Why a Sponsor's Approach to Leverage Matters
Larry Jacobson, President
When evaluating real estate opportunities, many people become hyper-focused on the deal specifics – including the market opportunity, rents, and potential returns for individual investors. Often lost in the mix is a deeper look at the sponsor’s approach to leverage in the transaction, including how much, what kind, and the terms for that debt. Debt, which usually represents the lion’s share of the capital needed to finance a deal, can take many forms. The terms for that debt can therefore have a significant impact on equity investors’ returns.
As part of an investor’s larger due diligence process, they should always consider how leverage is being used in the transaction being considered. In this article, we look at the many ways a sponsor’s approach to leverage can influence the outcomes of your deal.
What is Leverage?
Leverage is one of the most frequently used terms – and one of the most important concepts – associated with real estate investing. In simple terms, leverage is using borrowed money (i.e., debt) to fund the acquisition or improvements associated with a piece of real estate.
Unlike other assets, like stocks or bonds, that require an investor to pay for the full cost of the investment they are making, real estate investors can use leverage to offset their up-front and out-of-pocket costs. In simple terms, if a sponsor wants to acquire a property selling for $10 million, they can use leverage to fund a majority of that cost rather than paying for it themselves (using their own capital or that of their equity investors). Instead, a sponsor might contribute $3 million worth of equity and finance the balance of the transaction using leverage – generally a bank loan or other form of low-cost debt.
Loan-to-Value (LTV) vs. Debt Service Coverage Ratio (DSCR)
Most sponsors, when utilizing leverage, will refer to their target loan-to-value ratios. Debt service coverage ratio, or DSCR, is another metric to consider. It is important for investors to know what each of these metrics represent, and how they are used by sponsors and lenders alike.
Loan to Value (LTV) Ratio
The loan-to-value ratio, or LTV, is used by lenders when evaluating whether to make a loan on an income-producing property. The LTV ratio is calculated by dividing the loan amount by the property value. In other words, an $8,000,000 loan on a property worth $10 million would be said to have an 80 percent LTV ratio.
Most lenders will have a maximum LTV ratio, though this maximum can vary drastically depending on the type of the lender, the quality of the sponsor, and whether there are other assets being put forth as collateral (otherwise known as “recourse”). A sponsor may be required by the lender to put more equity into the deal in order to lower the LTV ratio.
Debt Service Coverage Ratio (DSCR)
Debt service coverage ratio (DSCR) is another metric lenders consider. Commercial lenders use DSCR to analyze how large of a loan can be supported by the cash flow generated by the property. DSCR is calculated as the ratio of the property’s net operating income (NOI) divided by the annual loan payment. For example, a property that generates $350,000 in NOI and has annual debt payments totaling $275,000 would have a DSCR totaling 1.27. This means that the cash flow generated by the property will cover the loan payments by 1.27x.
Most lenders require a minimum DSCR, usually no lower than 1.2. If the DSCR is lower than 1.2, a lender may require the borrower to invest additional equity into the deal, which will therefore lower the loan amount and correspondingly, increase the DSCR.
LTV vs. DSCR – Which is a Better Metric?
Historically, most sponsors were laser-focused on LTV as a metric to monitor. Today, it is becoming evident that DSCR is often a more appropriate metric to monitor for several reasons.
First, there are practical reasons not to overly rely on LTV. While LTV should serve as a general guide, there is no guarantee that cash flow will be sufficient to support loan payments regardless of the LTV ratio.
This is what makes DSCR an important benchmarking tool, particularly as it pertains to risk. A property with a healthy DSCR is considered lower risk than a high-levered property with a smaller DSCR. In the event of a recession, if rents drop, concessions increase and/or some tenants stop paying rent, properties with strong DSCR values are better positioned to weather the economic crisis. Even if rent collections dip 30 percent, for example, a property with a 1.5+ DSCR will have enough cash flow to continue making debt payments. Properties with a strong DSCR will be able to endure the crisis until, eventually, rent collections increase and property values once again rise.
Ultimately, LTV and DSCR are both valuable tools but if an investor were to place a greater emphasis on one versus the other, it should be a sponsor’s projected DSCR.
Understanding a Sponsor’s Approach to Leverage in a Transaction
As part of an investor’s due diligence process, they should consider how the sponsor is using borrowed money in the deal. The business plan for the acquisition may determine the amount of leverage the sponsor elects to take on, as may the sponsor’s track record and access to capital.
For a largely stabilized deal with little value add such as unit renovations or major operational improvements, a sponsor may elect to acquire the property using long term fixed rate debt, with leverage typically between 55% to 70%. Conversely, where the sponsor believes the property is significantly undervalued and plans to replace management and/or bring dated units to a higher upgraded spec (for instance by installing quartz countertops, stainless steel appliances and vinyl plank flooring) and upgrade the common area amenities such the clubhouse, the sponsor may elect to place short term floating rate bridge debt at a higher LTV, perform the work and bring rents to market and then place permanent debt at an LTV based on the now higher stabilized value. While that may seem riskier in the short term, the higher LTV upon acquisition is calculated based on the lower in place rents which is, according to the sponsor’s investment thesis, a temporary condition which will be corrected as part of the strategic improvement plan.
In some cases, though, the sponsor may take on significant leverage in a deal simply because they do not have the ability to raise enough capital to close at a more conservative LTV or because investors who have looked at the deal did not feel comfortable investing in it.
Before investing in a property, take the time to understand how the sponsor is leveraging the transaction– including how much leverage they plan to put on a property, the type of leverage they plan to use, and on what terms. Ask about their plan upon property stabilization: do they generally pursue a cash-out refinance of existing debt (such as by paying off a floating rate bridge loan and replacing with long term fixed rate debt at the stabilized (i.e.; higher) property value, or by putting on a second or “supplemental” loan in addition to the original fixed rate loan)? In the event of a refinance, what does the sponsor then do with the cash they take out upon refinance? Does this go back to investors? If so, how does the new debt service affect distributions to investors? As you can see, a sponsor’s approach to leverage directly impacts investors.
Why a Sponsor’s Approach to Leverage Matters to Investors
There are several reasons why a sponsor’s approach to leverage matters to investors, some of which we have already discussed above. Here are three additional ways in which a sponsor’s approach to leverage can impact a deal, and therefore, investors:
Determinative of Investor Returns
While leverage by definition introduces an incremental amount of risk to a transaction, intelligent use of leverage is one of the many differentiating benefits real estate offers investors. Borrowed money enables investors to diversify their capital (across several deals rather than just one) and improves the percentage return over an all-cash investment. As an example, assume a building is bought for $1,000,000 all cash. If it generates $50,000 cash flow per year, that’s a 5% return on equity. Conversely, if the investor puts in $400,000 in cash and borrows the balance of $600,000, that same $50,000 in annual cash flow is now a 12.5% return on the invested capital.
The type or terms of the debt the sponsor secures are also important in determining the returns of an investment. While long term fixed rate debt may reduce the risk of reduced cash flow if interest rates rise, on an acquisition with a substantial amount of value to be added, fixing the LTV at the going in valuation (i.e.; before the renovations have been done, the management team replaced, etc.), may not maximize the potential returns to investors. Placing a higher LTV (higher because of the lower going in cash flow and valuation) floating rate bridge loan on the property at acquisition, performing the required work over the next 18 months to 2 years and then refinancing may be a leverage strategy more suited to the business plan.
Preservation of Capital
Obviously, the more leverage, the higher the risk. The question becomes, how much leverage is prudent. A sponsor with experience underwriting deals should be able to generate reasonably accurate projections of income (including near and long term rent growth) and hopefully runs disaster sensitivity analysis to determine how much rents or occupancy would have drop before the debt could not be serviced. That enables an experienced sponsor to strike the appropriate balance between maximizing returns and minimizing risk. A sponsor with fewer rides at the rodeo may generate pro forma projections with less credibility than a more experienced sponsor.
Black Swan events, such as 9/11 or the COVID-19 pandemic, create unexpected economic shocks that impact nearly all sponsors to some degree. To be sure, no sponsor is adequately prepared for unexpected events like these, not even the nation’s largest sponsors like Blackstone. That is the very nature of a Black Swan event: nobody sees it coming. That said, a well-capitalized investment without excessive leverage (both LTV and high DSCR) will be better positioned to withstand a downturn and will be more likely to see their investments through to the other side once the economy recovers—which it always does, eventually.
At The Jacobson Company, we believe in taking a conservative approach to leverage. We strive to put no more than 65 to 70 percent debt on each deal that we do. We carefully consider not only the amount of debt we place on properties, but also the types of debt (fixed, floating, etc.). We lean on our mortgage broker and lender relationships to ensure we are getting great terms on debt as a way of maximizing the benefit for our equity investors. And we sweat the details when it comes to our underwriting, putting hundreds of hours into our research of the market, the property we are acquiring and making—and questioning—the most reasonable assumptions we can regarding our operating costs and rent growth potential.
If you’re interested in learning more about our approach to leverage, and why we feel like this approach provides extra value for our partners, contact us today.
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