Owning real estate can be a superb long term investment if done properly. The question arises how do individuals manage to amass immense equity portfolios (especially if each building is valued in the tens of millions of dollars). The answer lies in a concept called financing out. Once again, the best way to easily present this concept is via example.
Example:
Investor A decides to acquire a dilapidated shopping center that is in need of some serious help. The center was operated poorly and as a result there is a good deal of vacancy and needed capital expenditures. This said, investor A is still up for the challenge and decides he wants to acquire the property. Due to its state, the property is sold to investor A at a discount– 1,000,000 dollars. Moreover, Investor A has already budgeted numerous capital expenditures and has a good idea of what tenants he can put into the center to increase the net operating income. He estimates another 1,000,000 in repairs, leasing fees, etc. The bank loans him 80% loan-to-cost for his improvements. So, in total the bank has loaned him 1,600,000 dollars and he has put in 400,000 of his own equity. If every project he did required 400M equity than he could not undertake many while holding them long term (i.e. leaving his 400k in the deal). So, Investor A spends some time fixing the center up and leasing the vacancy. He increases the NOI of the property and then goes to the bank requesting a permanent loan. He requests a loan of 2,000,000. This loan encompasses the initial construction loan as well as his equity. The goal for the investor is to make sure that 2MM is no more than 80% (or whatever amount the bank is willing to lend on a loan to value (LTV= final stabilized project). If they agree he now has 100% debt on the property and has returned his equity. Moreover, it is now a solid property and his cash flow from rents covers his monthly debt obligations. So, he takes in a bit of rent after paying his debt each month and slowly pays down his mortgage over X years. This is an ideal situation for any investor, but it can have a small downside known as Phantom Income which I will address next week.
Cheers,
John
Similar Posts:
- Builders Corner: Negative Leverage
- Builders Corner – The Benefits of Leverage
- Builder’s Corner: Phantom Income
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