket after you do the
deal. More often than not, that’s not the result. Let's say that you do find a
lender that will loan 80%, and a seller that will carry 20%. In all but the
rarest of cases, the combined debt payments are going to eat up all but the
tiniest portion of the cash flow. It has to be this way, and I can show you why.
Instead of projecting how much you’re going to make from the deal, think about
it terms of the occupancy level it takes to break even. Then consider the
difference between physical occupancy and economic occupancy.
Economic Occupancy vs. Physical Occupancy
Let’s face it, the deals that we look at with decent prices, motivated sellers,
and opportunities for turnaround or upside are usually not the cream of the
crop. If it were an “A” property, with well-screened tenants it probably
wouldn’t be on the market at a price that would interest us anyway. So it’s
pretty likely you’re going to inherit a less than stellar group of tenants. The
first advice here is to factor delinquency into your projections to avoid a rude
awakening later. Comparing the economic occupancy to the physical occupancy can
be an eye-opening exercise.
Economic occupancy differs from physical occupancy, sometimes widely so.
Economic occupancy is calculated as the actual cash collected divided by the
total potential rents. The answer will be a percentage, and it is important, as
we will see in a moment. Delinquency in apartment rent rolls is a fact of life.
You are not going to collect 100% of the money due, on time, 100% of the time.
It is not uncommon for even well-run apartment buildings to run a 5% delinquency
rate, and poorly operated projects may run a 30% or higher rate. For calculation
purposes, if the rent is past due past the due date it is not included in rent
received.
In the same way, vacant apartments are also a fact of life in the apartment
business. Vacancies are actually phantom expenses that only show up in an
economic occupancy analysis. Together, vacancy and collection losses are
typically projected to run 5% of gross income. In my experience that is a low
number. In the twenty-five plus years I’ve been in this business, a more
realistic figure is 5% for vacancy loss and 5% for delinquency and collection
loss. In a twenty-unit complex with average rents of $416 per month, that’s
equivalent to one apartment vacant for one year. Every investor quickly finds
how easy it is to “tweak” these numbers on paper to make the bottom line more
attractive. I prefer to err on the side of reality, and would advise that you,
“Tweak at your own peril.” But we’ll use the 5% figure for this discussion, just
to save the argument, and to prove the point that even using optimistic numbers
a 100% leveraged deal is tough to structure.
Always Run the Numbers
Let’s use twenty-unit apartment building with potential gross income of
$100,000. That works out to average rents of $416 per month. If it is a normal
building, there will be about 40% expenses, ($40,000), including management, but
not including vacancy and collection (delinquency) loss. Included in the expense
estimate is a “reserve for replacement” deduction. This is an annual estimate of
funds needed to perform capital improvements. An average figure is between $200
and $250 per unit per year. While many owners do not actually reserve the funds,
some lenders will deduct the amount from the cash flow before calculating the
debt coverage ratio. Other won’t, but that doesn’t mean the improvements won’t
be required.
Lastly, if you use the standard projection of about 5% ($5,000) for vacancy and
collection loss, then the building must have an economic occupancy of 45% just
to operate (40% operating expense + 5% vacancy and collection expense = 45%).
That leaves a Net Operating Income (NOI) of 55%, or $55,000. We call it NOI, but
the lenders call it, "funds available for debt service." Ever wonder why? Read
on.
Most lenders require a minimum 1.25:1 debt service coverage ratio (DSCR) to fund
a deal. Some are higher, very few are lower. There's a good reason for that.
At a 1.25:1 DSCR, 80% of the NOI is used for debt service. (1/1.25=.80). In our
example, the maximum debt service would be $44,000, ($55,000 x 80%), or 44% of
the gross POTENTIAL rent. Add the 45% of expenses to the 44% of the debt
service, and you need 89% economic occupancy to break even. That leaves 11%, or
$11,000 for profit, pre-tax.
That’s with normal deal structure, and 20%-25% cash equity. At $416 average
rent, the profit margin is equal to just over the annual rent on two of the
twenty apartments. Or, looked at another way, if there are two vacant apartments
for twelve months, and the rest of the complex operates normally, the project is
going to lose money for the owner. The lender will get paid (in theory!), but
the owner won’t. And that doesn’t take into account any increases in utility
costs, insurance costs, property taxes, fix-up cost for a trashed apartment, or
any other of a hundred things that can and do change during the year. Now can
you see why the lenders are so tough on debt coverage ratios?
Pushing the Limits
So now let’s move to a deal that has 100% financing. Say you find the above
building and the owner just has to get out. He’s willing to take $500,000.
That’s an 11% cap rate on the $100,000 NOI, and sounds like a great deal. You’ve
got a bank that will work with you on high leverage deals, and they offer to
finance the deal with terms of 80% of cost, 7% rate, and twenty-year
amortization. That’s probably a little low on rate nowadays, but a fifteen-year
term is more typical of local banks. Further, we’re assuming you’ve got great
credit, high net worth and are an experienced real estate operator and can get
the best loan terms available. The seller wants out of town so bad he’ll finance
the rest at 8%, with twenty-year amortization, but a balloon in three years. He
wants out, but he does want his money.
The annual debt service on the first mortgage ($400,000) with the bank will be
$37,214 with a DSCR of 1.47. So far, so good. The annual debt service on the
second, seller held mortgage ($100,000) would be $10,037. That’s total debt
service of $47,251, or 47.3% of gross potential income, and a cumulative DSCR of
1.16:1. Add 45% expense and a conservative vacancy/collection loss allowance,
and the break-even economic occupancy level is increased to 92.3%. Or, stated
another way, the best-case profit is 7.7%, or $7,700 per year. The most you can
make is $641 per month, if everybody pays on time and nothing happens. That’s a
cushion of one and a half apartments per year over break even, before any
unanticipated costs or expense increases. That is a razor thin margin.
Now go back to the more realistic 10% vacancy and delinquency loss and the
break-even economic occupancy becomes 97.3%. If anything outside the perfect
world of the paper projection happens, anything, then you’re running negative
cash flow. You’re upside down from the get-go, and few if any options to cure
it. So now tell me, you’ve caught this deal, now what are you going to do with
it? Can you imagine yourself a year from now being a “don’t-wanter” seller? I’ve
seen it happen just that way so many times.
Is This Your Story?
I had a call a few weeks back from a fellow that bought a small apartment
project we had looked at about a year ago in a town about thirty miles from our
office. He wanted to sell, and called us because we are fairly well known as
buyers in the market. He started describing the place and it sounded familiar,
so I asked if he had bought it from “Mr. Jones”. He said yes, and I knew it was
the same deal we had looked at.
I asked how much he was asking for it, and he said he was willing to take what
he had in it, which was about $240,000. It had more land next door that could be
developed with more units and he would include that with the deal. (We had
offered the original seller $200,000, owner financing, no money down, and the
development parcel next door free and clear, or $175,000 all cash. The Seller
didn’t take either offer, and we walked away.)
I asked a few questions. Nothing much had changed. He had painted the place, but
the rents were the same. I asked him how much he owed, and he said $240,000,
twenty percent of which was financed by the Seller. He was three payments in
arrears on the Seller’s note because there had been two vacancies he couldn’t
get filled.
He mentioned that this was his first real estate investment and he really didn’t
know what to do. I could hear the strain in his voice, and could tell he really
wanted out. I said I was sorry, but I couldn’t help him. I didn’t preach this
sermon, figuring he was already paying tuition for an advanced degree in the
proper use of leverage. His desire to acquire was stronger than his desire to
learn how to figure cash flow before jumping into a deal. He didn’t think it all
the way through.
Pigs Get Fed…
If all of this doesn’t give you pause to think twice about high leverage, then
consider this. If the building in our example is full, there are twenty tenants
with payments due each month. That’s 240 payments due each year. That’s also
twenty potential stories each month as to why you can’t get your money, 240
potential stories each year. What is the probability that of the 240 potential
payment events per year, somebody won’t pay on time? That should make you wonder
how well the tenants you inherit from the Seller were screened. Or did he just
get warm bodies to fill the place to sell? Believe me, it happens.
Don’t get me wrong; there are situations where 100% leverage is possible and
profitable. I’ve done it a number of times, but in every case there was
considerable upside available, or a development opportunity that I could
capitalize on to better the odds of success, such as my original offer on the
deal above. We structured the two offers so that either way we could win. It had
the potential to cash flow in the present, and plenty of upside in developing
the property next door. We walked when we couldn’t structure the deal to win.
Someone else came along and wanted the deal bad enough to do whatever it took to
acquire it. Now the Seller has a non-performing note behind a first mortgage
that is barely being serviced, both secured by a property that is declining in
value because of poor management and a tough market. Did anyone really win?
There’s another saying that comes to mind here, “Pigs get fed, hogs get
slaughtered.” That’s a barnyard expression to describe what happens when we
reach for more than we’re entitled.
I hope you can see from this discussion why high leverage is a strategy that
requires the experience, capital, and resources to use it properly. Be careful
when you contemplate highly leveraged deals. Figure the break-even economic
occupancy rate. Know what the costs are going in. Know the market. Know your own
capabilities and be able to move quickly to capitalize upside. Above all, do not
tweak the numbers to support your own “desire to acquire.”
Bio:
Ray Alcorn is an active investor who averages over $10 million in deals per
year. He has over 25 years of experience in owning, developing and managing
commercial real estate of all kinds, including mobile home parks, single-family
subdivisions, apartments, hotels, restaurants, office buildings, shopping
centers and multi-use projects.
When not writing books and causing mayhem on internet newsgroups, Ray is the
Chief Operating Officer of and a principal in Park Real Estate, Inc., a real
estate development and investment firm with headquarters in Blacksburg,
Virginia.