When you’re looking to finance a deal, you need to have a couple things in place before you can start. You should have the deal together and be in communication with the property owners and sellers. That’s the best way you can get started jumping into real estate. Additionally, financing a deal is critical. There are lots of banks to choose from. The best place to start is working with some of the local banks in your area. Also, depending on the size of the deal, each size works differently and better for different banks. Keep reading to know how to finance a deal.
How To Finance A Deal? The First Thing To Do
The first thing you have to do before you can start financing your deal is you have to actually have a deal. You have to talk to a seller and you need to have a deal that you can put under contract. Once you have a deal under contract, then you’re going to start your due diligence. When you’re in the due diligence phase, it’s the best time to go out and finance the property.
When we’re financing deals, we’re working with a lot of banks, institutions and insurance companies. Depending on the deal size, let’s say a $100,000 – $3,000,000 deal, maybe you’ll want to use a local bank. That’s the typical size we give to the local banks. If you’re going to a $5,000,000 – $10,000,000 deal, you could use local banks or start looking into agencies or insurance companies to finance these deals.
Choosing a Lender
Depending on the size of the deal you’re trying to finance, you can select which type of lender you want to finance the deal with. Some banks are better at deals than others. For example, the smaller banks usually have lending limits to $10,000,0000 per deal. After that, sometimes you have to partner with other banks. It’s important you pick the right lender who can finance the deal. If somebody can’t finance a deal over $10,000,000 without a partner, it might be easier to find one bank that will do your $10 or $15 million deal, instead of looking for two banks that will work together.
The next piece is going over the term sheet. We want to show you how you can draft a term sheet so that you can share it with your bank. Then, they’ll have the exact terms you’re looking to finance your deal at. This will make it a lot quicker and faster working with your bank.
How To Finance A Deal: Term Sheet
I’m going to go over a term sheet we usually put together when we put a new deal in place. This really saves a tremendous amount of time. If I have all of the terms together in a sheet to share with the bank, then they know exactly what we’re looking for which makes it a lot easier. There are different categories to go on the term sheet. To start, you put an entity to be formed with, for example Matt Green, or your name. The entity to be formed is a new company that you’re going to set up. When you purchase a new property you want to set up a new entity. That way if somebody ever sues you or sues the property, then they’re going to sue that property and the entity instead of you personally. This will help limit your liability.
Let’s Talk About Loans
The next part of the term sheet is the loan. You want to outline what you’re looking for and the loan amount you want to achieve. This goes back to your underwriting. You have to make sure your underwriting is really tight, clean and put together. Once you have your underwriting set up, then you’re going to be able to figure out what that number is.
For example, I’ll share the numbers for the deal we put together at our office building. We asked the bank for a $2.6 million loan which is an 80% LTV (Loan-To-Value) based upon completion value. Basically what that means is we were looking for a construction loan where, once we put the money into the property, 80% of the future value is going to be $2.6 million. We’re able to turn around the project within three months. That’s what we were able to achieve with the bank even after the fact. Now that we’ve completed the project and everything is done, we achieved the specific number and everything worked out according to plan.
What’s Your Loan Amount?
Therefore, you have to figure out your loan amount. This goes back to your underwriting and what numbers you put together for the deal. Maybe you have a deal under contract, and you figure 80% of the acquisition price should go towards the loan amount. If you’re doing a construction loan, you can put in a complete budget. You should do a construction loan if you plan on doing renovations and improvements to the property. This will allow you to apply for a larger loan where you can have 80% of the proceeds of your acquisition price at closing.
You’ll get money in escrow that you’ll be able to draw upon as you complete renovations at your property. Therefore, depending on what type of loan you’re going for, this is an important category to fill in here. You need to fill in the purpose of the loan. For this project, it was to finance the project with a construction loan to complete improvements to our office building.
Next you have the terms. We were looking for a ten year term, 5 year fixed, a rate reset from the 6 to 10 year period with no prepayment penalty. What this means is we’d have the loan for 10 years, and it would renew at a new rate after 5 years and that rate would be fixed. Then after that it would reset to however the market is at that time. Then we’d be locked in for years 6-10.
What’s nice about the term is we have the commitment for a full 10 years to have the property financed, versus if you just did a 5 year term. After that 5 year term, you‘d have to refinance with the bank or you would have to start working with another bank to pay your original bank off. Afterward, you have your amortization for the construction projects. We typically do a 2 year interest only, which is amortized over 25 years thereafter.
This is what’s really great about these construction loans. You have interest only periods. Sometimes we get interest reserves too. We don’t have to pay any mortgage payments for the first two or three years of having the property under management. This is a huge benefit that really increases the cash flow of the property, since we don’t have to make any loan payments. If you can get a 2 year IO and interest reserve, that would be a huge benefit to your business. It would help to increase your cash flow and your return on investment would go up substantially because you wouldn’t have the extra payment every year.
Then you have your collateral. The banks are going to take a first lien mortgage on the project and an assignment of leases and rents on the project. This is pretty standard. Then, you’re going to have either a floating rate of prime during your interest-only period, or you could ask for a fixed rate of prime or a fixed rate of a number of basis points over the federal home loan bank. There’s different rates that banks tie basis points to, which is called their spread, to help figure out what interest rate you’re going to pay for the loan. That’s important to figure out and to try and achieve the best interest rate that you can so your cost of capital is as efficient as possible.
Which Type Of Loan To Choose When You Finance A Deal?
You have to figure out which loan you are looking for in order to move forward with your property. There’s non-recourse and recourse loans. A recourse loan is where you personally guarantee the property and the loan so if something goes bad on the loan, the bank can go after any other projects that you have. With a non-recourse loan the bank can only take the keys back to the property you have the loan for. They wouldn’t be able to go after you for anything else, but there’s different perks to each type of loan.
Usually we do a lot of recourse loans because we invest into a lot of projects we believe in. We can see these projects all the way through and how they’re going to be successful. With a non-recourse loan, it removes your contingent liabilities so you have less. Your signature is more valuable if you have non-recourse loans because it’s not tied up with guarantees on a lot of different projects. There are pros and cons as to each route, but either way they’re not big deal killers.
The next step is having your appraisal. We did an upon completion appraisal with an 80% LTV of that value, which was our construction loan. Basically it says the reports are going to be engaged immediately upon acceptance of the term sheet with a good faith deposit.
There’s some covenants you’ll typically find on some of the term sheets that banks provide. Some of them have debt service cover ratios. Usually the lowest number that a bank will go is 1.20, so that’s another thing to keep in mind. There’s some other conditions that banks typically put into their term sheet and commitment letter. Most times there’s conditions and due diligence items that are typical on transactions when dealing with multifamily real estate. Then there’s some documents for underwriting. Our banks are going to want a personal financial statement and a borrower of ownership and entity name. All of these things are going to have to be submitted to the bank so they can put all of the pieces and your organizational charts together.
Lastly, the borrower typically is responsible for closing costs associated with the loan, unless you can negotiate closing costs to be included in the closing. This is your term sheet, all the way, start to finish. This is going to give you a good head start on what to ask the bank for.
The big question we get all the time is what do we ask for, how do we ask a bank for the terms we want and what terms do I want to ask for when I’m applying for a loan. This is going to answer all those questions. It’s going to give your bank a good idea of what you’re looking for. It’s going to cut through all the back and forth of questions and things that your banks are going to be asking you because they’re all going to be on this term sheet. This is going to help you out tremendously, save you a lot of time and allow you to get deals from your bank a lot quicker without all the back and forth. Start putting your term sheet together and presenting it to your bank.
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