Determining Interest Rates
The first question most clients ask, “What is your interest rate?” The question is a good one, but we believe it should come at the end of the conversation rather than at the beginning.
Investment property loans are quite different than primary residence loans. With primary residence loans, the mortgage world uses the concept of “conforming” loans, meaning that loans can be sold into a government-supported program, where most borrowers are lumped into the same large “bucket”. Most mortgage officers simply quote the standard interest rate for the “bucket”, with 30-year conforming being the most common. Primary residence lenders have very little leeway to offer flexibility to clients whose needs do not match the guidelines. On the other hand, investment property lenders rarely use the “bucket” system. Each loan is looked at individually. Each interest rate is specific to the loan. Investment property lenders and their clients understand that there are other concerns (such as length of time to close or length of term) that may make the interest rate a lower priority.
Lenders prioritize different aspects of the loan profile when determining interest rates. Like all good lenders, at Stronghill Capital, we think about risk first. Though no one begins a lending contract thinking about having to foreclose on a property, it is acting responsibly to consider what we could recover if we had to foreclose on a property in the worst possible conditions. This leads to the following, in rough order of priority:
- Loan-to-value (LTV) and spread of the loan
- Location of the property
- Type of property
- Condition of property
- Occupancy of property
- Credit history of borrower
Loan-to-Value Ratio (LTV) and Spread
As discussed in Loan Structures, LTV is the most important measure of risk for a loan. It measures the amount borrowed relative to the property value. A closely related concept is “spread”, which measures the dollar difference between the value of the property and the loan size.
- A $50,000 loan on a $100,000 property has an LTV of 50% ($50,000/$100,000) and a spread of $50,000 ($100,000-$50,000).
- A $300,000 loan on a $500,000 property has a higher 60% LTV ($300,000/$500,000), but also has a higher cushion with $200,000 of spread ($500,000-$300,000).
All else being equal, we charge higher interest rates as LTVs increase and as spreads decrease.
Location, location, location. Very overused, but very true. A decent house in the nicest neighborhoods of Dallas is always likely to have reasonable value even during a downturn. The same house a couple hundred miles west in the middle of boom-and-bust oil country may be almost impossible to sell during an oil downturn but would be worth a fortune at the peak. The same house moved to a dangerous neighborhood in decay would be nearly impossible to sell at any price.
Thus, the better the location, the more willing we are to make the loan, and the better the interest rate offered.
Type of Property
We typically group properties into one of four risk categories:
- Investment residential and prime retail/office space
- Warehouse, mixed use, and non-prime retail
- Industrial and special use
- Vacant land
These group rankings reflect how quickly the properties could be sold or rented in the unfortunate event that we have to foreclose. We make very limited numbers of loans against vacant land because these properties decline the most during economic downturns.
A lower group number equates to a lower interest rate.
Condition of the Property
It surprises many that the condition of the property falls this low on our list. It is important, but as long as the buildings are structurally sound, cosmetics are not so difficult to improve. We care most about the quality of the roof. Water damaged properties are rarely salvageable. We then consider how the condition of the property impacts the ability of the property to be usable. An office building with collapsing ceilings is unlikely to attract new tenants.
Not surprisingly, the better the condition, the lower the interest rate.
Occupancy may be rented, owner-occupied, or vacant (or some combination). We prefer rented because there are immediate cash flows if we ever had to foreclose. However, we commonly make loans for owner-occupied commercial buildings (we do not loan against owner-occupied residential) and vacant properties because these properties are difficult to finance through traditional banks.
Rented properties receive the best interest rates.
Clients often ask why we care about credit history at all when we are primarily loaning against the value of the property. We care because we hate having to foreclose on people. It makes us feel bad and we have almost no financial upside because the property gets sold at auction to pay us off. Additionally, a bankruptcy filing often stops us from receiving payments for many months. The credit history helps us determine the likelihood that we would need to foreclose or that the borrower might declare bankruptcy.
We almost never reject loans based on credit history. Still, an especially strong borrower may improve the interest rate we quote.
Some have termed us a “story” lender. We want to know the whole story behind the loan before we make it, before we even give you the terms. This is how banking used to work and how we believe it should work. We align our interests with those of our client so that we can all prosper.
Sometimes, our interest rate is a bit higher than going through a bank. Often, it means that we can lend money to borrowers with a dream, borrowers who want to grow, and borrowers who make our economy work in a non-conventional way. As a company, we are in business to make money, of course, but as individuals, we work here because we thrive on helping borrowers succeed.