Financing a Build-to-Rent Property - EP08

In this episode, we dive into the different strategies available to finance a new construction rental property. Whether you're looking for hard money or an A&D loan, our hosts break down the pros and cons and what to expect during the process.

"Just know that the construction loan is more of a 12-month loan, interest only. The rates can be about a point higher than a 30-year fixed conventional loan. The rates are a little bit higher, so you don't want to be on that loan forever. You want to be in it for 12 months, or as short as you can. Then when it's done. It's just a simple refinance into that 30-year fixed conventional loan..." - Chase Leavitt, B2R Show

Steve Olson: Welcome to the Build-to-Rent Podcast, the first-ever real estate show dedicated exclusively to helping investors go from raw dirt to a cash-flowing rental property. Whether you're looking to do a massive syndication, or a one-off rental property, the Build-to-Rent Podcast will help you get there.

Our hosts Steve Olson, Chase Leavitt, and Sherida Zenger bring together more than 4000 properties of experience as they break down how to find and finance projects, make the most of market and tax strategies, and maximize the returns of a build-to-rent portfolio. This is the Build-to-Rent Podcast.

This is Steve Olson here, along with Chase Leavitt and Sherida Zenger.

We got a good topic for you today about financing build-to-rent investment properties. Financing in the build for rent space is kind of the Wild West. We were at a convention a couple of weeks ago in Vegas, dedicated exclusively to build-to-rent. I went to that same convention, I think it was in 2013 or 2014. We were lucky to have 100 people there. And it was a very unknown space. All the financing that was available was like, "Yeah, we'll loan you money, we got capital!" But it was five points. 17% interest, 50% loan to value... it was terrible money. Like Russian mob rate money.

Financing build-to-rent has become a lot better since then because the build for rent community is a lot more well known and the asset class is more established.

The kind of financing that you're going to get depends on what you're going to do. So we're going to talk through that a little bit today and give everybody a little taste for it. You can certainly contact us if you have any questions. We might know somebody that can help you if you have financing needs in the build to rent space.

Let's start things off with its most basic sense. Go to the very beginning here. Maybe you're going to do an infill lot, you're going to build your own property.

What kind of financing is in play here? What would you guys do?

Sherida Zenger: You're gonna go residential, you're probably going to have to do 20% down depending on if you're able to wrap your lot into it, which you should be able to sometimes it all depends, sometimes they're gonna want you to put 30% down and put a little more skin in the game, but you're gonna go residential.

Chase Leavitt: It depends on the building.

Sherida Zenger: Yeah, I was thinking single-family infill.

Chase Leavitt: Some infill, there are some good opportunities. 1-3 acres that are bigger units, 5+ plus units that could be 30 or 100 units infill.

Steve Olson: So the question is, is the lot is the land already approved? Is it permitted? Is it approved for a certain kind of building?

So in that case, do you own the lot? Or do you not? The lot counts as equity in the deal. So if a lender is only willing to go up to 70 cents on the dollar as to what they're going to loan you and maybe you own the lot free and clear you inherited or something that goes towards your equity, and you might be able to get a construction loan, just for what's called your vertical costs, right, actually building the building.

How does it get different though, when we're talking about land that is not approved? Maybe it's not subdivided? Or entitled? Well, how does the financing become different there any thoughts?

Chase Leavitt: For my understanding when you're getting a loan on a piece of dirt or some land? It's interest-only terms aren't going to be as good they're probably going to want to see a good chunk of money down at least probably 30 maybe 35% down so yeah if you're buying a piece of property for a million bucks, you're going to be into it at least 300,000 maybe a little bit more interest only.

Sherida Zenger: I think some people are gonna go the hard money route too.

Steve Olson: Right. Because there are loans through banks, where you fit a certain there's a loose set of parameters, right? I know that if I can check these five boxes, a bank is probably going to give me a loan but hard money is when banks don't want to give me a loan. That's why I'm willing to pay the astronomical interest rate that comes with hard money. Right and that's all a question of risk.

Sherida Zenger: Do I need to close pretty quick. So I'm going to use hard money to close and then you can clip yourself out of it with a construction loan of some kind.

Steve Olson: Correct.

So one of the terms we want to go over is, it's called A&D money = acquisition and development money or capital.

And that's a specific kind of loan that banks definitely do, right? Well, if a builder needs money to buy land, and develop it and get it all, all the way to permit, right, that's an A&D loan. And banks can and can do that.

But if you're new, and you're going to go and say, I need A&D money, I need $4 million for this 20-acre piece. You're not getting that loan, you typically have to have a relationship with that bank and a track record before they're willing to cough up some end money. And beyond that you need to go, you need to go hard money.

Chase Leavitt: Or you might need to have some cash in the bank or some assets.

Steve Olson: They want to see that, they want that risk to go away and know that they're well collateralized. Yeah, you know, our good friend, Lane Aldrich, who's our preferred lender for most of the multifamily that we do on the fourplex front. mentioned to me today that he invests money in a vertical construction fund. These guys set up a fund. And they're all they do is fund vertical loans in the first position. But what is the first position?

Sherida Zenger: They're the first ones to get paid off. So they're at the top of the line, you're going to possibly usually you're going to have a second on it, too. But they're the first person that gets paid off when money comes due.

Steve Olson: It's the most secure position, right, you know that you're very likely to get all your capital back if the property gets sold, or if there's a foreclosure or something like that you secure that with a lien in states in the West, where they're a non-judicial foreclosure.

A&D money, these guys just do it for vertical. Private investors come to them and say, Here's $300,000 from my IRA, and then the fund goes out and finds builders that have land that's ready to go and they need capital to go vertical with, right, so you could find a company like that. The specializes in vertical financing.

That vertical financing is going to be more expensive. Why would somebody go the more expensive route, then? Why don't they just go down to "First Bank of Arizona"?

Sherida Zenger: Usually it's because they don't have the funds behind it to back it.

Steve Olson: The terms at the bank are better, but the qualifications are much more stringent. Is that what you're saying? Yeah.

Sherida Zenger: There's no way they're going to qualify. So if I know that, hey, I could go get some hard money. Because some of these hard money people are going to, or a fund, if you will, they're going to be more willing to loan to you knowing they're in the first position because they can take over the piece of dirt or land, whatever you're trying to develop, right?

Some of these banks, they're not in that market to go do that. They don't want to do that. But yeah, they're the qualifications are going to be a lot higher and more stringent.

Steve Olson: They're gonna ask you a lot of stupid questions, go through all your paperwork. And I would add, though, that the hard money is gonna still ask a lot of those questions 100%. But they can typically move a lot faster, you know, a bank is gonna, I mean, they can't go to the bathroom in less than 30 days, let alone do an AMD loan.

So the first step listeners have to take in mind, is my land, in title, and approved doesn't have permits, you might be able to just get a construction loan, depending on how much money you're bringing to the deal. But are you subdividing? Are you actually developing dirt, you're going to need private capital or A&D capital.

Like when we do our stuff for FIG, the fourplex Investment Group, Aaron in our company has a whole bunch of individuals he goes to and he created a fund that only loans money on a big deal, right. And the way that that gets handled is they record a mortgage against the entire property. And then when our investors come in and start closing on fourplexes, that A&D capital gradually gets paid down until it's paid off.

And that's a great way to minimize the capital that we have to have into the deal. But once again, a normal bank that's not going to fly, they're gonna want to see equity in the deal, right? So there are creative ways to do it. Okay, so that's and money and you know, interest rates with a bank.

Four-ish percent is we record this right? hard money is going to be close to 10%. With a couple of points on the front. Yeah, a couple of percentages of your loan amount.

So we've got our land, it's developed, it's ready to build on. What about construction financing? What thoughts do you have there?

Chase Leavitt: I think when people hear of construction finance or construction loan, if they haven't been through it, they get a little bit nervous, it's a little bit foreign or unknown.

But once you've been through the process and understand it, it's not as scary or intimidating. But typically what you can plan on is a construction lender gonna want to see at least 25% down, and you're gonna plan on some buying cost, or closing cost.

So you need to understand, okay, what's in that buying costs, closing costs, just like with any other loan that we're talking about here. A lot of times in the buying costs, you're gonna see an interest reserve account, you can either pay on that monthly, a lot of times, or it could be paid up upfront.

That's how we do it, we collect 12 months upfront, and we have that health and interest reserve account. So when you're getting a construction loan, it's interesting only to plan on paying either monthly payment for that loan or upfront, there's gonna usually be a 1% origination fee, maybe more, you're gonna see appraisal fee, closing costs, things like that.

Sherida Zenger: I think it also depends on are you gonna have to go commercial Are you gonna going to be able to do residential, right, depending on the number of doors. We've done projects where anywhere from one to four doors, we can get to residential, and then five and above, you need to go commercial. Commercial terms are usually not as favorable, but they still do work. Sometimes that process is a lot harder. But through commercial, you can also do it in the name of an LLC, where to go residential, it has to be in your personal name.

Steve Olson: That's right. Going residential. Once again, this is a bank, and they have very set requirements. When we say going residential, we're talking about these conforming Fannie Mae, Freddie Mac loans. And there is a very specific set of criteria that you have to go through and you either meet it or you do not very rarely Is it is it blurry. One thing that happens to me a lot is when I send somebody to a commercial lender that's been used to dealing with residential, they always call me like 60 days later mad, like these commercial guys are clowns like, well, there's not a set of criteria, right?

This is a bunch of old bankers that collect all your financials and get in a committee eat some donuts and talk about does we like this guy? and black and white answers don't always come out of that meeting.

So commercial is there's like a thought that's expressed a lot of people say, I want to do a commercial deal because they don't care about my credit score my financials, they just care about the deal. Not true at all. But what is true, they care a lot more about the deal. on a residential loan. It is chases, credit score, and debt to income ratio, purely that does that deal on a commercial deal. It's, is Chase an idiot? Okay, he's not great. Is he financially viable? Is he solvent? Great. Now, how does this deal look?

Because it doesn't matter how good you look if the deal doesn't look good. It has to stand on its own.

There's a term called "debt service coverage ratio". Does anyone want to take a stab at that?

Sherida Zenger: I know we want it to be at 1.3 or 1.4%.

Steve Olson: Usually one and a quarter.

Sherida Zenger: I know that just from doing a few of the deals, but I'm not as knowledgeable about it. So we'll punt that back to you.

Steve Olson: Debt service coverage ratio, is just a way of saying, how much income do we have to cover the debt that's being incurred. And if that ratio falls below, one and a quarter, lenders are gonna just want more money down.

It's the equivalent of an appraisal not coming in high enough. On a property, if the debt service coverage ratio is too low, they say, we're giving you too much debt for this business. That's what they consider it to be as a business. And your business doesn't make enough for us to feel comfortable that you're going to cover the debt. So bring more money in. Instead of 30%. down, bring 35, or bring 40% down.

I'm working on a deal right now with a foreign national that I'm partnering with, to do 72 doors. And the bank kept saying, Well, I don't know what the debt service coverage ratio is, well, this guy's from overseas and is feeling lucky to borrow the money. And he'll bring as much as possible.

So I said, you tell me, what does it need to be we'll bring the amount of equity than when they say, oh, wow, you're the dream client. You're just going to put more down? If that's what it takes. But then I looked at, but I'm gonna get you on the next one. When we prove that we know what we're doing here, right. So that's the debt service coverage ratio.

What about the length of the construction loan on a normal conventional loan versus a commercial loan? Are they typically longer/shorter? What's that like?

Sherida Zenger: Residential financing is going to usually be 12 months. You can get it longer, and commercial is usually going to start at 18 months, the total term.

Steve Olson: And we're getting them longer now because of construction delays.

The commercial loan has to be 18 months at least because that commercial lender wants to be sure that once this property is done, the buyer has sufficient time to lease it. Typically to 90%.

Because once again, they're qualifying a business here, and you're not going to build a commercial property and lease it, (ie. 50 units or more), in 12 months. You're probably not doing it in 18 months, given how things are going right now.

So most of these terms are creeping up on 24 to give you time to build and lease and then refinance out of that commercial construction loan.

So you said something about terms not being as favorable? What do you mean specifically?

Sherida Zenger: I'm meaning more your long-term interest rate, usually on commercial, you know, it's anywhere from a quarter to a half a percent more, sometimes it can be even more than that. But it's usually a higher interest rate for your permanent financing long-term financing.

Steve Olson: What else? I can think of a few things...higher interest rates, amortization period.

Sherida Zenger: Yeah, you're gonna go 25 years. Some of them have been able to do 30 years, but it's usually 25 years. And they're usually a 7 or 10 year ARM or something of that nature.

Steve Olson: And if you're a big, accomplished borrower, with HUD. HUD might amortize over 40 years. With no balloon payments.

So the typical commercial loan is, well, we're amortizing this over 25 years or whatever. But you got to pay off in 10 years. And on some of these giant HUD deals, and they're tricky, but some guys are really good at them. I've personally never done on 40 years, due in 40 years. That's crazy. We get got to get some of that capital going.

I think too, one thing that you got to keep in mind is when you have a commercial long term loan, you're subject to audits by the bank, right? They said they underwrote that saying, Oh, yeah, you do meet the debt coverage ratio. But in a year, do you, they're going to want to know, right? So you got to have that dry powder, in case you don't, because they're going to require more collateral for the loan.

The advantage on fourplex loans which have been our bread and butter is that 30-year fixed true. Nobody's bothering you, because it's only you qualify for it. Nobody's asking any questions, and it's an excellent inflation hedge.

Sherida Zenger: One thing that I like that we do is with Lane, we get everyone pre-approved ahead of time. So when you're going through our process, you're actually getting pre-approved for your long-term financing, which is a little bit harder to get approved for than the construction. So don't let the construction loan scare you off.

Chase Leavitt: Just know that the construction loan, like we've talked about, is more of a 12-month loan, interest only. The rates can be about a point higher than a 30-year fixed conventional loan. So just know the rates are a little bit higher, you don't want to be on that loan forever. You want to be in it for 12 months, or as short as you can whenever the construction is done. And then when it's done. It's just a simple refinance into that 30-year fixed conventional loan.

Steve Olson: That's assuming, though, that you're going with the bank. If you're going with hard money, it's three, four, or five points higher. It's a lot. And I would add to that, when you get a construction loan through a bank, your terms are usually better if you prepay your interest reserve, if they know that's just sitting in their bank. They've got that they can pull that out every month. That's worth something.

I've seen it get a couple of loans across the finish line, where they were marginal on it. Well, what if we prepay the interest? Oh, they perk up a lot.

Sherida Zenger: They like that, having that money sitting there.

Steve Olson: Financing is a tool. Use it. I'm a big fan of the Real Estate Guys, Russell Gray and Robert Helms. They say to do the math and the math will tell you what to do. And the good thing about loans is it's pretty straightforward. You know what you're getting.

Sherida Zenger: There's a lot of options, so explore them to see what works best for you.

Chase Leavitt: There is a difference between good financing and bad financing. To understand the difference between the two, understand what you're getting into. Understand what the numbers look like, from a cap rate/cash flow perspective when it's all said and done.