- On March 26, 2020
Just as people borrowing money from financial institutions have their own point-of-view about how systems work or should work, so do those same financial institutions. The lender’s perspective is one of safety, security, and risk prevention in order to make sure that money ends up in the hands of those who can pay them back and even make them money in turn. Ira Zlotowitz explores the perspective that lending institutions take when evaluating those that are applying for loans. There are, of course, a bevy of factors to take into account when you apply for a loan. Let Ira talk you through these different factors and how you can get better standing among these lending institutions in order to secure your financing.
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Chapter 8 – Through The Eyes Of The Lender
Know What You Can Negotiate
We’re going to go through Chapter 8 in this episode. It’s going to be Perspective Number 3, Through the Eyes of the Lender. It’s important to see everything from everyone’s perspective. An important perspective is going to be the lender, because most of the money you’re getting is coming from the bank. If you’re buying a deal, going with the same example we’ve been using, a $1 million building. $750,000 in $1 million is coming from the bank. In a case like that, to understand the bank, why do they do the lending? What’s behind the scenes? That way you know what you can and can’t negotiate. Every dollar that you get from a bank allows you to leverage and get a better return on the money you’re putting in.
The most successful people take the time and energy to fully understand how the banking works, how the financials work. Much like on the other end of the spectrum, you want to understand your equity and where your money’s coming from. Remember, that’s only $300,000. If the risk is $300,000 of the $1.05 million, because you’re putting up $300,000 coming from equity and $750,000 is coming from the debt. Together, you have your $1.05 million. We’re going to focus on through the eyes of the lender.
Let’s start from the ground up or the basics. I know many of you could know some of these terms and some of these foundations. When I want to focus on this topic, what I found amazing over the years are the different nuances of words or terminology that some people are accustomed to and some people weren’t. It’s worth to repeat even the basics. Who are the primary lenders and what are their root differences? All of lending pretty much falls into two different categories. We’re going to call the first category banks, which are cashflow lenders. They lend money based on a property that has income. There’s cashflow. There’s money that’s coming in. It flows with cash. The second are called bridge lenders. Bridge lenders are asset-based lenders. They don’t care if this is cashflow. They look at the value. If there was a vacant building, many banks wouldn’t want to lend on a vacant building. It’s an asset, a building.
A bridge lender would say, “It’s worth $1 million. I might not lend you 75% but I want to do 70% or 65%.” Primarily, they’re going to focus on the value first. That’s where the differences come back. Who are these banks that we discuss? Banks comprise of what we know as conventional banks, savings and commercial banks. As far as that’s concerned, it’s a bank you could walk into. After all the years of being a mortgage broker and dealing with banks. I never understood the practical difference if the charter is a savings bank or a commercial bank. As far as you’re concerned, to borrow money from them is the same. The differences have no real effect on you.
You also have Wall Street lenders, which we will call typically CMBS. They lend the money and then they securitize it. They bundle them together and they sell it off as a bond. Life insurance companies, every one of us has life insurance. Upon death, it covers your estate tax and your family gets money. When you’re paying for life insurance, what does the life insurance company do with the money? They will also at times lend money against commercial real estate.
You have credit unions. They are like banks. It’s similar to a bank but instead of it being owned by an entity like Chase is publicly traded. The credit union is owned by like the fire department. All the members of the fire department like a union get together and they in effect are partners within this bank or credit union. When they lend money, it’s the same. The difference is if you are a member, you don’t get dividends like my 2% of the bank. Instead, you get profit sharing. I never spent the time to understand all the details because I want to focus my energy on things that are relevant to me, but it’s important to understand that there’s a concept of a credit union.
You have Fannie Mae and Freddie Mac. These are quasi-agency type or implied government-backed entities. As far as we’re concerned for the purpose of a borrower, what you have to know is that there are different sources and we’re going to call them banks. That’s a big reason why someone comes to a mortgage broker. When someone calls me up, money is green and they say, “I’m buying a building. I need to take out a loan of $750,000 for this building, for the story I need. Who is the best person to lend me the money?” At the end of the day, if I found them someone at 4% to 3.5%, they don’t care what type of entity it is. If the business terms are great, they’re going to go with it.
I happen to know nuance-wise that if a client is looking for a certain type of a perk, they want the ability to come back for a second mortgage, they want flexibility this way, they don’t care about this, they want more dollars, depending on those nuances, I would know how to narrow it down to which type of bank to go to. If you’re buying a building, if you’re getting the loan amount and you’re looking for the business terms, for the most part, you don’t care about where the money came from or what the source of money is. It’s like the joke, “If you borrow $1 million from the bank and you can’t pay them back, you’re in trouble. If you borrow $100 million from a bank and you can’t pay them back, they’re in trouble.” The bank is lending you money in commercial real estate and millions of dollars as time goes on. They have to be concerned. Once you close, they have to be concerned you’re going to pay them back. Once you get the money, if the terms are there, you’re fine with it.The most successful people take the time and energy to fully understand how banking and financials work. Click To Tweet
The next type of lender is a bridge lender. Sometimes they call them private lenders or hard money lenders. We’re going to go toward bridge lenders. I know that certain things are changing. You have Apple coming off the credit card. You have Amazon and Uber now coming out off credit cards. They talk about Facebook wants to open up banking. We might have different terminologies and funds and debt funds, but all of those things and entities are going to fall into one of the two categories I’m mixing and matching. We might not have banks. I personally believe we’re going to have banks as we have them now with different type of entities.
I always say, “What would happen if Apple told you, ‘From now on, you deposit your paycheck directly into your Apple account. We will give you 5% of Apple products for free every single year. If you have $100,000 in your Apple account, we’ll give you $5,000.’” Banks are giving 2% or 1%. Tons of people will keep the money in Apple. If the banks don’t have money, they can’t operate. The world is changing. As far as you’re concerned, you care about the business terms. How much money do you want to borrow? Who’s going to give it to you and at what terms? Some of these entities have regulation and some don’t have regulation. That’s how we move forward.
How does a typical bank work? They are on the business of renting money. They take money from depositors, from me and you because we all have a bank account. They pay us somewhere between 0% to 2%. They take that money and lend out that money at an interest rate of 4% to 6% and they keep the profit. It’s about 4% or 2% profit. It’s usually a 2% spread. They’re lending money at 2% or 4%, roughly that’s what the range is. The target is a little more but usually it’s about 2%. If you think about it, “Why are we allowing the banks to take our money and make that spread? Why don’t we lend the money ourselves?” The answer is because the banks are federally insured. It’s called FDIC insurance where they insure the depositor’s money, that if the bank makes a mistake and goes bankrupt, there are restrictions but for the most part, if you have money in an account, they’re going to give you back your money. Because of that, you’re not letting a bank make money on your money. It’s the other way around.
This bank created the vehicle to insure your money. As long as it’s with them, they will give it back to you with interest. You don’t care what they do with the money. That’s ultimately how bank works. A bank is in the renting business. It’s important that you understand. I had a client that had a deal of $21 million loan with a bank. At that time, it was the bank’s biggest loan on the books. He was making late payments every month. They’re charging him penalties. The bank was getting very frustrated. The guy tells me, “Why does the bank care? The building is worth $50 million to $60 million. I’m in a contract to sell it. I’m going to sell it soon and pay them up. What do they care if there’s a loan of $20 million? I’m never letting them foreclose. I’m going to sell it to someone for more than $20 million. They’re not taking a loss. They should be happy. They’re collecting interest and penalties. Why don’t they back off?”
What the guy doesn’t understand that I had to explain to him is that a bank is regulated because they have this FDIC insurance. The FDIC regulates and monitor them and say, “You better do the proper thing with your money. You better be conservative.” They don’t look if it’s a low leverage deal. You have penalties, big deal. They look simply at, “What are the biggest loans in your books? Are they performing? The guy has late payments. That’s a problem.” If they have to flag that as a late payment and the bank now has to put away reserves against this loan and other loans, they start losing money. Your penalty doesn’t cover their problems. More importantly, banks don’t want to be on a list with a demerit that they’re doing something wrong.
The point to understand is when you’re going out to borrow money, you could be taking a risk. You’re buying a deal for $1 million like a bank told me, “The clients can buy a building for $1 million. If he makes a mistake, my lousy 4% interest rate, I lost money. If the guy bought it right and he turns into a $2 million deal or $1.5 million deal. He’s going to refinance and go to another bank. I don’t want to take any risk.”
That’s what you have to understand. When you go into a bank, no risk. A bank wants to know, “I’m lending your money, make sure I’m having no risk.” That’s the mindset. A bank wants no risk. If you could show a bank how they’re going to be able to make a loan to you at no risk, they’ll stretch by showing them no risk. There’s an old banker when I first came into the business. He’s an old man. He ran a bank and he took me under his wing. He said, “Let me teach you something. I’ll make a loan any day of the week.” This is before there was a lot more bank regulation but he had a board. He said, “If you could show me that if there’s a foreclosure or we have to sell this building in a fire sale, under the hammer of the judge that I will be able to get my money back, I’d do anything you want.”
I learned when I had a deal that there wasn’t enough cashflow and other banks were nervous to lend more. Let’s use the same example, a $1 million building, not fully rented. Every other bank would say, “I know it’s worth $1 million. I should lend you 75% but the cashflow only supports $650,000.” I knew I could come to this banker. His name was Jerry Dansker. I could tell him, “Jerry, we’re doing this loan. It’s worth $1 million. Can you lend me $750,000?” He was totally fine doing it. He says, “The market at that time is 4%, pay me a little higher rate, 4.5%.” He thought he was doing the greatest deal in the world, which he was. He secured $750,000. He doesn’t have to give away the house and only get 4%. He got a little bit higher. He gets 4.5% and it worked for him.
He taught me a lot of different things about real estate. Once I’m on the topic with him, he told me that what he learned over the years is when somebody buys a building, they normally don’t go into foreclosure or have issues in the first two years. When they buy a deal, they put away enough money for reserves. They have everything planned out. As they start running the building, suddenly they’re having issues like a tenant has a problem with a leak. Instead of having to write a check, they typically make a deal with the tenant, “You have a leak in the ceiling? How much do you think it will cost you to fix the leak?” The tenant will say, “$500.” They go, “You know something, take $500 off the rent next month and sign a paper that I’m not responsible for the leak anymore.” The tenant then would patch it up to $200 and keep the extra $300. Slowly over time the building starts deteriorating. That happens at year 2 or 3. I remember what he used to do when he used to stretch the dollars. He would sometimes go to 80%. He’d say, “I’m not letting you have 30 years to pay it off. I’m going to give you a loan for three years. You have to pay it back at a rate of 15% a year amortization.” It’s very quick.
What would happen is the person would have enough money to buy the building because they only have to come up with $200,000 instead of $250,000. He gave a loan of $800,000 in the million versus $750,000 in the million, but the payments were choking. The person has to pay a lot every month because the amortization was very tight. The person would stop working the building and fix it up. A year later, he built up some rents and things are in order. He’d refinance at another bank and everyone was happy. This is showing you the perspective of how banks think in different structures over time.
Banks have to protect themselves. How does it work? What are the steps in the process? A bank has a minimum debt service coverage ratio or DSCR and a maximum loan to value. They take two approaches at the same time. One approach is that this building has to be worth enough money that 75%, assuming that’s their number, they’re protected. They’re not going more than 75% of the value. It’s a $1 million purchase, 75% of $1 million is $750,000, that works. On the other side of the coin, they say they want to make sure that he has enough money, that in addition to paying the mortgage payment, he has a cushion of about 20% to 25%. That’s called a 1.25 debt service coverage ratio. You can now afford to have a rainy day. If there’s a buffer, you can still afford to make the payments. The bank does a two-prong stress test, one on value and one on payment.
I want to digress the same exact concept that happens on your home. When you bought a home and you took out a mortgage, the loan to value is the same wherever you go. They also did another test. They did a test to see what is your ratio of income to expenses. If the ratio wasn’t high enough, they wouldn’t lend you money. That’s why when people get a pre-approval on a home, they go to the bank and show them their income. The bank says, “Based on your income, as long as the appraisal works, we will lend you up to $800,000.” You could buy a house up to a price that $800,000 would be the mortgage.
These two steps are the protective measure. They typically only lend on stable cashflowing income producing properties. The reason why is because they want to make sure there’s less likely going to be a problem. More importantly, if one of their protective measures is if there’s enough cashflow, the building itself should support itself. They have to have a building that has this cashflow. Here’s a key piece of the puzzle. Remember, they have no interest in owning the property ever. They want to get paid back every month, on time and at maturity. Once you understand this, you’re never going to go to a bank and say, “Mr. banker, what do you care? That building is worth $1 million, all I want is $200,000.”
If you can show them, you’re going to make the payments, they don’t want to foreclose. People think, “The bank is lending me because they want to take over the building.” It’s not true. They have no interest in taking the building. They’re in the business of making loans, getting paid back, keeping the profit and moving on with life. What do they do to protect this? They take time to do underwriting. They take time to analyze the deal. They take time to do research about the borrower to understand, “Is this building worth $1 million? Does this building have enough cashflow to support the loan for the loan that you’re looking for?”
What are the risks to lending? I want to stress that even though when a bank does a loan, they have first position. The biggest perk to remember is that when a bank does a loan, they’re the first position on a loan, which means if something goes wrong, and the building has to get sold. It was a $1 million building, the bank lent $750,000 and the guy stops making payments. They sell the building for $800,000. The bank gets its $750,000 and plus whatever fees and interest they wrote. If there’s money still left over, the client gets it. The bank is first position. It seems like I don’t have a risk as long as the value doesn’t go down. To understand that a little bit, what are the trigger points that they have to be concerned about? Forget about regulation, it’s simple business sense.
Number one, they have to keep a buffer. What happens if the borrower can’t pay for some unforeseen issue that they never thought about? The market changes and market conditions change. There’s an environmental issue on the property, which means that they find out that something went wrong. There was an environmental leak somewhere. There’s a problem. You didn’t prepare for it. You didn’t do a research in advance. Some banks are going to make them do environmental report before they start the deal to make sure nothing goes wrong. What happens is the market changes? We’re experiencing a very big wave between Uber and Amazon. People used to decide the rents based in the city. “It’s near a train station, because it’s how I get to work, on the train.” If someone takes an Uber to work, or they don’t mind, taking an Uber to the train. Every morning they add $5 to the train, because they’ll live a little bit further away from the train stop. Rents are cheaper, it’s quieter. Uber allowed that. If you didn’t have Uber, how’s the person getting to the train? It’s too expensive. They can’t afford to have a car and drive it and park it for the day.When it comes to commercial properties, there's no government protection. Click To Tweet
Uber changed also how you go shopping. Uber change the way you have to live together with Amazon. You have Uber Eats. You make a different decision in this market condition. Market conditions used to have one meaning which says, “The market changed. Rents are going up here. The neighborhood is changing around.” Now technology is playing a role in these market conditions. When they’re making a loan, they have to say, “Do we believe they’ll always maintain the value of $1 million? Do we believe they’ll have enough cashflow always?”
The second risk is if something does go wrong, are you prepared to go through the foreclosure process? Are you prepared for the time, and the cost to work through issues and hopefully avoid the foreclosure but still work through issues on time? Go through the whole foreclosure until the end, and take the process all the way to the end and believe that when it’s said and done, there’s been a lot of fighting and neglect throughout the fight. Is the building even going to be worth more than the $750,000? Maybe now it’s worth $850,000 or it’s like a year of fighting, when the owner couldn’t care less and the tenants know there’s a fight, and they’re not fixing up the building? The building can go down to $700,000 and then what about the possibility of fraud? You thought this person is buying a building for $1 million. In reality, the person bought the building off a flip. Someone went and bought it for $800,000 and he bought it off the person for $1 million. When you made a loan, you pretty much made almost 100% of what it’s worth.
These are concerns and risks. There’s a whole slew of risks that are obvious to each of us. You have to take into effect these few points, that if there’s a problem, can you afford to work it through and get to the end of the finish line? If they foreclose, you can get it back. If the guy lied to you in fraud, you have to consider these points. Things are going to change. It’s the obvious, but these are the things that are under the hood that might come to fruition. What are the two most important things a bank focuses on in order to protect themselves? Let me sum it up very clear. Number one, if they’re lending you the money, they want to make sure they recoup the loan balance in the event of a foreclosure.
The bottom line is if everything goes to crap, everything blows up, and it’s not worth $1 million anymore, that’s a foreclose and not to sell it, will they recoup the $750,000? How do they protect themselves? Number one is they put a buffer on it and say, “If there’s a fight, the value might drop by 10%, 20%, 25%.” Therefore, most lenders say, “We’re comfortable. 75% even if there’s a problem, we’re protected.” Number two, banks would love to get a personal guarantee. It’s called recourse. They’d like to get the borrower to guarantee that in the event that they foreclose, they sell the property and they can’t recoup all their balance, they can go up to the borrower for the difference. They still lost $50,000 because they only sold it for $700,000. They get their money back.
It’s interesting thing to note that in several states, you don’t have wait for the foreclosure to go through. The bank can say, “I don’t want to go fight you. The bottom line is you’re in default and can’t pay me up.” Other states say, “No, you’re in default, you have to foreclose. If there’s a loss after the foreclosure then you could come back for the money.” There are different laws at different times. The second most important point that a bank focus on and what they use to protect themselves is the monthly payments are made. How do they make sure the monthly payments are made? They can’t force someone, so they check out, is the person honest?
In their underwriting, from the profit or the net operating income of the building, is there enough money in there to cover the debt service coverage ratio? If they want 125% available from the mortgage payment, which means if the mortgage payment’s $100,000, and they want a debt service coverage ratio of 25%, they could get that 25%. If there’s $100,000, 25% is $25,000. In total, they want 125% available NOI. If the building had $125,000 worth of NOI, they will allow the client to pay $100,000 worth of mortgage payments, because he still has 25% leftover. If the loan would require a payment of $106,000, then you’re going to run into a situation where the bank’s going to say. “I’m sorry, I can’t lend you that much money because you don’t have enough buffer, you only have $125,000 NOI. You need $132,500.
These become very heavy discussions that go back and forth to make sure. We spent a fortune of money upgrading our calculators on the app to come with a feature called eCalc. You’ll be able to see how it ties in from your purchase. How much money you putting down to your mortgage payments, what the debt service works and how much you could borrow if this and if that and see everything coming all together. Now we now we got a little bit of the background. Banks are ready to lend. What are the typical terms, amortization and prepayment penalties?
The typical term and rates are fixed for 5, 7 or 10 years. This is a very important thing to understand. When you are buying a home, the lingo that a bank talks to you in is, “You want a 30-year mortgage.” It’s the most popular mortgage. The second-most popular is a fifteen-year mortgage. I would say 98% of all mortgages are either a 30-year fixed or fifteen-year fixed. Banks, if you understand how we said they’re making money, banks are taking your deposits, paying you 2%, turning around and lending it out at 4%. They’re keeping the spread, the difference. Each of us have the ability to walk into a bank and take the money out. How does the bank give a 30-year mortgage?
That’s where Fannie Mae and Freddie Mac come in, a quasi-backed by the government. They are set up to ensure that there’s liquidity in this 30-year fixed rates because the government wants to protect the layman. The layman could be a doctor, a lawyer, a carpenter or garbage collector. It doesn’t make a difference. The government wants to tell a person, “You’re buying a house, you don’t get the financing. You know one thing, you bought a house, you need the same fixed payment for 30 years. No problem, we’ll protect you.”
When it comes to a commercial building, there’s no protection there. It’s the opposite. The government’s looking to protect the banks from a borrower who is not going to be strong, who’s playing games, and dishonest. That borrower could borrow millions of dollars, do fraud and the bank can be stuck holding the bag and lose money. There’s the FDIC insurance where they have to come in and bail out all the depositors. The way it works typically by commercial real estate, it works that a bank would say, “I will lend you and make the payment over 30 years in space, however, I’m only going to commit to be an adjustable rate mortgage. I’m only going to commit to stay with you for 5, 7 or 10 years. I’ll take the risk to lend you the money for five years and keep the rate the same for five years or a little bit higher rate, we’ll stay for seven.” No bank will stay more than ten years. On a typical deal, the overwhelming majority is a 30-year amortization, where a bank has a 5, 7 or 10 years. They’ll fix the rate and that’s the term.
The lingo in the business, the eCalc on the Eastern Union app is an amazing calculator. It will show you what is the term? Seven years. What is your rate? This is the rate. What is the amortization? It’ll show you all the different payments and what the balance would be. Because there’s a few extra components you need for commercial loan first when you’re doing loan in your home. Typically, a bank will lend 5, 7 to 10 years. What is the amortization typically? Thirty-year amortization. A very popular thing came in of late, which is called interest-only. Many banks, lenders, institutions, would lend you that for the first 1, 2 or 3 years depending on the deal. There are exceptions for longer, they would say, “We’ll do interest-only.” Which means if you’re borrowing $750,000, using that same example, at a rate of 4%, your payments will be $30,000. Pay the 4%, don’t pay anything down. Starting in the year 2 or year 3, then pay it off as if there’s a 30-year amortization. The payments will be higher because not only are you paying the interest of the bank, but you have to pay down part of the principal so that the loan will be paid off when all is said and done.
In a deal now, going back to the example I was telling you before where a bank says, “I’ll stretch on the dollars,” let’s reverse a little bit. A bank would tell a client, “You’re buying a building? You have a lot of expenses in the beginning. We’ll make it easier for you for the first year, before you build up your rent, just pay me my interest. What I have to make. Year two, you pay the difference of extra money to pay down the loan.” Now we spoke about the term and the interest rate is with the term. Let me talk to you about the prepayment penalty. When you buy a home, there’s no penalty by law. Thirty-year mortgage, you can pay it off whenever you want. On a commercial real estate deal, the bank is turning to you and saying, “I have to hedge my money.” I know myself, my money that’s in the bank, I have the right to walk out any moment. Some money in a six-month CD or a year CD, but I don’t have a relationship I commit to the bank to keep the money long term.
The bank is taking a big risk by lending a five-year loan with fixed rates when at any moment, the money could be taken out to another bank. Don’t they have averages, ratios and hedging? Yeah, but the bank comes back and says, “I’ll lend you the money but if you want to pay me back early, you’re going to have to pay me a penalty.” Typically, the most common penalty is a sliding scale. It’s going to be a penalty where the bank is going to say that as long as you ask me to stick around with you, you’re going to have to pay me a penalty that’s going to start up as high as 5%, the most common one, and then we’ll go down as time goes on. On a five-year loan, it will typically be 5% on year one, then 4%, 3%, 2%, 1%. Which means if at the end of the first year, the guy goes, “I committed for five years, but I decide I want to pay you up, the balance is still let’s say, $750,000. The penalty is going to be $750,000 plus 5%. It was in the second year, it’s the balance plus 4%. Balance plus 3%, 2% and 1%. If it was a seven-year loan, the bank will double up the first few years. It will be 5%, 5%, 4%, 4%, 3%, 2%, 1%. If it’s a ten-year loan, it will be 5%, 5%, 4%, 4%, 3%, 3%, 2%, 2%, 1%, 1%, that’s the lingo.
The reason why they’re doing this is because the bank is committing to stay long term. They probably spent money to hedge themselves. Now you want to be able to leave. You can leave if you go ahead and hedge yourself on the sliding scale schedule. Let me talk about two other penalties on the extreme. On the opposite end of it. If you come to bank and say, “Don’t lock the rates, give me a floater, prime or whatever it is. Don’t lock in the rate. If your rate goes up, Mr. Bank, raise my rate. If your rate goes down, lower my rate.” The bank says, “No problem.” If that’s the case, I don’t need to prepayment penalty from you because I’m not hedging against anything.
However, I have some costs, I did a loan for you. I want a fee, pay me a 1% fee and that’s it. On a floating rate deal, the penalty is going to be in the 1%. On a fixed rate deal, it’s going to be a sliding scale from 5%, 4%, 3%, 2% and 1%. There’s another penalty, which makes much more sense logically, that’s called the yield to maintenance. Another word is defeasance. It’s both roughly the same and on the Eastern app, we calculate the prepayment penalties. It’s roughly the same. The basic gist of it is telling the bank, “You lent me money at 4%. I want to pay back early. If you wanted to lend out the money in effect or do something with the money.” You bought treasury bills, let’s say. You don’t want to lend money anymore. You take the money wanted to be safe, you buy treasury bills. The treasury bills are paying 2%, you’re losing out 2% a year. “If I’m coming back to pay you back two years left, using 2% a year? I should pay you a 4% penalty in order to maintain the yield that you had.” “You’re paying 4%? Let me go down and pay the difference.”
However, what happens if interest rates go up? The bank could take your money and buy treasury bills for the remaining two-year treasury bills and they could earn 4.5%. Why should you pay the bank any penalty? You committed to make sure the bank will earn at least 4% each year for the next five years. If you have a way to earn 5% or 6% with the money now, then you shouldn’t have to pay anything. The slight difference in defeasance is, if it works out the way we described it, it’s a mechanism that will allow you to make money on the loan. You tell the bank, “We have a deal going. I’m supposed to pay you 4%. If I’m paying you back early and now you’re going to take 5%, I should keep that difference.” In effect, that’s what happens. On yield maintenance, if it goes up, the bank says, “Pay me 1% penalty.” If it goes down, “Make sure I maintain my yield.”The banks sends their terms to you through their Letter of Intent. Click To Tweet
An interesting thing to note, this is a little bit on a deeper level. For those of you that are more sophisticated and appreciate math, the ten-year treasury bill is more expensive than the one-year treasury bill and the two-year treasury bill or the equivalent of a two-year treasury bill. The reason is obviously because people think overtime rates will go up. You’re taking a loan now, the ten-year T-bills, let’s say is 1.6%. If you want to say, “I think rates are going to go up. I’m not so nervous when I come to prepay later on. I’ll have to pay the difference of what went up and down.” You have to remember a very important thing, when you come to prepay eight years later, you’re prepaying based on a two-year T-bill is or what the old ten years trading for two years left. It’s a technical thing to go off on a tangent a little bit.
You have to realize this is on a very deep level. Day one, the ten-year T-bill was 1.6%. If now the two-year T-bill is at 1.2%. You say, “I think rates are going up.” You’re right, but if there are two years left, and the 1.2% goes up to 1.5%, the bank’s losing money. You have to realize that the difference of the T-bills is based on the remaining years when you come to prepay it. Comparing apples to apples, you have to say where was the two year when I started and where’s the two year when I go, to see that the rates will go up two years from there.
I’ll go into the most common indexes. When a bank lends you money, a bank can give you a rate one of two ways. They give us and say, “My rate is 4%, 5%, 3%, 7%, 10-year money, 5-year money, 7-year money.” They could also say, “I don’t want to tell you my rates. Let’s go a little more sophisticated. Whatever I could borrow money at, I’m going to charge you a profit margin for the difference.” Let’s say for argument’s sake, the bank says, “My rate is not fixed. Behind the scenes, I’m going to fully disclose it. I’m going to charge you a rate of 2% above my cost.” It’s very important before I explain it, that you all understand that when they tell you 2% above the cost, the bank before closing will go out there. If they do it over the ten-year treasury bill, they will secure treasuries, buy treasuries, add the price difference, and then you’re going to pay them the coupon, the interest rate. They’re going to, in effect, have to pay off the treasury and they keep the difference.
The most common indexes, if you look on the Eastern App, we’ll have all the rates. Prime that’s set by the feds. What is prime? Now, prime is 4.75%. Every 30 days, it changes. Don’t take the risk of locking it, there’s a 1.67%. Ten-year T-bill? Now it’s 1.56%. If a bank would say your spread is 200 over, if you are closing now and they are locking the rate, your rate would be ten years fixed for 3.56%. In the business, when someone thinks that interest rates are on its way down, a couple of months ago, the ten-year T-bill table was close to 2%. It was in the 1.70% and 1.80%. Someone could have bought a building, used the Eastern App as soon as getting an interest rate of 3.8% and all of a sudden, didn’t close the loan, rates dropped. Now he has the opportunity to rate lock at a lower rate. He wins, same token, going reverse.
Some people like the fact that’s priced this way, some people don’t. It comes out cheaper typically, to get it done this way because if I came to you and you have a contractor to do work on your house, and the guy says, “You want me to give you one price? What happens if I make a mistake and the pipe burst? I have to fix this.” You tell the guy, “I don’t care, give me one number.” He’s going to end up building in excess. A job should be $80,000, he’ll charge you $90,000 because he wants to be protected. Could it come out that you lost out $10,000 or no? Something goes wrong and it ends up costing him $90,000. He doesn’t make any money. It’s the same thing with a bank. Sometimes a bank says, “My rates can be 4%. What I do behind the scenes is none of your business.” The best ways for bank also is to say, “I don’t want to tell you my rate. The day I have to lock up your rate, that’s the day I’m going to go into the deal.”
To put this in perspective, that same banker showed me and he was the one who told me how banking works. It’s much more sophisticated now but he would go, “You want to borrow money from the bank for five-year money? I’ll give you a five-year loan at 4%.” He’d go into the internet, change five-year CD 2%, flood in the $750,000, shut the window and lend it out at 4%. He’d say, “If I wanted to prepay those people early, I have a penalty to them.” He matched the penalty to match it. He’s literally scientific to that level. There’s something called swaps. It’s a blend of a floating rate where people think the ten year is going to average. It’s a little bit complicated, but it gives you an indication of a swap rate, which where people think that ten year is going to average over the next ten years, which is interesting. Even though the ten-year T-bill is low at 1.56%, the bottom line is that the Smart Money thinks that interest rates are going to be dropping over the next ten years. When you’re going to look back, the average is going to be being 1.51%. Sometimes it’s the same. Sometimes the swap is higher than the ten-year T-bill and sometimes it’s lower than the ten-year T-bill.
The next few points, I’m going to show you an amortization graph to explain how the amortization rates work behind the scenes. What’s happening is when you’re doing a loan, when you go into a mortgage calculator, what is the mortgage calculator doing? It’s converting your payment to a constant which means as follows. I take out a loan for $1 million. It’s got a $750,000 loan. What should happen is if the interest rate is 4% and is divided over 30 years, you should pay to the bank 4% of $750,000, which is $30,000 plus 30-year payment, 1/30 is $25,000. Pay the bank this year the $30,000 plus $25,000 which is $55,000. Year two, you should pay 4% of the $725,000 balance, you should pay the bank 4% of $725,000. Let’s say instead of $30,000, it’s $29,000 in the bank plus $25,000 brings you up to $54,000. If you think about it, $55,000, $540,000 slowly but surely over time, 30 years, your balance is zero.
When you buy a piece of real estate, you don’t think your expenses are going down, it’s going up. Your income is also going up, you want it the other way. Tell the bank, “I want to pay you less going in and every year, I could afford to pay you more or average it out.” Someone figured out a mathematical calculation, which equates amortization. It divides up this loan over these 30 years and gives you one constant payment. That constant payment is that if you take 4% of the interest rate and you find the 30-year line, and it meets at 5.73%, which meets and tells you that if you want to borrow money, $750,000 at 4% rate and you type into mortgage calculator 4% interest rate and 30 amortizations. It’s calculating what is the constant? What is that one number if you paid it consistently every single month for 30 years, by the time 30 years are up, you will have no more mortgage balance, your payments will be zero and that’s the constant.
I met a fascinating guy who was able to be on the top of his head, “How much are you borrowing?” In a simple calculation, he got you the math. This guy memorized a few constants. If most people are taking now 5, 7, 10-year money and the range of rates is between 3% and 4%, he doesn’t memorize what the constant is for 3.5%. The constant is for the 4% and he goes, “The loan amount times that number,” and that was the payments you’re going for.
Everyone has this preconceived mistake or notion that, “I bought the building. I pay most of my interest in the beginning.” You don’t pay most of your interest in the beginning. In the beginning of your loan term, most of your payment goes towards interest. A guy says, “I have five years left to my loan. I don’t want to refinance even though I’m paying 9%.” “You’re overpaying.” “No, I paid my interest already.” “No, you didn’t.” This is how it works. On a $750,000 loan, at a 4% interest rate, 30-year amortization, your yearly payment is $42,967. That’s what it works after using the constant.
It comes out that your payment works out to, every single month, $3,580. Month one, $2,500 of that is interest, $1,080 of it is principal. Of the $3,500, most of the payment went towards interest. At the end of the first month, your balance is no longer $750,000. It’s now $748,919. Come month two, you make the same payment of $3,580, you don’t owe the bank $2,500 in interest. You owe the bank $2,496 in interest. The bank, instead of paying $1,080 down to the loan, it pays $1,084 down to the loan and change. Your balance in $747,835 so on and so forth. By the time the 30 years are up, the pendulum swings, your balance is zero. If you took a five-year loan on a 30-year amortization. At the end of the five years, your balance is $678,356. If you’re refinancing and you borrowed the same $750,000 again at no cost, you’ll be cashing out about $70,000. The difference of $750,000 down to $680,000. In a normal case, but this time hopefully your building is worth now $1.2 million. You’re borrowing $900,000 minus the balance, an extra $200,000. You have $200,000, you’re going to buy another building.
That’s why people in real estate keep buying, because they have a deal, five years later the value goes up and they keep refinancing it. They have no goal to pay it off. They take the building and keep making the payments, because they’d rather use the extra loan to buy new properties. That’s on the good days. The rest gets very detailed. If you want to understand each piece, I’ll break it off in a different episode, but for here, let’s go through what are the steps from here to close? Pretty much I told you how the bank thinks. The bank agrees to a term with you. They’re ready to move forward.
What happens once terms are agreed to? The bank has it into writing and they send it to you. It’s called a letter of intent. They put these terms out in the letter of intent. The client signed the letter of intent, which says, “Mr. Bank, I’m prepared to close with you and I’m going to give you the deposit. Go out, Mr. Bank or Larry The Lender. Go out, Larry. I agree in good faith to move forward.” The borrower, Brian, writes out a check to the bank to cover all their costs to do the due diligence, cover the costs to do the appraisal in environmental. Everything that has to happen, they cover all the costs so the bank could go ahead and move forward on the on the third-party reports. What does the bank need to do? They want to make sure the building is worth the money it is.
They need to do an underwriting of the building. They need to do an environmental report. Is there any environmental problem? They need to do an engineering report. Are there any physical to third parties to make sure that they’re covered across the board? In addition, they send them all the list of due diligence items. All the items at that the bank needs to determine, “Can you afford to go ahead and make the payments?” What are the main due diligence items the bank needs? A guy told me a line once, “Do you trust me?” I’m like, “Yeah, but like in the Army, it’s called trust and verify.” Number one is the tax returns on you and on the property to show that the income is there and the expenses that you’re telling the bank you could afford and in the deal, the setup, the income and expense statement is accurate.
Number two give me a real estate owned. Another word for real estate owned is the acronym it goes by REO, “Show me REOs. How comfortable are you that you know how to manage his property and you know what’s going on in this neighborhood? What else do you own?” The personal financial statements, PFS, to show how strong you are in case there’s a problem. In good faith, whether you signed the personal guarantee or you didn’t, what’s your ability to pay this up? The income and expense statement which you sent already to get this far, but they want it updated and certified. You’re going to sign off and say, “This is the income and expense on the property.” If there are tenants, I want to see copies of leases that will back up everything you did.
Historical profit and losses, P&Ls, “You tell me this year, your income is X and your expenses are Y. What was last year? What was the year before? Is it trending up, trending down? What’s going on?” The third-party reports, which are the appraisal, the environmental, engineering. The appraisal tells you the value. Environmental tells you if there’s any environmental issues around. An engineering report says, “What’s the structure this building? Is the building fine on the structure?” To do an environmental report is very expensive. People say, “I have a building in the city. There’s nothing negative going on around there. Why do you make me spend so much money?” The banks came up the standard where they broke it up to a phase one and phase two. They said, “You’re right, do a phase one environmental, go out and send an environmental expert to snoop around the property. See if he senses anything, if they sense nothing wrong, then great, that’s all you do. It’s much cheaper, but if he senses something wrong, then you’re going to have to get a full-blown report with a lot more testing.” Titling and survey. Title tells the bank that no to lien. This guy is buying it, no one else owns or owes money on this property.
The survey is telling you what you own. You look at the property, “Is this land in the back a part or not of this property?” A survey outlines exactly what is owed, what is being bought or what is being owned and used as collateral for this mortgage. What are the last few steps after the bank finishes our underwriting and due diligence? After due diligence they call back the borrower and they reconfirm the updated terms with the borrower. They’d say, “When we started, we thought the building is worth $1 million or so. We thought this. We thought that but we did some research. We’re a little bit nervous about this. We’re willing to go forward but we want to make these changes.” As soon as they come to making up their minds, the bank will then go back into committee and get it approved. On the final loan terms, if they agree, then the bank will issue commitment, which will not be just a letter of intent. We’ll talk in terms of a commitment, “We are going to lend you $750,000 at these terms, at these conditions and work the whole details through.” The client then will hire an attorney, the bank has an attorney, and the attorney will read through the legalese.
The client focuses on the business terms. The legalese is to ensure what happens if you can’t make the payments. All the what-ifs. I tell people, a closing document used to be two pages. Now, it’s a whole big stack. That’s because every time a bank or a borrower had a scenario where they got in trouble, that’s where these things ended up. I want to thank you. This was the longest episode we have. It’s on the banking, which makes sense it’s the longest because majority of the money comes from the banks. Thank you very much.