First and foremost I want to help people understand that it’s always a Borrower’s cash equity that erodes first when Commercial Real Estate deals take a turn for the worse. For Investors who are cash heavy this sets up a perfect scenario for them to cash in and make some game changing plays. Nobody actually expects a Bank to cut into the value of their first lien position without first burning through a Borrower’s equity. To be clear, I’m talking about small investors who borrow from smaller institutions and use loans that have full recourse for the Lender and which are personally guaranteed by the Borrower. And bailing out small Banks from deals with a lot of these type Borrowers is exactly were cash heavy Investors can make a fortune on certain assets.
It’s not a complicated scenario at all. To give a very simple example let’s assume that about 3 years ago a Bank loaned out $1,000,000.00 on a building that was valued $1,200,000.00 with their Borrower having put $200,000.00 into the deal as cash down. Let’s assume it was an interest only loan at 5% and the property had a net operating income of $96,000.00 reflecting an 8% Cap Rate to this original Borrower. And today when it’s time to renew the note and the bank is (for a myriad of possible reasons) asking the Borrower to pay down the balance of the original note before they’ll renew it (yes, at a much higher interest rate probably much closer to 8.5%) they’re going to ask their Borrower to toss in another $200,000.00. Let’s assume for a moment that because of the way things have gone over the last 36 months, the Borrower is strapped for cash and can’t put in any more cash equity. So the Bank says alright we recommend you sell the property because we’re calling the note in. However, there’s a problem. No one else out there is willing to pay the price for the property that our original Borrower paid, and so to avoid litigation or a bankruptcy, our original Borrower is expected (forced) by the Bank to sell the asset for just enough to cover their first position note. This is where it gets interesting.
Being desperate to avoid litigation or a bankruptcy our original Borrower sells the property to another (you guessed it) Bank Customer who has a lot of cash on hand. This person will become the new Borrower for the Bank. This new Investor tosses in the requested $200,000.00 cash that the Bank is wanting (as principal reduction from the original Borrower) and originates a new note for $800,000.00 against an asset that just 3 years ago was a fine stabilized cash flowing machine for the first Borrower who paid $1,200,000.00 and is now just very sadly out of luck. Out of luck from the standpoint that the property is still cash flowing the $96 K per year which he or she will lose along with his or her original cash down payment.
But, our cash heavy new Investor and new Borrower tells the Bank “No, I’m only willing to take over in this “troubled” situation for the same amount you originally loaned to the first guy. I’ll still toss in the $200,000.00 you’re asking for but I’m just not willing to take this deal down at a penny over the amount that you originally loaned.” The Bank recognizes that this is about as good a deal as they’re going to get for themselves because they’re able to close this whole thing up in-house without listing the property in the open market, paying commissions to Brokers, paying any other carrying costs and maintenance of said asset while searching for another Buyer / Borrower. And, they get to avoid involvement in any kind of costly litigation. Also, our original Borrower is relieved to get to avoid a humiliating bankruptcy and/or lawsuit.
And so now here we have YOU, the cash heavy Bank Customer, picking up that stabilized cash flowing asset that’s tossing off that cool $96 K per year in Net Operating Income for at an attractive 9.6% Cap Rate ($96,000.00 net income divided by your $1,000,000.00 purchase price). You borrow the $800,000.00 at 8% interest only (which is a slightly reduced interest rate because you’re a model customer and again the Bank takes a first position lien against the property). You have interest only payments of $64,000.00 per year. Taking that amount away from the $96,000.00 net operating income you have a cool $32,000.00 per year positive cash flow to add to your growing stack of cash in said Big Bad Bank. That $32 K per year represents a 16% annual return on your solo $200,000.00 outlay.
So fast forward about 8 years after which you’ve collected $256,000.00 in positive cash flow (8 years at $32 K per year excluding any additional income from rent increases) and man has the economy come roaring back in a spectacular way. And WOW at just what kind of mood the Banks are in and they’re again lending money out left and right and your property’s net operating income has grown to $110,000.00 per year. And look who’s again sitting out there. Almost predictably, it looks an awful lot like someone who is situated just like our original Borrower that bought the property at that 8% Cap Rate and they want to do a deal with YOU also at an 8% Cap Rate. So you do the deal at $1,375,000.00 (which is an 8% Cap to them with $110,000.00 net income divided by the desired 8% annualized rate of return). You pay off your interest only $800,000.00 loan and you sock your net proceeds of $575,000.00 in the bank (on top of the $256,000.00 you collected in cash flow over the last 8 years) for a whopping $831,000.00 total gross profit.
And yes, you probably guessed it, it’s absolutely possible that a similar future fate awaits this new Investor who bought the property from you. And this exact or a very similar cycle will play itself out over and over again with each and every economic boom and bust cycle. Sometimes, cash is simply King.
Hope this helps some of you to understand why I disagree with a lot of other Brokers out there about how to use your cash in the Real Estate game at the time of this writing. The role of cash is changing right now. A higher and better use of at least some of it is coming just over the horizon. There’s currently about $1.7 Trillion USD in commercial bank notes sitting out there that are going to have to be renewed in the next 24 – 36 months. If only 20% of those deals work out like the example I’ve shown here, that’s $340 Billion USD in equity that cash heavy Investors are going to be able to cash in on in relatively short order.
Leo M. Bullock, IV – Real Estate Broker & Investor