In the December Issue
- Understanding Debt Investing
- Understanding Equity Investing
- Examples of Good Investments for Each
Debt and Equity Investing
Our flagship fund, Tempo Opportunity Fund LLC (TOF), invests in both debt and equity investments, each with its own unique advantages. Within each investment, there are lots of opportunities to explore. Let’s first begin with debt investing.
Part 1: When is it a Good Time to be a Debt Investor?
- There’s a responsible borrower
- High yield note
- Downward trending interest rates
- Strong security and collateral
- Property has strong financials and good exit options
- Safe LTV (loan-to-value) ratio
A debt investor is the same thing as a lender or note holder. While you don’t share the upside in ownership of the property, you do minimize your downside. Normally, you can expect your return to be around 9-12% with debt investing.
Let’s dive deeper into these elements of debt investing.
What is a Safe Loan-to-Value (LTV) Ratio?
One of the most important considerations is having a safe LTV. So what is considered safe? In the current market, 70% is a good target.
In addition, it’s imperative to know your borrower, their track record, and their creditworthiness. If your borrower has a proven track record and the deal is solid, you can bump the LTV up as high as 80%.
What is a Good Rate?
A lot of the mortgages that are secured by Fannie Mae and Freddie Mac have rates around 4-5%, but these are below average.
In today’s market, most of the private mortgages that we do are in the 9-12% range. 8% is decent, as long as the LTV is solid and you’re investing in a safe loan.
Knowing the financial condition of the property is essential to debt investing. Let’s take a look at two different properties:
- A multi-family unit with high occupancy will have high cash flow and strong financials– a safe investment.
- A retail space that declines in occupants due to the economic environment of the retail space could result in a collapsing cash flow– a high risk investment.
Bottom line, if the collateral is a good property with a promising underlying value and the title is secure, then the investment is solid.
Example of Debt Investment from our Portfolio
When we funded a loan on a West Palm Beach property, it was fully stabilized with good cash flow. We were able to finance it with roughly ⅔ of the money necessary to purchase the property.
This was a bridge loan to an investor who couldn’t get bank financing because he was not a U.S. citizen. He needed the bridge loan to line up alternative financing. We made the loan a 12% rate and charged 3 points. That’s a safe investment because of the low LTV.
His plan was to invest about $100,000 in the project, which should result in about $250,000 increase in value upon renovation. Overall, the initial loan was 66.7% LTV, but upon completion, our LTV was going to be below 50% based on the after repair value. So this was a very safe loan with great risk adjusted return.
- Purchased for $600,000
- Loan: $400,000 at a 12% rate and 3 points
- Projected improvements $100,000
- Projected value increase $250,000
- LTV at start = 66.67%, LTV based on ARV < 50%
Part 2: Equity Investing
In simplest terms, equity investors are owners (as opposed to lenders). As an owner, you have the benefits and responsibilities of ownership, meaning you share the upside and downside, so your returns vary depending on property performance.
Two Basic Approaches to Equity Investing
You can buy a property yourself (solo), or you can participate as a partial owner with a group or partnership.
Buying the full property nets you all the benefits, but you also take on all the risks. This approach is when you have a slam-dunk opportunity, or if you cannot find any partners for a high-risk property.
Partial owners invest into a partnership with other people; this is known as equity syndication. When buying a partial property, you will receive fewer benefits, but in return the whole group shares the risks.
Equity Investing Responsibilities
As the owner of the property, or partial owner with partners, you have the benefits and responsibility of ownership. As real estate investors joke, you have to deal with “tenants and toilets,” but you also get benefits of depreciation (for tax purposes) and appreciation when it’s time to sell.
When is it a Good Time to be an Equity Investor?
Owners, of course, are subject to the fluctuation of the market. If the local market goes down, the equity value goes down. However, when the market goes up, the value of the investment is magnified.
The best times to invest are when…
- The market is appreciating
- You have access to affordable financing
- The rate, or expected rate, of appreciation is higher than the rate you’re paying on a mortgage
- The property has good and reliable management, strong cash flow, and the potential for value-add or other upside
Important Conditions of Equity Investment
You’ll want to ensure that you have good and reliable management when you’re investing outside your local market, investing in a turnkey property, or investing in a commercial property with many tenants.
You’ll also want to make sure your deal begins with strong cash flow. For example, you buy a commercial property for cash with a cap rate of 8%. You then borrow the money with a mortgage at 5%. Even if you borrow 60% of the money, the cash flow magnification from the leverage will send the cap rate into double digits.
Finally, try to invest in a project that has high value upside opportunities. A classic example of a value-add would be rehabbing a property to increase rent and “force” appreciation.
Example of Equity Investment Based on Fix-n-Refinance Strategy:
Let’s continue with the debt investment example from above. We are looking at the same West Palm Beach property bought for $600,000. Upon renovation and full stabilization at the higher rent level, the property was expected to generate $8,500 per month in rent-roll.
If the borrower refinances at a new loan of $600,000 at the conventional 5% 5/1 ARM loan, the value of the property would be around $850,000 at the time of refinancing.
If we subtract $1,500 in operating expenses and vacancy and repair reserves and $5,000 in PITI (Principal, Interest, Taxes, Insurance), we are left with a net cash flow of $2,000.
As a result, the net investment would be $160,000 (actual cash in the deal from the borrower after the refinancing). Our cash flow after debt service is $24,000 on a $160,000 capital investment, representing a 15% annual cash-on-cash return. In addition, the borrower would be left with a $90,000 built in equity by doing renovations.
It’s a strong investment with a 15% cash return, built in equity, and in a good area.
- Rent-roll on stabilization = $8,500/month
- All in Capital = $160,000
- Value at Refinancing = $850,000
- Refinancing: $600,000 at 5% 5/1 ARM loan on 30 year amortization
- Resulting cash flow:
- – NOI = $7,000/month
- – PITI = $5,000/month
- – Cashflow: $2,000/month
- – Cash on cash (after the refi): 15% (24K/160K)
- – Built in equity = $90,000
I hope this helped further your knowledge of both debt and equity financing and provided insight into which opportunities are right for you.
If you have any questions regarding debt and equity investments, or any others offered by TF Management Group LLC, please do not hesitate to contact us. We’d love to hear from you.
Thanks for reading,
CEO, TF Management Group LLC
TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.