Intro to real estate lending

March 24, 20155 min read
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brownstones-real-estate-lending At Yieldstreet you’ll be able to consider numerous real-estate investing opportunities. We work with loan originators who are experienced at evaluating real estate loans, and we consider a range of the offerings they bring to us. When Yieldstreet decides to go forward with an offering, the borrowers obtain the capital they seek to, for example, acquire or rehabilitate a property, and our investors have the opportunity to consider investing in those real estate opportunities. Our best opportunities often come from borrowers who are creditworthy and have solid collateral, yet may not fit neatly into the specific and stringent credit requirements of a bank loan. Real estate developers often face this situation when they attempt to borrow money to renovate or purchase property, simply because a bank officer may not have the time or expertise to investigate a property and accurately assess its value. These situations provide great opportunities for Yieldstreet investors. Our real estate lending offerings typically fall into two categories: hard money loans and mezzanine financing. Here’s how they work:

Hard money loans and hard money lenders

Hard money loans are backed by “hard” or tangible assets–like real estate! Hard money is used to finance properties for very brief periods—a few months to a few years–at interest rates that are higher than conventional property loans. Hard money can be used to renovate and flip a house, for example, or to buy a rental property until a mortgage can be put in place. A hard money lender will typically lend up to 65-70% of a property’s After Repaired Value (ARV), which is the amount it is expected to sell for after it has been renovated. Hard money lenders usually charge at least 10-15% interest, plus points–which are a percentage of the total loan. Hard money lenders are also in the “first lien position,” meaning that if the borrower runs into financial trouble, they are the first creditors in line to be paid if the borrower has to sell those tangible assets. Hard money loans can be structured in various ways: The borrower may not have to pay any interest or points until they sell a renovated house, for example, at which point they make one large payment to the lender for the loan principal, interest and points. Please note that all the numbers and values used here are strictly hypothetical and for illustrative purposes only. apartment-building-intro-to-real-estate-lending

Here’s how real estate financing works:

  • Jason puts in a bid on a foreclosed house for $50,000 that he plans to renovate and flip for an ARV of $120,000.
  • A hard money lender lends Jason $84,000, 70% of the property’s estimated ARV, at 14% interest and 3 points for six months. Jason will use the funds to buy and renovate the house.
  • Jason conducts the repairs and renovations on the house. The lender pays the repair and renovation bills directly from the loan as they are completed.
  • Jason sells the house for $120,000.
  • Jason pays the hard money lender $5,880 in interest, plus $2,520 in points (3% of the $84,000 loan) as well as the loan principal of $84,000.
  • Jason’s profit after paying back the hard money lender is $27,600.

Mezzanine financing

In architecture, a mezzanine is an intermediate floor that fills in a gap between two floors of a building. Mezzanine financing is what real estate operators and developers use to fill financing gaps. If a developer can raise most, but not all, of the money he needs to develop a property, for example, they may turn to mezzanine financing to obtain the rest. Mezzanine financing typically provides between 10-40% of a real estate project’s capital. Mezzanine loans are great opportunities for investors to earn attractive returns because these loans are short in duration (six months to two years), backed by strong collateral and charge high interest rates. Mezzanine loans are often collateralized by a development company’s stock, for example, instead of the property itself. Should the borrower default, the lender can seize the stock in just a few months, as opposed to foreclosing on the property to get its capital back, which can take longer. modern-housing-with-blue-sky-real-estate-lending-intro

Here’s how mezzanine financing works:

  • The owner of a small bakery in Cheryl’s rapidly gentrifying neighborhood is retiring. Cheryl wants to buy the business and turn it into a vegan bakery that will attract the local hipsters.
  • The bakery’s financial statements prove it earns $200,000 per year. The owner is willing to sell to Cheryl for $1 million.
  • Cheryl’s parents agree to lend her $600,000 at 8% per year.
  • Cheryl and her husband could scratch together the other $400,000 but it would put them under financial stress. Cheryl decides to lower her equity investment to $200,000 and approach a real estate lender for mezzanine financing to close the gap.
  • The mezzanine lender lends Cheryl $200,000 at 15% per year. This may seem like expensive debt for a new business owner to take on, but bear in mind that at the standard corporate tax rate of 35%, her pre-tax interest rate of 15% is only 9.75% after taxes are calculated.
Now let’s check out the surprisingly positive impact mezzanine financing has on her rate of return. Scenario A: Cheryl buys the bakery with $600,000 debt at 8% from her parents + $400,000 equity.
Bakery revenue $200,000
Interest Expense -$48,000
Pretax income $152,000
After-tax income @ 35% tax rate $98,800
Annual return on Cheryl’s $400,000 equity investment 24.7%
Scenario B: Cheryl buys the bakery with $600,000 debt at 8% from her parents + $200,000 equity + $200,000 mezzanine loan at 15%.
Bakery revenue $200,000
Interest Expense -$78,000
Pretax income $122,000
After-tax income @ 35% tax rate $79,300
Annual return on Chery’s $200,000 equity investment 39.7%
By using a mezzanine loan, Cheryl’s after-tax profits fall from $98,800 to $79,300. But because she cut her equity investment in half (from $400,000 to $200,000), her return on her equity rises from 24.7% to 39.7% per year. Not too shabby!
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