How to Reduce Exposure to Risk in Trust Deed Investments from Volatile Real Estate Prices

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How to Reduce Exposure to Risk in Trust Deed Investments from Volatile Real Estate Prices

This post is in retort to a recent article written by Alex Pollock entitled ‘Commercial’ Bank Is Misnomer. ‘Real Estate’ Bank Is More Apt exposing the systemic risk present in our commercial banking system, and my observations as to how a trust deed investor can avoid the next bump.

The take-away here reinforces the importance of sound underwriting and how Trust Deed Investors can hedge their investments secured by real estate with conservative valuations and low loan-to-values.

Mr. Pollock’s article discusses the evolution of the banking system from being principally business banks to being principally real estate banks and its exposure to a higher risk of failure due to a disproportionate ratio in real estate assets on its balance sheet, which are vulnerable to volatile real estate prices.

Trust Deed Investing Elements of Property Valuation: Property concept diagram hand drawing on blackboard

So, why are a banks real estate loans so susceptible to real estate price fluctuations? I believe it’s because banks tend to ‘overvalue’ the real estate and lend at too high a loan-to-value.

 

Loan-To-Value

A Loan-To-Value Ratio, (‘LTV’) is simply the ratio of the total loan amount borrowed in relation to the value of the property. Different banks have different LTV requirements. This is driven by regulators, internal policies and property type.

Typically, banks cap LTV Ratios for commercial real estate loans at 75% or 80% and some have developed non-conforming commercial loan programs that provide 90% LTV. In contrast hard money generally lends at LTV’s of 60% to 65%.

LTV and Risk

As an example of LTV, let’s look at a recent loan submission we received with a bank appraisal. The borrower was seeking a second trust deed of $100,000, behind an existing SBA first of $492,000. Using the banks appraised value of $900,000, the combined loan-to-value (‘CLTV’) was 66%. Using an internally calculated market value of $645,000, we figured the combined loan-to-value at 92%. On a side note, the maximum CLTV we would have considered on this transaction would have been 50%.

In my opinion had the bank made their loan, they would have over-leveraged the property.

Valuation

A critical issue with the loan to value ratio is how a lender determines value. Value (on income producing real estate) is derived primarily upon an appraisal method know as the income approach. This method converts the income of a property into an estimate of its value – if the property were bought with all cash. Without getting into detail on its mechanics, let’s just fast forward to a key component in this method, known as the Capitalization Rate or Cap Rate for short.

The cap rate varies per market and property type and is calculated using a non-complex formula, R=I/V, where I is the net operating income and V is the value of the property.

The cap rate assigned is somewhat arbitrary, and is more art than science.

The banks rely more on science or a market extracted cap rate by using other properties’ operating income and recent sold prices and evaluating the financial data of similar properties which have recently sold in a specific market.

At Hanover MC, we rely more on art or Intuition. I’ll explain.  One way to think about the cap rate intuitively is the return on investment you want and what the property is worth in a liquidation event – what will the market bare.

Valuation and Risk

As an example of Art vs. Science, let’s use the same bank appraisal referenced in the earlier LTV example. The appraised value of the property was $900,000 using a cap rate of 6.5. The property was special purpose, owner-user, legal, non-conforming with hazardous material use on two adjoining parcels with separate APNs and limited marketability. In our opinion we needed to consider an appropriate annual ROI. After our own market research, verification of existing expenses and analysis, we assigned a cap rate of 9, thus deriving a lower market value of $645,000.

In my opinion the bank had overvalued the property.

Conclusion

Risk tied to volatile real estate prices is mitigated by a number of factors, but largely reduced when the valuation of the property is market based and the loan-to-value ratio is conservative – a staple in Trust Deed Investing.

By |2017-03-08T20:03:30+00:00August 14th, 2016|Categories: Trust Deeds|0 Comments

About the Author:

G. David Lapin is the president and Broker of Record of HanoverMC, a private money lending and trust deed investment firm located in Orange County, California and is an author and speaker on the topic of private money lending and trust deed investing. Lapin was most recently featured in Robert Irwin’s book “Armchair Real Estate Investor” and hosted his own radio show “The Hard Money Hour”. Lapin's professional career in real estate encompasses 30 years of entrepreneurial experience in both the commercial and residential sectors, bridging property management, development, construction, investment sales and finance including residential mortgage banking and brokerage - originating, processing and closing 5,000 + purchase & refinance transactions, and the underwriting and funding of private money transactions.

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