Demonstrations in Optionality: Real Estate

Building optionality into a portfolio is key to generating solid returns while limiting drawdown risk.  Obviously this sounds very attractive, but remember that there is always a cost to these options.  Understanding what the costs are and finding the least costly and most efficient way to gain access to these options is important.

Real estate allows for one of the more natural ways to gain optionality: a loan.  When a lender gives a loan on a property, they are implicitly agreeing to buy the building at the loan value.  For example, if you buy a $2 million building, put $500,000 down, and have a $1.5 million loan, then if the building drops in value below $1.5 million, you can simply mail in the keys and wish the bank good luck.  Granted, you’ll be out your $500,000, but that’s the point of optionality.  Imagine if the bottom fell out of the real estate market and your building dropped in value from $2 million to $1 million.  If you had a loan, you would only lose the $500,000 and the bank takes the loss on the other $500,000.  If you had purchased the building for cash, you’d be out the full $1 million loss.

Generally speaking, loans do not participate on the upside while participating on the downside.  If the building increases in value from $2 million to $3 million, then the investor earns all $1 million in gains, while the lender maintains their $1.5 million in loan value.  Their loan-to-value (LTV) has dropped substantially and has hence become a much safer loan, but they do not earn a share of the $1 million gain.

Recourse vs. Non-Recourse Debt

Central to all optionality is the difference between recourse and non-recourse debt.   This is especially true for private investments such as real estate or private equity, where investments are generally held in a limited partnership or an LLC.  For a recourse loan, a lender receives a personal guarantee from the principal investor or several individual investors.  In the event that a loan cannot be satisfied (either at maturity, or upon sale before the end of the term), a lender has a right to go after the bulk of the assets owned by the guarantor(s).  In effect, if you have a recourse loan, you have a personal loan that must be thought of as a personal liability.

For a non-recourse loan, the lender only has the ability to go after the asset that the loan is collateralized against.  For example, if you hold a single industrial warehouse in an LLC and receive a non-recourse loan, the lender can only go after the warehouse in order to fulfill the loan obligations.  If you default on the loan, there is no recourse to your personal assets, or any assets outside of the LLC.  Non-recourse loans come with a cost.  They are, after all, riskier loans for the lender.

Non-recourse loans tend to have the following characteristics:

  1. They generally must be larger loans. You likely cannot get a non-recourse loan on a $500,000 building.  Banks and other lenders would like to see more money put out on the loan, so a building must be worth a few million or more to justify the additional work needed to close the loan.
  2. Recourse loans will be flexible with terms, whereas non-recourse loans are generally take it or leave it. There is limited ability to tweak maturity dates, prepayment rights, interest rate, or amount and type of collateral.
  3. The LTV will be lower. For recourse loans, even investment properties can generally receive 75-80% loan to value.  For a non-recourse loan, 65-70% on the high end is more common.
  4. Interest costs will be higher for a non-recourse loan. Expect to pay .5-1.0% higher for rates on non-recourse loans.
  5. The lender will impose cash flow and other operational restrictions. The lender’s only recourse is to the asset, so they will want to ensure that there are proper funds to maintain and run the property smoothly.
  6. Non-recourse lenders may look to “cross-collateralize” against other assets that you own. Be very careful here, as a cross-collateralized non-recourse loan begins to look a lot like a recourse loan.
  7. Non-recourse lenders will also include “bad boy” provisions, which convert a non-recourse loan into a recourse loan in the event of fraud or other unethical activities.

I cannot stress this enough: you must seek non-recourse debt in your portfolio.  This is a core tenet to building true optionality in a portfolio.  If you’ve taken on recourse debt in an investment, you may be acting in a penny wise, pound foolish manner.  You own a recourse loan personally, so there is no ability to build in positive optionality.

Real Estate Optionality Example

To demonstrate the optionality built into a non-recourse private real estate transaction, let’s use an example of a mid-sized multifamily apartment complex.  Let’s call it Meadow Grove Apartments (apartment complexes always have nice sounding names like that) set in a lovely inner ring suburb of a major metropolitan area.

Meadow Grove was purchased with a net operating income (NOI) of $200,000 per year.  Net operating income is simply the property’s revenue (rents and fees) less operating expenses, but without regard to financing costs.  The idea behind NOI is to provide a common metric to compare buildings without having to factor in how it is financed (buildings can be bought for cash, or any combination of debt and equity).  The capitalization rate (cap rate) of the inner ring suburbs in this metro area is currently 8%.  Cap rate is just the NOI divided by the property value, so the inverse of the cap rate is the multiple paid for NOI.  For an 8% cap rate, the multiplier is 12.5, so the building is purchased for $2.5 million ($200k * 12.5).

Our investor was smart and used a single-asset LLC to purchase the building with 30% down and non-recourse debt for 70%.  The debt is a 5 year loan with a 25 year amortization period, pre-payable without penalty after year two.  The investor puts down $750,000 and borrows $1.75 million.  The payoff profile of the building (ignoring any potential net income earned) looks like this:

The vertical axis represents the profit and loss while the horizontal axis represents the overall building value.  While it’s difficult to see, the red line representing the equity investor is the same as the blue line at the point where the two intersect and increases one for one above the loan value of $1.75 million.  For those familiar with option payoff charts, the red line should look familiar.  It’s a call option payoff, which means limited downside and unlimited upside.  This is the type of optionality we’re looking to build.  A portfolio of these types of option payoffs on multiple assets would be nirvana, assuming the options were purchased at a reasonable cost.

Alternatively, the lender has sold the investor an out-of-the-money put option.  This means the lender has limited upside and can lose their total investment on the downside.  This chart is technically not 100% accurate, as the lender is still making money on the interest payments and fees (why else would they write a loan?).  However, as it relates to the price of Meadow Grove, this chart should suffice.

How to Maximize Optionality: The Refinance

Now let’s say that you’ve worked exceptionally hard over the following two years and have been able to increase NOI by 30%, to $260,000 per year.  Let’s also say that the market has improved a bit, and prevailing cap rates are 7.25% instead of 8%.  Your multiple of NOI has increased such that a new buyer is willing to pay 13.8 times NOI instead of the 12.5 times NOI that you paid.  Meadow Grove Apartments has increased in value from $2.5 million to nearly $3.6 million ($260k * 13.8).  Nice work!

The investor in this building really likes the property, and sees it as a nice asset to use for intergeneration wealth transfer down the road.  However, there are other interesting things to invest in and they want to take some money off the table.  They go back to their lender, who is still willing to advance them a loan equal to 70% of the market value of the property.  At $3.6 million, the lender writes a loan equal to $2.5 million.  Does this number look familiar?  It should, it’s the initial purchase price.

The investor is able to pull out all of the $750,000 they initially put down.  They also still have an equity value in the property of over $1 million because it’s increased in value.  Assuming the second loan is still a non-recourse loan, the new payoff diagram looks like this:

Again, the vertical axis represents the profit and loss, while the horizontal axis represents the building value.  The investor now has an option on all of the upside of the building, along with a current equity buffer of over $1 million, with no cost basis in the building at all.  This is how talented real estate investors are able to earn outsized returns and continue to build generational wealth.  Buy a good asset at a great price, improve operations and hope the market helps you along the way, refinance and pull out your cost basis, and hold a “free” option to the upside.  Lather, rinse, repeat.

Simple Formula, Tough Execution

On paper, this seems so easy.  Find a good value-add real estate deal, improve operations and maybe play the real estate cycle a bit to your advantage.  In practice, this is incredibly challenging.  The best deals tend to be found by the most active investors.  If you’re a real estate broker, why work with a small, first time investor, when you can have near certainty of close with an experienced, high bankable investor.

When you see large investors get in trouble, it generally has to do with poor leverage structuring.  At some point, banks and other lenders become nervous and begin to ask for better terms, such as a lower LTV or more collateral, to make a loan.  Large investors generally do not give personal recourse loans (although some do), but lenders may ask to cross-collateralize against other assets.  This is another form of recourse: recourse against other assets with equity.  One project fails and it causes a cascading impact to an entire real estate portfolio.

The best advice is this: resist the temptation.  Use leverage cautiously but effectively.  Structure on the debt portion of the deal is often just as important, if not more so, than structure on the asset side of the deal.  When lenders get nervous and begin to ask for recourse, slow down and take some money off the table.  Build a portfolio of single assets with non-recourse, non-cross collateralized debt and build optionality to the upside.  Use these assets to transfer wealth among generations.

Keep building my friends.

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