I love breaking down my deals and sharing real estate principles. Giving people a window into my world demystifies the process of purchasing and managing real estate. I love it when the light bulb turns on and something clicks. To help more of those light bulbs go off the next few weeks, I’m going to be writing a series focused on leverage.
Before I go too deep, let’s set the foundation. One of the requests I get is to share definitions of commonly used terms. Here are 15 key terms to remember:
LTV stands for loan-to-value, loan amount divided by the value (or how much it’s worth). LTC is its twin brother, this stands for loan-to-cost. Costs don’t always equal value because you have closing costs, improvement costs, additional development costs, etc.
A mortgage rate, or just “rate”, is the interest rate on the loan. A “floating rate” means the rate changes based on a baseline market rate like Prime or LIBOR.
The term is how long a particular rate is valid. Commercial mortgages are not like home mortgages. They are almost always adjustable. After the term is over, it generally adjusts based on Prime or LIBOR + a certain amount of basis points.
A basis point is 1/100 of a percent. You use this to calculate adjustments and fees related to the loan. 30 basis point fee is .3% of the loan amount.
Amortization schedule, sometimes just called “AM” as in “30 year AM”, is the schedule for which the loan is amortized. Amortization means the repayment of the original principal amount of the loan. In commercial lending, these range from 15-30 years, with 20-25 year AMs most common in my sector (self-storage). Most real estate folks fight for the longest term possible on their loans because that reduces the monthly obligation.
Interest-only period, or “I/O,” is the duration, in months, of the interest-only period before you need to start paying down the principal of the loan. Interest-only periods are GOOD for investors because your monthly obligation is lower. Bankers generally only like to use them on new construction or value add deals where there is minimal cash flow to cover the debt service.
Prepayment penalty, or “PrePay”, is a percentage of the loan that is charged as a fee by the lender to the borrower if you prepay the loan back before the end of the term or in a given year. Banks have expenses to write loans, and they like to keep them on the books. These prepays are often negotiated out of a deal in exchange for a higher rate if you know you’re going to add value and refinance soon (and you’re confident and okay with the risk).
Lenders charge an exit fee if you pay off a loan before the term is up. Generally, it’s 1%. Sometimes it’s waived if you negotiate or place the new debt with the same bank (remember they like loans).
A lender charges a commitment fee to a borrower to originate a loan. It is a fee to make sure the loan officer can drive a nice car too. Generally 30-100 basis points.
An escrow account is an account that banks put in place to hold back funds as collateral or to pay bills like property taxes. “Escrowing” is the act of holding back funds to cover obligations. My bank escrows my property taxes.
Personal Guarantee, also called “PG,” means what you think it means. You are pledging your personal assets as collateral to your loan. If you default, they can take your house and seize your accounts.
Debt Service Coverage Ratio, or “DSCR,” is your Net Operating Income, or “NOI” divided by debt service obligation, both interest, and principle. If you have $80k in NOI and $50k in debt service, your DSCR is $80k / $50k, or 1.6x. This is a way to think about risk. The lower the DSCR, the riskier the deal.
Cash on Cash Returns, or “CoC,” is the ultimate figure. What % return, in cash, is the cash you put in the deal earning you? This is different from cap rate because it takes into account debt levels and mortgage payments.
Then there’s leverage.
Leverage is what investors use to buy an asset with debt. The higher you are leveraged, the higher the risk.
In real estate, the property is under-leveraged if the equity is high and the debt is low. If you own a property outright, you’re under-leveraged. The Loan-to-value (LTV) for this property is 0% because there is literally no debt on the property.
An over-leveraged property has high debt and low equity. Let’s say you put no cash down and finance 100% of your asset. You, my friend, are over-leveraged. Your LTV in this scenario is 100%.
Most deals exist between these two extremes. And understanding how deals are financed (and how much they are leveraged) is crucial.
Leverage is incredibly powerful. It can make or break your investment.
Keep your eye out these next few weeks as we unpack some specific examples of how leverage can amplify your returns — or accelerate your losses.
Onward,
Nick