1103: Special Guest Interview (Trevor Calton - Part 2)
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00:01
Welcome to episode 3 of season 11 of the Growing Empire Show. Today I'm back with my special guest, Trevor Calton from Evergreen Capital and we're going to continue our conversation about how to increase your returns with proper funding. So stay tuned.
00:20
Welcome to Growing Empires. Hosted by real estate entrepreneur and trusted investment advisor, Jennifer de Jesus. Growing Empires provides insight to building wealth through passive income producing real estate investments for those who want to build and manage a more profitable real estate portfolio.
00:41
So what's the main difference between debt and equity capital?
00:47
Well, the main difference between debt and equity capital is priority. And the way that the capital stack works, you typically you have senior debt, which comes with a senior lien on a property and and liens are put in place in chronological order. So the first party to put a lien on a property is first in line should that property be foreclosed on, and creditors need to be paid out. So debt holders are always going to have a lien position and a senior debt holder, like a first mortgage would have the the first position and then a junior lien holder, like a, maybe a an equity line of credit, or if it was in the case of a house, like a second mortgage on a house would be the second in line. And only after all debt holders, who have a contractual right to recover their funds, only after they are satisfied, do equity holders get any distributions. So it's really just whenever there's if it's cash flow, or if the property is being foreclosed on, it has to be sold, the cash is distributed in order of priority. So senior lender gets paid first, Junior lender gets paid second, if there's anything left over, that would go to the equity holders. And in commercial real estate, you frequently see, you know, four layers in the capital stack. We do deals all the time where we have, we've got senior debt, we might have some mezzanine financing in there, which could be a bridge loan, or maybe just another loan behind the senior loan for capital improvements. And then if say, when we organize an investment group, then we will typically do two layers of equity, we'll have preferred equity, and then we'll have common equity. And equity can be really structured however you want. That's the nice thing is equity is distributed according to however the owners have agreed. And I really like to give my preferred equity holders, who are going to be ahead in priority of the common equity holders, I like to give them you know, terms that they can count on. And so we often will structure our preferred equity, similar to debt. So maybe give an 8% preferred return. So that investor is getting an 8% yield, and then save the project outperforms, they might they make it something above and beyond that. And then anything leftover, typically at the end, upon sale, or refi, the rest of the spoils go to the common equity holders. So it equity can be much more flexible. Can be structured just like a loan, or it can be structured as just a percentage of the profits or a blend of the two. There's a lot more flexibility with equity. But it's typically harder to get. Because there's more risk.
03:53
Okay, so from an investor's perspective that's looking to acquire property, how would they pick or I assume that's part of the mortgage broker is going to help with this. But why would they pick one over the other? You know, is there a real clear path to whether they want debt or equity to purchase their properties?
04:12
That's a great question. And the answer. The answer is it depends. It depends. It depends on a lot of things. One, how much debt the lenders willing to offer. And because lenders have first position or priority over the equity holders, they usually have a lower required return, AKA a lower interest rate. And debt is usually easier to get but a lot of times there's a gap between what the lender is willing to lend and what the investor has to put down and their down payment is their equity. But let's say somebody has 25% to put down and the lenders only offering 70%. That means there's a 5% gap in there that the investor doesn't have and the lender is not going to lend and so then they have to go find that elsewhere. A lot of lenders won't allow for a second to be placed on a property. So going and finding that as equity or getting it from a private lender or secured by something else is maybe their only option. But it comes up all the time. And this is a very frequent challenge that investors have, you know, you see something that, you know, it's bigger and better than then what you might have originally thought you could get, but it's just a little bit out of reach. And like, Oh, I'm just, you know, 5% of the total purchase price away from being able to take this down, how am I going to get that? And I would say, you know, the, the lowest cost of funds is from a senior lender, and typically an equity holder or a partner is going to have a higher required return than a lender would. So there's a lot of math and analysis that has to go into it, you know, will the property cash flow? Can I satisfy the debt? And can I satisfy my preferred equity holders? A lot of times with equity holders, they, they won't necessarily require that they get a payment every month or every quarter. And sometimes what they're owed can just be accrued and then paid later. Maybe if the say if they, you know, the owner increases the income and they start getting better cash flow, they can get caught up with that equity holder. Lenders won't allow that, you know, you got to make your payment every month. And once you go into default, and things can go south really fast. So it's a long answer. But the answer is it depends on the deal. And it depends on the property, the resources of the investor, how much lenders are willing to lend, and even things just as fluctuations in interest rates in the market. That can change things. Because one another common misconception is that if a lender says, oh, we'll lend up to 75% loan to value, a lot of borrowers think, Oh, I'll be able to get 75%. But they don't understand an actual, the real underwriting metric is debt service coverage. And if, if the property doesn't have enough net operating income to cover the debt service, then they're not going to be able to get as big of a loan. The lender will scale down the loan amount, so that the monthly payments fit within that debt service coverage requirements. And some of these are pretty technical terms, I have a lot of videos that explain these on my YouTube channel, which actually get, they get a lot of a lot of people coming to me saying what does that mean, or what does this mean? But it's unlike buying house where it just goes as a function of the value, the loan to value, and then the borrower's credit score and their income. Commercial properties, the underwriting takes a look at, you know, all of the different sources of revenue, all of the different expenses, and which of those expenses are recurring, which of those expenses would be required, if the bank had to take over. An example is, if somebody is going to buy an apartment building, and they think they're going to manage it themselves, they're not going to have a management expense. So they're gonna have greater cash flow than they would if they had a third party professional management, like your company, managing the property for them. But what they suddenly might say, oh, there's no net operating income, and the cash flow on this property looks really good. But what they don't realize is the lender is going to look at it as if they were the owner, and they wouldn't be managing the property, they would outsource that management. So they're going to add an assumption in there that there's going to be a management expense. Whether or not it actually exists, the lender is going to put it in there. And so a lot of times, what happens is the loan amount is based on a function of the property's cash flow, and the interest rate on the loan, and the amortization, and a combination of those things, rather than just being Oh, it's a loan to value. So it's far more complex than people often realize.
08:51
Yeah, that's so very true. You know, just from all my years in doing the real estate side of the business, I mean, we have, obviously lenders and brokers that we have been doing business with for many, many years. And, you know, I even get calls to the extent of I just want to verify that you're going to manage this property for this client, once we fund their loan. Because it's almost like there's a sense of security there to some extent, you know. Especially if the property is like super distressed, or has a lot of value add component to it. They want to make sure that you know, that somebody that is not local to the area that they're investing in is not trying to do that from afar, right? They want somebody that is, you know, boots on the ground that has experience, that can actually get it done. And there's been multiple times where we've actually helped people get loans because we were willing to take the property into management for them when the lender would have seen them as as risk.
09:46
Nowadays, a lot of lenders will make that a requirement, they're going to want to see a signed property management contract in place prior to closing. And, you know, and I think that's smart. A novice investor going into commercial property, particularly, as much as they think, Oh, I can handle this, they don't want to do it themselves. Because it's so much more than, you know, fixing leaky faucets. It is you have landlord tenant laws that you have to abide by. You have, oftentimes you have State, County, Municipal regulations. Rent control, relocation fees. There are so many different moving parts in commercial real estate. And then if you get into a mixed use property where there's a retail component, then you're often negotiating leases, tenant improvements, and you know, things that can be very, very complex and not something that a novice investor wants to tackle on their own. So what I tell people who want to manage their own property, and you know, save it, if you're, if you're buying a six unit, right, that's not going to be as complex as buying a 60 unit property. But it's still going to have a learning curve. And I always tell people, hey, at a very minimum, you know, three to six months, get your management, get a professional, third party experienced manager in there. And, you know, find out what their procedures are. Like, you know, what, are they using a product management software, like yardie? Or something like that. You know, do they have lease agreements that are state specific? Are they using a generic lease? What sort of marketing program do they have? What software do they have? Do they allow people to do, you know, online rent payments? You guys have a property management company. There are so many different things that go into managing a property and not every owner has the same, the same style. They don't all have the same wants and needs from a manager. But regardless, if somebody is new to investing, they have a lot to learn, and having a professional management in place is really, really important. And I, I mean, I, I encourage people all the time, like, don't even consider going into this without professional management. One, because the lender may not even let you and we'll probably find that out. But even if they do, you can still put yourself at risk. Especially if you're buying value, add a lot of value add properties have, you know, physical distress. And I have, I could tell some crazy stories about you know, novice owners going into properties and thinking that, Oh, they're gonna, they're gonna win over the residents by being nice, and they just get run over. And so people look at investing in real estate as a business. But the tenants, the residents look at it, that's their home. And a lot of times, if they don't like something, they're going to put up a fight. And once once you start getting into any sort of conflict with your tenants, things can go sideways really fast. So beginners don't want to tackle that on their own. They want to leave that to the professionals until they've learned and watched and, and seen how to do things.
12:54
Very great points
.12:57
The episode will continue in just a moment.
13:01
As an investor, we know it's important to stay on top of market trends and real estate opportunities that add value to your portfolio. We also know that having a trusted source of reliable information to help you stay a step ahead of other investors is critical to your success. If you're interested in having these types of resources, as well as access to me and my team, I invite you to join the Empire Investment Club. A free service that gives you an easier way to make sense of today's and tomorrow's real estate opportunities. As a member of the Empire Investment Club, you'll get access to relevant resources and investment focused experiences such as live interactive webinars, market trend presentations, and investor socials designed to equip you with what you need to succeed. So whether you're an active investor, passive investor, a combination of both or just starting out, the club is where you'll get what you need to build a portfolio you love. To join, just head over to JenniferdeJesus.com, sign up, and we'll see you in the club, where everyone's on a journey to becoming a better investor.
14:00
So do you think that having the proper funding or having the proper type of loan package for the deal you’re buying helps investors increase returns?
14:12
Oh, absolutely. Yeah. The example that I gave earlier about having a loan just with a different type of prepayment penalty, that can that can change your overall returns significantly. Another thing is, the thing that borrowers need to understand is that lenders want to work with professionals because they're all about risk, right? They want to ensure that they're gonna get their returns their their interest on their, you know, regular monthly payments, and they don't want to have to deal with problems. So if an investor is going out to source debt in the market, and let's say you know, they just show up with a an unorganized stack of papers. The good lenders that have great terms are not necessarily even going to want to look at that. They might just turn them down right away. But what we do then that's a huge part of our job that we do before we even have a fee agreement in place with the borrower or client is, we help them compile the best loan package that we can put together with the information that they give us, you know. Write out a great summary, explain the project, explain the sponsor, you know, talking about the financial solvency of the investor, you know, talk about what sort of level of capital they're looking for, and for how long how long, you know. You want to put your best foot forward with the lenders, immediately. Because you only get one chance to make a first impression. And once a lender has said, No, we're not interested in that deal, they're unlikely to look at it again. But having a well organized package ready to go to submit to a lender, in the beginning, can make a huge difference in the rates and terms that you're offering. Because if you think about if, if the like the conventional lenders say no, just because the package is disorganized or incomplete, then frequently you're going to non bank lenders or private money, and the cost of funds is going to be higher there. And so the investor's returns are going to be a lot lower. So it's really, really important to have all of your ducks in a row before you go out, started making offers on properties and shopping for financing.
16:20
Very, very true. Thank you for listening to the second part of my conversation with my special guests, Trevor Calton. Please make sure you tune in to our next episode, where Trevor and I will continue our conversation about how to use as little of your own cash as possible, and the best practices for scaling and diversifying your investment portfolio. Until next time, take care.
16:45
For more information about how Jennifer can help you plan, develop and manage a strong real estate investment portfolio visit growingempires.com