Understanding Leverage and Liquidity in Real Estate Investing

Episode Sumary

Today’s segment is about understanding leverage and liquidity in real estate investing. We want to focus on real estate financing. To frame this conversation, I’m talking about real estate assets, or investments, under five-million dollars. Once you get about five-million dollars then you’re competing in the professional class. With assets under five-million dollars, most of those real estate assets are purchased by local people in local markets.

Episode Transcript

John Wilhoit: [00:00:00] Hello and welcome to John Wilhoit On Real Estate. My name is John Wilhoit. Today I have Darsweil Rodgers of Cape Fear partners. He is a managing partner and executive coach and consultant. Hello.

Darsweil Rogers: [00:00:14] Hey man how are you.

John Wilhoit: [00:00:15] Mr. Rogers we have you on this program because you have extensive experience in radio and instead of me just talking into the wall it's so much more engaging having a professional such as yourself on this program. We've set it up so that you're interviewing me and hopefully extracting a little more qualitative and quantitative information out of me other than just my voice.

Darsweil Rogers: [00:00:39] I thank you for the opportunity and I hope to do a good job on interviewing you providing the listeners with the sort of information that they're going to consider valued.

John Wilhoit: [00:00:52] Mr. Rogers and I have known each other for many years as I shared he is with Cape Fear Partners. His email addresses DLRogers@CapeFearPartners.com. He is an executive coach and consultant and we've known each other much longer than 10 years.

[00:01:08] Today's segment is about understanding leverage and liquidity in real estate investing. We want to focus on real estate financing. To frame this conversation, I'm talking about real estate assets, or investments, under five-million dollars. Once you get about five-million dollars then you're competing in the professional class. With assets under five-million dollars, most of those real estate assets are purchased by local people in local markets. There are not a lot of people buying five different five-million-dollar buildings in Dallas, Chicago and Fayetteville. If they're buying five-million buildings they're probably buying them all within a 100 mile radius. That's the frame for today's discussion with respect to financing and liquidity. We're presuming they are smaller assets, under five-million dollars, and they're being purchased by people that reside close to where that asset is.

Darsweil Rogers: [00:02:08] John, with that is an offshoot. Let me just note that at your Web site John Wilhoit.com you can get information on home-ownership, property management and real estate investing. You've got such a wealth of knowledge and information. I don't want to miss the opportunity to tell folks if they haven't already been there to go to John Wilhoit.com.

[00:02:29] We want to start by understanding leverage and liquidity inreal estate investing. There's the question of leverage and liquidity almost being opposite sides of the coin, at least in my mind. When you're investing in real estate, you have the benefit of putting debt on it that you couldn't on some other sort of business. I want you to explain why that is. Because of the nature of real estate, meaning it's not liquid, you can't sell it easily. You really have to think about how much cash you have on hand. Let's start with the basic parts about leverage. Leverage means that you are borrowing money to purchase the property?

John Wilhoit: [00:03:19] One of the benefits of hard assets is that they are lendable. More than one institution will make a loan against a hard asset as you purchase the asset. It doesn't require all cash. There is leverage that can be obtained. There's different levels of leverage. There's high leverage. We used to be able to do 85 percent loan-to-value loans on a commercial asset in a local market. And even that today can occur if you are very high quality client of a local lending institution. But even then, the mortgage lender is going to want some form of cross collateral on other assets that you own to get to that level of leverage.

[00:03:59] Seventy-five percent of the purchase price, or of value, is a more common level of leverage today. And that's a real positive for a number of reasons. Number one is there will be fewer defaults, because there is more net cash flow (not NOI), because there's less leverage going into the deal.

[00:04:19] High leverage, even though it can work for some, it's generally something that you should stay away from because with high leverage comes high stress, high anxiety. And with that high stress and high anxiety that generally means if anything goes wrong you have to find more cash. If you already put all of your cash into the deal then where are you going to find that additional cash?

Darsweil Rogers: [00:04:43] Right. The thing about real estate, it's a concept, it's a buzz word that's been around for a long long time, which is the idea that in real estate you can use other people's money. Explain that, the basic unit. You said it a little bit, you called it a hard asset. Compared to other sorts of assets banker's will lend on real estate. Why does this translate into a good thing from an investor's point of view?

John Wilhoit: [00:05:16] Why does what translate? The leverage part?

Darsweil Rogers: [00:05:19] Yes the ability to in effect use other people's money from a lender’s point of view. Why does that translate into a good deal for investors?

John Wilhoit: [00:05:30] Think of a springboard and let's use a very simplistic example. Let's say it's a one-million-dollar asset that you have placed $100,000 into. There's very high leverage. But because there's very high leverage that means you're able to purchase that asset. You've taken only 10 percent of the value of the asset and bought the entire thing. That sounds like a really excellent thing to do, excepting, because there's such high leverage there will be a very high payment due on the loan. That mortgage loan, if it's not paid in a timely fashion, the property will not be yours for very long and that hundred thousand dollars that you placed into it will be for naught. It will disappear as the property disappears. Because if there's ever an event of extended negative cash flow that you as the owner can't cover, or can't find cash to cover, then your bank's only going to tolerate you for so long.

[00:06:30] Let's take that same asset and put down now $200,000. At $200,000 the payment on the mortgage is less and there's a higher probability of positive cash flow. Now I understand for folks that are listening in New York and Los Angeles, they're snickering, because you've got to have 40 percent cash down just to get to break-even, just to get to zero NOI (net operating income). But that's not the case everywhere and it's not the case every time. Different points of history you could do a 10 percent down loan and have a cash flow transaction.

[00:07:06] In the property type we're talking about now, and I shouldn't say type, property value, because, Darsweil, we can be talking about a five-million-dollar strip center or a $400,000 4-plex. We can be talking about a medical office building for $2.50 million that three doctors have bought. She owns two pieces and he owns one piece but the two of them together bought this two and a half million dollars property. It doesn't matter the property type. What we're talking about is the leverage on that property. Different types of assets will allow for different levels of financing but commercial real estate is commercial real estate- The rules are pretty straightforward. A 75 percent new first mortgage today is a commonality which means you need 25 percent cash down.

Darsweil Rogers: [00:07:58] And in terms of where you go for leverage today, where should a person go if they were a borrow, using the example, a million dollar piece of commercial property?

John Wilhoit: [00:08:12] If it's a local asset and you live in that community and you know the use, if you have an extended plan for the asset (a business plan), then your local bank is a good place to start. They know you. They know the market. They're likely to have a little bit more leniency in terms of the amount of leverage that they will allow. Not necessarily a lot, post-recession things have changed. That's a place to get a good barometer to let someone locally (your local banker) see the underlying structure of the deal let them see if it makes sense, etc.

[00:08:45] That's all well and good, and that's a good place to start, but mortgage bankers, particularly commercial mortgage bankers, they will have an array of lending options that will extend beyond the local bank. They can be competitive. Yes, they will charge a point or two. Maybe two points depending on the size of the loan. You have to balance that initial cost against the form and structure of the financing that you are obtaining. If you're going to go to, and I'll name names, Northmarq then call my buddy David Garfinkel  in St. Louis and he'll tell you about life companies. If you're going to go through MONY of New York ,then you know they have a different structure as a life company where they make loans but they only have underwriting standards for MONY. They're not going to give you competitive rates for other companies that do the same lending they do. Your commercial mortgage banker is a good place to start.

Darsweil Rogers: [00:09:44] Is there such a thing as too little leverage in real estate transaction?

John Wilhoit: [00:09:48] There is such a thing as too little. Yes there is.

Darsweil Rogers: [00:09:52] How does a person determine if they're being too conservative or don't have enough leverage?

John Wilhoit: [00:09:57] When you talk about too little leverage we have to bring family into this discussion because when people start paying all cash for a deal its usually for a reason other than financial, even if it's a small commercial deal.  Let's say that that's you and your sister own an  HVAC business and you've decided to buy the building that the business is in. If the value of the business is a million dollars and the value of the building is two hundred thousand dollars. Well, that family may decide to just go ahead and pay cash for the building because they want to.

[00:10:36] But if you're looking at a building strictly as an investment then once you get below 50 percent loan-to-value then you're probably negating some of the potential return that you can have on your money. That's not necessarily a plucked-from-air number but it's a barometer, it's kind of a point on the map to look at.

Darsweil Rogers: [00:10:56] So 50 percent. That was number?

John Wilhoit: [00:10:59] 50 percent. There's a number of reasons for that. One is, with respect to home-ownership, 30 percent of the homes in the United States are free and clear. So, there's nothing wrong with having a free and clear asset, particularly if it's your home. But if it's a commercial asset and you're putting more than 50 percent cash down then you're giving up the use of those funds. You are devoting that 50 percent all into a single asset. Before doing that, consider buying a second asset and utilizing 65 percent loan-to-value financing on the first asset and then taking that differential and putting those funds into a separate asset for the sake of diversity.

Darsweil Rogers: [00:11:42] I want to segue. I'm going to come back to the question of returns in a minute, but I do want to talk about liquidity because this is the balancing point around leverage, at least in my mind. Is there a rule of thumb as it relates to the amount of liquidity, cash available on hand, that an investor should have and what would it be?

John Wilhoit: [00:12:09] It's different for a stabilized asset than for a newly constructed or a highly leveraged asset. For a stabilized asset, if you have 5 percent of revenue cash on hand plus the reserve for replacement, you are golden. There's not a lot that can happen that you couldn’t take care of with that type of reserve.

Darsweil Rogers: [00:12:31] John, explain- what's a stabilized asset?

John Wilhoit: [00:12:31] A stabilize asset is one that has a history of operations, an asset that you can count on to do the same thing next year as it did last year. And the reason you know it can do the same thing next year as it did last year is because it did the same thing for the five years prior. So, you have a history of operations there. And with that history you can pretty much know what the stabilized going-forward numbers will be and that's what I call a good business; one that's an operating business, one that has a history, one that has forward looking financials that are solid, that are sound, you know what you're getting. With that form of an asset, presuming that leverage is in order. You still need a reserve for replacement and that reserve for replacement is likely going to be somewhere between 1.50  and 5 percent of revenue.

Darsweil Rogers: [00:13:29] I'm sorry a replacement of what?

John Wilhoit: [00:13:31] Reserve for replacement is set aside funds to address long-standing capital expenditures such as replacement of roofs, replacement of flooring, replacement of windows, to replace cracked concrete: things that wear out over time. It could be water heaters things that have a value or a useful life are more than X number of years. It's an accounting term and I can't tell you explicitly what they would call a capital need but something that has more than a 1 year lifespan.

Darsweil Rogers: [00:14:04] Yeah I'm going to say, probably beyond three.

John Wilhoit: [00:14:08] For certain things like water heaters they generally last five years. For roofs, although they can last 20 years and longer, you can bet that some of them are going bad in 12 years.  That's capital needs. Set aside reserves every year out of revenue- a certain percentage of revenue- that's basically an impound account, or a set aside account, for those events.

[00:14:37] Then there is a cash reserve. A cash reserve is for operating expenses that may be out of sorts. Maybe there is a spike in vacancy. You have to have a cash reserve for things such as that, for things that may happen seasonally or maybe a once in a lifetime event, but they're not necessarily a capital need.

Darsweil Rogers: [00:14:59] Let's just use a scenario here. You've got a property that has annual cash flow over $100,000 each year.

John Wilhoit: [00:15:08] Cash flow or revenue?

Darsweil Rogers: [00:15:10] Revenue. The property has revenue over $100,000 a year. Based upon your analysis your capital reserve should be what?

John Wilhoit: [00:15:20] Fifteen-hundred to five-thousand dollars annually.

Darsweil Rogers: [00:15:22] Okay. And then you've got annual occupancy that your hundred thousand dollars is based on. We have an occupancy number in order to determine where your liquidity should be, or your operating reserve.?

John Wilhoit: [00:15:38] That operating reserves, I'm suggesting that's a separate account aside from capital needs. Let me give an example. If it's a retail strip center and it's been 95 percent occupied for the last five years and then some event occurs where there's now 20 percent occupancy in that strip center , depending on where it is, that vacancy could be there for three months or thirteen months. That's where that cash reserve comes in; in case the remaining occupancy doesn't generate  cash flow to address PITI; principal, interest, taxes and insurance for the transaction. That's in a commercial deal.

[00:16:20] If we're using a multi-family example, let's say that you have 12-units and it's been running and humming along forever and a day, not a worry, not a problem in the world. And then you have two vacancies all of a sudden, which ok, vacancy is not uncommon. Then once you go into those units, because you weren't doing inspections annually, you find out that there is $10,000 in damages. And this is the first time you've learned of this - ten thousand dollars of damages in each unit. Well, some of your capital reserve can ally that. But you may not have $20,000 in your capital reserve. You may have to pull from another reserve just to get that work done and then put those units back on line as soon as possible.

Darsweil Rogers: [00:17:11] I think my key question is how do I figure out what that reserve should be?

John Wilhoit: [00:17:16] Liquidity should be a cash reserve of 10 percent of revenue. And that's a reasonable barometer. In your example, Darsweil, if you have a property that's generating $100,000 revenue annually then you keep 10 percent, or ten-thousand dollars in a cash reserve. Another way of saying that, would be to keep one month rent in cash reserves. So, that would be eight and a half percent of annual revenue.

Darsweil Rogers: [00:17:45] OK.

John Wilhoit: [00:17:46] That's really, for many people, that's just the working capital. You can't use the same money three times is what I'm really saying. You can't use the same money for your impound account, your capital expenditure reserve and for cash reserves. That's where a lot of people kind of go off the rails. People will say "we've got $10,000 sitting here, we can use it for any one of those items." Well, when you're talking about a small property, and here we're talking about transactions under five-million dollars, then you can't use that money three times. Once we get into larger properties, institutional commercial property owners, they're not trying to keep cash just hanging around. They have other uses for those funds. They're trying to get that yield out to thte third decimal so they're going to keep a little cash on hand as possible. But even in that circumstance their impound accounts is going to be fully funded.

Darsweil Rogers: [00:18:43] OK. What I'm hearing is that you may have as much as five percent or $5,000, on a $100,000 revenue stream, you might have as much as $5000 in the capital investment reserve.

John Wilhoit: [00:18:58] Which is reoccurring every year. You are putting an in additional 1.5 to 5 percent of revenue into that capital reserve every year.

Darsweil Rogers: [00:19:07] Every year. So, it's not a one-time thing and you hold it.

John Wilhoit: [00:19:09] One time every year.

Darsweil Rogers: [00:19:12] One time every year. So, that is going to be a growing account every year.

John Wilhoit: [00:19:17] It is.

Darsweil Rogers: [00:19:18] The cash reserve count, which we said, could be about 10 percent of revenue, that is a fixed number every year which doesn't grow is that correct.

John Wilhoit: [00:19:26] That's correct.

Darsweil Rogers: [00:19:27] OK. That's big. Is there a third reserve that we should be considering?

John Wilhoit: [00:19:32] Only if you're ultra conservative then you would increase the level of the capital expenditure reserve or the cash reserve. On smaller properties, there is nothing wrong with having more cash on hand and less, right?  But at some point it's going to cap out on the cash reserve. On the capital expenditure reserve, if there are needs pending or those coming at you rather fast that are not fully funded then you may want to increase the amount that you place in that reserve to make sure that you're ready for, or prepared for, those cap ex items as they come up.

John Wilhoit: [00:20:08] I have one question for you and I know you've got either in a book you've already written or coming forward… with all the reserves that you're holding, what would one consider to be a good return expectation for investors? Let's go back to the million -dollar multifamily property example. What would be a reasonable expectation in terms of what sort of returns the investors will get? And then where else would they go to learn more about that?

John Wilhoit: [00:20:36] Well that's a whole other segment!

Darsweil Rogers: [00:20:39] Well then, which book do you have or that is either out there or that you've planned  that is going to help investors understand that question?

John Wilhoit: [00:20:49] All right. I'll take a stab at it in 60 seconds or less. So how do I know what my yield should be on real estate. And my response to that is you cannot know until you know what your leverage level is. That's the paramount feature that will determine cash on cash on your invested dollar. There is a sliding scale; as leverage increases net operating income (NOI) decreases which means there's less cash flow.

[00:21:17] We talked about this earlier, this doesn't mean you want to do 100 percent cash-in either. Just because you can do that doesn't mean yyour yield will increase. It will actually decrease because of not using any leverage.

[00:21:31] There's a median in there somewhere between 50 and 75 percent leverage that will boost your yield on cash (presuming positive cash flow). But there's more than one yield on real estate. There is the income of course. There is appreciation, when it occurs. There is depreciation; that's the tax benefit that varies from one person to the next. And then there's the mortgage reduction.  Those are the four basic yields on real estate. And then I always add a fifth one which is asset management/property management. The function of the income on the four yields of real estate is highly determined by the professionalism and the expertise of your property manager, and with commercial assets, of your asset manager. Does that answer your question?

Darsweil Rogers: [00:22:21] It does, it gets me there. Thank you.

[00:22:23] Thanks so much for today Mr. Rogers. We've had an extensive conversation about understanding leverage and liquidity in real estate investing. My name is John Wilhoit. You can find me at John Wilhoit.com and here on this podcast John Wilhoit On Real Estate. You can reach out to Mr. Rogers at DLRogers@CapeFearPartners.com and also on his Web site, CapeFearPartners.com.

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