Cross - collateralization on a $3M deal

I have the opportunity to purchase a 188 unit multifamily portfolio for $3,200,000 (the amount the owner owes). The numbers are as follows:

$960K GSI
-$192K Vacancy (20%)

$768K GOI
-$442K Expenses [(expenses + vacancy) / GSI = 66%]

$326K NOI
-$260K Debt Service (assumable)

$66K BTCF ($29 / door / mo)

This isn’t super, however, the out-of-state owner hasn’t been at the properties in 5! years. This portfolio is mismanaged.

There are three things that can be done to improve the property to well over $100 / unit / door:

  1. The rents are under market.
  2. The owner pays ~$120K in utilities
  3. The occupancy rate is well below market (s/b 90% minimum, closer to 92%)

I am 25% owner in an S corp. I am not an officer. I have bad credit from past family medical issues but experience in real estate and have successfully owned rentals before. The other 75% ownership has very good credit. The S corp owns a piece of real estate worth ~2M. This property is free and clear. Collectively we have very little cash.

I am comfortable with the level of return on this deal and I’m confident I can improve the NOI significantly.

All that leads to my question:

Does the S Corp (30 yrs old but no lines of credit to speak of) have a reasonable expectation of assuming the loan (or obtaining new 100% financing) using the $2M in equity to cross-collateralize the portfolio to an LTV of 70%-80%.

I don’t want to spend the next 60 days doing the due dilligence if there’s no chance of getting the financing.

I know that was a lot. Hope it makes sense.

This seems pretty easy to get done. 80% ($2,560,000) bank and 20% ($640,000) from your free and clear property. I’m not going to get into the numbers because that wasn’t your question, you seem like you know what you’re talking about, why wouldn’t you think you could do a 80/20 deal w/ the bank?

JBaldwin is correct you should not have much trouble getting this approved with a local bank. However there are two things that would worry me more about this deal. First is that you have very little cash. Going into a 3.2M deal without have a significant cash reserve is very dangerous. All it it would take is one or two months of non-paying or late tenants and you are in serious trouble. The other thing is that you are going into this deal thinking that while the numbers are not good now, you think or should I say hope that you can make them work better for you. Keep in mind that you will not just be able to dump the utilities on the residents and when you try to do that you may have a mass exodus of people moving out which could cripple your plan. Not to mention the fact that is a 92% occupancy rate really possible? There is a reason the current owner is willing to dump this property for only what is owed on it.

Indeed. Whenever I see a deal like this I always ask myself, “Why could I turn the property around if the current owner couldn’t?” No matter how smart and capable I think I am, unless I can verify extenuating circumstances (the current owner got really sick, ran out of money, property manager embezzlement, etc.) I usually conclude that my bag of tricks is not much different than theirs.

From the numbers you said not to evaluate (though you did post them), the current owners either got a fair deal on a performing property and let it deteriorate, or overpaid for a mismanaged property and thought they could do the same as you intend. Now they’re suggesting you make them whole and pull their chestnuts from the fire.

Both the cap rate and cash-on-cash return here are about 10%. Unless this is in an area where the prevailing cap rates are very low (i.e. LA, SF, or NYC), I don’t see an adequate return for the work or risk involved. You know the deal better than I of course, and would obviously disagree.

First off, thanks for the excellent responses. I appreciate it!

JBaldwin, I ask because I don’t know. I haven’t financed a commercial real estate deal of this size before and though I’ve done my homework, I haven’t approached local banks yet. I guess I look at them as a limited resource and I don’t want to look too much the fool on first meeting. If I’m asking the bank for something that is beyond the pale, I’ll end up a topic of discussion at the next rotary club meeting and I don’t need that. If I need a cash partner, I’d like to know that going in!

Christopher, you have a good point with respect to the utilities. I believe that tenant paid utilities are the norm in the area. I would only meter units when tenants change and I don’t expect the full amount of the utilities to flow through to the bottom line. I can’t say yet what percentage will be realized in the NOI, but my first pass guess is about 50-60%.

When I say I’ve got little cash, I mean that in relation to a 20-30% down payment. I do have 3+ months capital reserves (no tenants / all expenses & debt service). I find it unlikely that I would lose all the rents at once since the units are spread out geographically (same city but concentrated in several different parts of town). A bad tenant or drug dealer problems can’t tank the whole portfolio like they could in a single location apartment complex.

I also have no immediate need for cash flow, so any BTCF that comes in will go into reserves as well, for at least 6 months. I’m actually a pretty conservative fellow, and I believe the riskiest part of this deal will be the first two months of ownership.

Equity, your point is well taken. When I see a deal like this, I also ask myself “Why is it underperforming? What can I do that the previous owner cannot?” and I agree that there must be extenuating circumstances. I believe that in this case there are such circumstances (specifically an absentee owner who purchased as a hands-off investment that has deteriorated because of lack of supervision of his in-house management staff). I will say, though, that I think you’ve convinced me that I might want to do a bit more pre-offer digging.

I assume that you calculated the cash-on-cash return using the encumbered 20% on the cross-collateralized property. I hadn’t really thought to do that but it does make sense. I have invested it, in the sense it can’t be used for anything else.

With respect to the upside, I guess I have to disagree. The upside here is good and I believe is worth the effort. A 6% increase in occupancy, a similar increase in rents and recouping 40% of the owner paid utilities would add about $140K-$160K to the NOI. At a 10% cap, even if it takes 3 years to implement the changes, it’s a decent return. (Conservatively: 35-40% per annum.)

Realize that everything we’re discussing here is in the context of pre-offer due diligence. I won’t know whether I’m right or not about the turn-around possibilities of the property (and the condition, and the expenses, etc.) until I begin due diligence in earnest. That will be a significant amount of work and probably end up costing several tens of thousands of dollars. I just don’t want to be making a commitment in money and time if I’m on a fool’s errand when it comes to the financing piece.

Again, thanks for all of your input. It’s greatly appreciated and has caused me to look a little more closely at the deal in a couple of areas.

It’s possible to cross collateralize the $2MM property that you own free and clear but cash is king so it’s a stronger deal if you can do a cash out refinance or obtain a line of credit on the free and clear property to put actual cash into the deal.

The other thing to remember is that the lender options on acquisition are limited since the property isn’t stabilized (low occupancy). Bad credit of the guarantors is an issue as well but one that be overcome with cash!

All the best,
Susan

Forgive a stupid question.

Since the NOI seems to be supporting the debt service with a coverage ratio of 1.25, why can’t you simply assume the existing financing? You say the owner is willing to walk away for what is owed. A loan assumption eliminates the need to cross-collateralize the other property you own.

Hopefully, the seller has a non-recourse loan.

Is this an avenue worth exploring?

Thanks Susan,

I don’t have the income to support a cash-out refi of the $2M property without the cash flow from the contemplated deal. A simultaneous closing would solve that but it’s not clear to me how the lender that did the cash out refi would feel comfortable with this situation (the primary lender would be happy, of course). Plus, this would increase the overall cost of capital and reduce the cash flow which makes the deal more risky for everyone.

Am I missing something?

Dave,

The loan is assumable but the terms aren’t great. It has a pretty hard reset in two years. I’d rather get a longer term loan, even with a slightly higher rate, especially considering what I believe to be a pretty significant risk of interest rate increases in the next few years.

But the terms are good enough to assume the financing and get the deal done today, right? Why can’t you take the next two years to turn the property around, then refinance?

I can, certainly. The issue for me is that I believe (rather strongly) that mortgage interest rates are going to be several points higher in a couple of years. What I’m trying to avoid is the need to refi to a higher rate just as the NOI of the property is improving. I really don’t want to give a couple years of hard work right back to the bank.

I can get a new loan with a higher rate but a longer term that will actually allow the property to cash flow better than the numbers I gave above. The new loan will have a longer balloon, 7-10 years and will help me control my perceived interest rate risk. I want to make this investment, as much as possible, on things I can control and I can’t control the mortgage market.

I know that this strategy will reduce the amount of principal that will be paid down during the hold period, and the overall return will be reduced somewhat, but as I said before, I’m pretty conservative and I’m willing to give a bit here.

I hope that clarifies things a little. By the way, I anticipate beginning formal contract negotiations by the end of next week. Even if this deal doesn’t work out, I’ve learned a considerable amount about my strategy and its implementation which will make the next candidate deal easier and allow me to move faster.

Another crazy idea I had was to use cash flow to purchase some long term options on 10 year T-bills to hedge against interest rate risk. I have NO idea if that even makes sense with regard to cost and correlation as I haven’t looked into it yet.

I wonder where these buildings are at? There are parts of the country where the population and amount of jobs are shrinking. Area’s where $25.00 per hour American jobs are leaveing to $3.00 hour forign jobs = external economic obsolesence. I hope Brahms is not rearanging deck chairs on the titanic.

I hope Brahms is not rearanging deck chairs on the titanic.

I hope he’s not either.

The properties are located in the South in an area as you describe. The community is in decline and is struggling to replace lost factory jobs.

The reason I’ve been interested in them is because they are student rentals located in very close proximity to a major state university which depends on off-campus rentals for 65% of its housing.

With that said, I’m probably going to pass. Deferred maintenance is high and the figures above do not include capital reserves. I’d probably be comfortable paying $2.5M and that’s obviously not going to happen here.

Good thinking.  No one has ever gone broke passing up a deal. 

However I would try to keep my ears open on this property. What if everyone has the same thoughts as you and the owner can’t get anyone to touch it. Eventually the owner may just give it back to the bank. I have also seen more times than I can remember other family members inherating real estate that younger family is not even interested in. Either way you could have a great oppurtunity. Stay tuned.