TERMS AND DEFINITIONS: DEBT TERMS

Video Transcript

 

Hey guys. Welcome to video number 5. Today we're going to be going through the debt terms and definitions. We're going to essentially teach you how to evaluate property debt. The key terms and definitions you want to be able to understand when you're looking at your own investments or if you're looking at a passive investment through syndication. And so, just really quickly - Warren Buffett is a guy that I think that a lot of investors look to for advice and his number 1 rule is: don't lose money.

 

And his second rule is: never forget rule number 1. And, in real estate, the way that you lose your principal most often is your debt is too aggressive. And when I say debt, I just mean your loan to the bank. Because, that's how essentially, a property gets taken from you. Is, you don't have the ability to pay your mortgage or your loan anymore and so the bank takes the property back and you lose all your original investment principal that you put into that particular property. And I think in 2007, 08 and 09, it was a great example of how that impacted a lot of just, normal homeowners, where they had too much debt on their house and when the values dropped, they were upside down. They couldn't pay their mortgage anymore and the bank foreclosed on them and took their property. So, I think this is something you really want to understand as you're evaluating real estate investment opportunities.

 

And, we'll walk you through a few of the key terms now. The first one we're going to look at is loan-to-value. Or you'll hear some people reference this as LTV which is obviously just loan-to-value. And, the definition is pretty straightforward. It's the mortgage that you take out on a property divided by the appraised value of that property. So let's walk through a quick example.

 

So if we have, let's say, a home that was appraised at $100,000 and you put down $10,000 of cash and the bank gives you the other $90,000. So your mortgage is going to be $90,000 and your appraised value, as we said here is $100,000. So our loan-to-value is 90% because 90% of the value of the home is consumed by a loan. And so, typically in commercial real estate, at least with the projects that Reliants buying. We're trying to buy at a loan-to-value of 70% or less.

 

Meaning, the banks giving us 70% of the purchase price and we're coming up with the other 30% syndicating that with our investors. So, I think this is one that you want to understand. I don't think there's a hard and fast rule. Typically, that 70% is a pretty conservative debt. Obviously, the lower that goes, the less risk that the bank can take that property because you have more equity in it.

 

The higher that number goes, the less equity you have as an investor. So, there's a greater risk that the property can be foreclosed on by the bank. So, let's go through another one. This one's pretty straightforward. This is the term. So, I just put an example here on our slide. A 5-year term with a 25-year amortization. All term means is the length that the bank is going to lend you the money for.

 

And what you want to understand is, in the example I have here, basically at year 5, there's going to be a big payment due. So that 5-year term, at the end of the year, the bank's going to expect you to pay that off. Now, most people are familiar with their residential mortgages and the terms on those are typically longer. 15 years, 20 years, 30 years. In commercial real estate, the terms are much shorter.

 

A long-term commercial real estate loan is typically 10 years, 7 - 10 years. Shorter loans - 3-5 years and what the risk is of that is, if you have a shorter-term loan - let's say 3 years and the market corrects during that term and the value of your property drops. Well year three, the bank is expecting you to pay them off and if you can't refinance the property and go get additional debt on it or can't come up with the cash out of your pocket, then the bank takes the property. And that's what happened in 2007, through nine, the last market correction where a lot of real estate operators were over-leveraged when their debt came due.

 

Their market values had dropped. So, they didn't have the ability to pay the bank and the bank came and took the property. So, you want to understand the term. A 25-year amortization just means that, even though it's a 5-year term, the payments we're making on a monthly basis are split. The total amount of the loan split over 25-years. So, something you want to understand - how the term is aligned with the business plan of the particular investment. Alright, so this is a little bit more complex, but not too bad. This is called the debt service coverage ratio. So, you'll see it as DSCR and this is a metric that the banks use and sometimes investors use to measure the ability of a property to pay its mortgage. So I'm going to give you a quick example.

 

We already learned what net operating income was in our last video. So that net operating income, let's assume we have $100,000 of net operating income and our total debt service, which just means, the annual amount of our mortgage payments added all up. So, in this property, let's say that it's $50,000. So, our debt service coverage. Just take the $100,000 divided by the $50,000. That's pretty easy. It's a two. So, our debt service coverage ratio is a 2. Now, that's really high. I gave you a pretty easy example.

 

That means the property has a really good opportunity to repay the debt. Most banks are going to require somewhere in the one and a quarter debt service coverage ratio. And it depends. It definitely depends on the asset class in the market that you're in. But most banks want to see that the property's going to kick off 100% of the mortgage, plus a little bit as  buffer to make sure that you can pay your mortgage and those are outlined in the terms of the loan.

 

And, you just want to understand that the property is going to hit certain debt service coverage ratios so that they can cover the mortgage. OK, so that's our last term in definitions, specifically for debt. I appreciate you guys watching today. In our next video, we're going to shift gears a little bit and give you some information on what syndications are, why they exist and where they may fit in your real estate investing goals. So, appreciate you listening and hope you have a good rest of the day.