[00:00:00] Speaker A: Welcome, listeners. You're listening to the Deeds in the Desert, where real estate investors tune in for the latest news.
[00:00:08] Speaker B: Welcome back to this week's episode of Deeds in the Desert, where we'll be concluding our Dirt to Door series.
And if you missed episode one or two, please make sure to find it in the description.
Now let's get ready to wrap this show up where we're going to finalize the design, the construction, and that exit strategy.
[00:00:30] Speaker C: So what goes into design? Designing a commercial space that works in the real world and not just on paper.
[00:00:38] Speaker D: That's, you know, it comes down to kind of two things. We talk about our business being a bit science and a bit art. The science is purely numbers. What makes the most sense. The art is something a certain je ne sais quoi that people add to it. There's special sauce, so to speak, that really changes things around.
What usually makes most sense is most sense is to build the biggest thing possible. Yeah, right. You're. If you are making $10,000 on a house, if you sell more houses, you're going to make more money. So we want to sell as many as we can. And if we're selling them at $100 per square foot, we want bigger houses because we can sell them for more. But that's not always what the market wants and that's not always what will be best for that community. And that's where the art comes in. And so there's a real balance between the number geeks and architects and designers as to what makes a good project.
And what truly makes a good project standpoint is the harmonization of those two aspects. Getting a big product but still designing it well. So you can't have just big boxes out there. Yeah, that does, Max.
Yeah. They have to be desirable and it has to be something people can afford. And because of those two aspects, there's a certain life cycle that these two groups need to go through to really work together.
[00:01:59] Speaker C: They have to synergize.
[00:02:00] Speaker D: Absolutely. Yeah. That symbiotic relationship has to be well in place and performing to the best of its ability in order to maximize that profitability of the project overall.
[00:02:13] Speaker C: Where have you seen that work best?
Maybe without naming names, or maybe you want to name names. I don't know.
What borrowing entity have you seen just hit it out of the park when it comes to stuff like that, it's.
[00:02:25] Speaker D: Hard to say without just looking at outcomes. So when you look at outcomes and see that they made a lot of money, you can say that project worked. Right. But what you don't know is that that government contract was renewed and it brought in the amount of employees.
[00:02:40] Speaker C: Of course it worked.
[00:02:41] Speaker D: So of course it worked. Didn't matter what they did. So it's hard to really say, but from my standpoint, where it makes the most sense and where it matters the most is in the home building side. Because your place to live is something more than just a financial standpoint. When you walk into it, it's more emotional than anything. When you walk in that front door, 90% of the sales happen right then and there, regardless of what happens else.
[00:03:06] Speaker C: Yeah.
[00:03:06] Speaker D: When they walk in the door, they have that feeling. Can they envision where their couch is?
And if you don't have that, then I don't care how much you built the house for. It doesn't matter.
[00:03:17] Speaker C: You know what is making me laugh right now? You see me smiling, and you're gonna know as soon as I say it.
It's even before you walk in the door.
We have gone to some projects, and I'm like, for the love of God, why didn't they at least plant a tree? Or the curb appeal was just off. It felt like a prison. And I asked you, why would people buy this?
And because the cost is low. And I'm like, okay, there's a market for everybody.
[00:03:47] Speaker D: Sure.
[00:03:48] Speaker C: But it just turned me off. And we've walked into houses before. We're like, yeah, why did they configure it this way? You know, so it does matter. That emotion is huge.
[00:03:58] Speaker D: Huge. The curb appeal, that. That sense of home. Because it is a very emotional decision. On the home buying side, it is more important than the commercial side to make it aesthetically pleasing.
[00:04:08] Speaker C: Yeah.
[00:04:09] Speaker D: On top of cost maximization.
[00:04:12] Speaker C: Yeah, that's pretty wild. So does matter.
[00:04:15] Speaker D: It does matter. I'm not the best designer out there. I think a shaved head looks best. Others say no. So, you know, who knows?
[00:04:23] Speaker C: What are some common construction issues? You have seen that you're like.
You just. You have to take a step back and go, why did they do that?
What have you seen where you're just perplexed by it? They've already received the funding from us. You know, we had already, you know, agreed to a budget, and then they build something. You're like, why? Because things change mid process.
Maybe the intent of the project was for it to be a shopping mall, and it ended up being multifamily, a storage unit facility and a Taco Bell.
Like, what happens during that construction phase? That you're just like, why did we have to switch gears? Why did we switch gears? Did it make sense?
Did it work out?
Because what we put out there on the investment overview is the intent.
But sometimes it changes.
[00:05:17] Speaker D: It does.
[00:05:18] Speaker C: Design and construction, you have to, you have to be a little bit nimble with that.
[00:05:22] Speaker D: Yeah. And a lot of times it changes because of borrower or, excuse me, buyer perspectives, what they want involved in a project. For example, if we're lending on a retail strip center, there's going to be four units and they are going to build out the TI's for everybody that comes in. The TI's may change because the use of that property changes. If you have a pet store that now is a bar, their ti's are gonna be a little different. And the configuration of that space may already be set in stone. Maybe they already put in the walls between them.
Maybe the front door is already put in place and they can't reconfigure it. And so they have to adapt.
And so when there has been it leads to a lot of design questions like why the biggest issue with construction defects really comes on the back end. There's been a lot of litigation that has happened where construction defects can be done in a class action lawsuit. Meaning if you have a defect, let's say a borrower is building a 20 unit townhome project. They're all attached walls and they all have an issue associated with it.
Previously, class action lawsuit lawsuits allowed all those unit, all those individual owners to join one lawsuit for any type of defect associated with it and go after the developer. Therefore, the, the warranties became very expensive.
Not only did they can go after the, the borrower directly.
[00:07:00] Speaker C: Yep.
[00:07:00] Speaker D: But the warranty company as well. And so there was a lot of attorneys that specialized in this, which was just calling up owners and saying, hey, do you have a leaky faucet? Oh great, there's a warranty. Let's go after it.
There's been a lot of changes to that. So now you can still have class action lawsuits. This is not a way to protect developers or make them immune for any liability that they may have. But it has to be done in a systematic way. So you can't say you have different construction issues. You have to say they're all the same. And it was something that the developer did, whether that was negligence or misinformation or improper implementation, implementation on that project that led to a warranty issue. If that criteria is met, then you can go after class action lawsuit. Because of those limitations that have been put in place, the number of lawsuits has declined. Precipitously which has allowed developers to go back into attached products where they otherwise wouldn't because of that elevated risk level. So the construction defects on the back side of the project is where I have seen the most issues when it comes to the construction process.
[00:08:14] Speaker C: So part of our process, when we're going through the underwriting process and before we commit to a borrower is we agree on the construction costs and timeframe.
How much do you see that change and evolve throughout that construction cycle every time?
[00:08:33] Speaker D: That's the simple answer. The more detailed answer is we'll always have slush in there. It's usually in the form of overruns or overhead or developer fee. There'll be a line item for one of those three categories, or in some cases, a small item for all three of those categories that are used to be implemented for overruns on a different category.
Although we do agree to a budget beforehand, before we even fund that first dollar, there are changes that come into play. And because of those extra line items, they can draw on those. So if tariffs go into place, if there's high inflation, if there's design changes by tenants or by the developer themselves, those can be implemented without going over budget because of those slush funds.
[00:09:19] Speaker C: Okay.
Have you ever seen where borrowers, you know, utilize the entire budget and still are unable to complete the project?
What happens at that point? Are they going out and get financing someplace else?
Are we refinancing the loans that we can continue?
How do you view that? Let's say tariffs do start having an impact. Let's say we start to see an increase in, you know, certain segments, steel, lumber, whatever it happens to be. What will we do? How will we react? How do we react right now?
[00:09:51] Speaker D: Yeah, we. If the money is run out and run dry on the project, we will typically refinance it with the caveat of we will not refinance a project if it is just to get our original loan paid off. It has to be able to stand its own two feet. If it's still a good loan on that refinance, we will absolutely do it. If it's not, we won't throw good money after bad.
And so if there is a deficiency, then it's up to the borrower to figure out whether that is an infusion of capital via equity, an infusion of capital via additional debt, or refinance on that.
And so that is really kind of the most important part of that capital stack and how it needs to be allocated.
[00:10:35] Speaker C: Yeah, makes sense. Makes sense. And that goes kind of back to our nimble aspect. Right. We need to make sure that we are, we're thinking like them, we're helping them out. Like, we don't, we don't want to be douchebags. Right.
And we're not going to blow up a deal or create an environment where they can't make interest payments or they don't want to anymore or it impedes our relationship in the future. Like, we are here to help get through that process. But, you know, it does have to stand on its own two feet and we're not, we're not putting the good, the bad after the good.
So, yeah, we refinance quite a bit here.
Why, why are we refinancing a lot of loans? Why do we do that?
[00:11:22] Speaker D: Because of the arbitrary nature of the term on our loans. Right now our average loan is a nine month loan with a nine month extension, total of 18 months. As we talked about on the onset of this podcast, the average life cycle of a project is over two and a half years. Well, two and a half years is more than 18 months.
[00:11:41] Speaker C: Yeah.
[00:11:41] Speaker D: So. And for the most part, when we go into a loan, we know if it's going to be needing a refinance in the end or not.
And so, yes, we do a lot of loans that are being refinanced. That doesn't mean there's been cost overruns. There doesn't mean there's been slowdowns in the development or entitlement of the project. It simply means it was going to take longer.
[00:11:59] Speaker C: We're on to the next phase.
[00:12:01] Speaker D: Yeah, yeah. And so we do, you know, half of our loans are being refinanced not because of cost overruns or delays, but simply because that was the intent all along. If we were to change our loan term to what we anticipate that project needing, then there wouldn't be.
[00:12:17] Speaker C: Yeah, but we also want to allow investors an opportunity to get out.
[00:12:21] Speaker D: Absolutely.
[00:12:21] Speaker C: We weren't intending this to be long term for them and it's not long term for the borrowers. So, you know, we try to strike a balance between both of those things. So a lot of times it's just, you know, you have to have an opening.
[00:12:34] Speaker D: Yes.
[00:12:34] Speaker C: You have to open that up for, to allow investors, you know, should they need the funds for something else, or maybe they want to change the portfolio that they intend to have for the future. Maybe they don't want to be in a certain class anymore. This gives them an opportunity to move around as well. That's why they get to choose.
[00:12:53] Speaker D: Absolutely.
[00:12:54] Speaker C: And so something that we Kind of stand behind.
[00:12:56] Speaker D: Yes.
[00:12:57] Speaker C: All right, home stretch. Guess what?
[00:13:00] Speaker D: What is it?
[00:13:00] Speaker C: The exit strategy.
Here we go.
[00:13:04] Speaker D: So.
[00:13:06] Speaker C: So every one of our investment overviews has an exit strategy.
How many times does that exit strategy play out to a T0.
Everybody wants to know how am I going to get my money back?
[00:13:19] Speaker D: But yes, how are they going to.
[00:13:21] Speaker C: Get their money back?
[00:13:22] Speaker D: Well, the simple answer is through the sale or refinance of the property.
In the most basic terms, those are the two outcomes. There's a third outcome that is less favorable and that's through foreclosure. Those are kind of the three ways a lender or investors get their money back.
Two of those are positive aspects, the sale or refinance. And before going into the asset or into the loan, we will know what the borrower's intent is. But that doesn't mean that's what's going to happen. What we usually do is we build into our loans a way for the borrower to be able to pay off the loan via sale or the refinance.
Typically when a hard money lender will lend, the only way for a borrower to get out of it is through the sale of the property because the loan to values are simply too high to be refinanced on the back end. We want to make sure that there is enough equity built up in this project that the borrower will not need to bring additional capital to the table to get the refinance put in place.
If done properly, they will have 2x strategies. The sale or refinance of the property without getting into the third option, foreclosure.
[00:14:29] Speaker C: What do you see utilize as an exit strategy more? Is it refinance or is it sale?
[00:14:36] Speaker D: Well, it depends on the. The asset class. Right, the residential asset class. It's mostly on the sale of the property. That's what they do. They build houses for people to buy and ultimately sell them to those home buyers. Yeah, on the commercial side it's more of a coin flip.
And that does change not only from a borrower to borrower perspective, but on a project by project basis. We've had borrowers change what states they want to hold in. Maybe they want to divest out of certain areas. So ones they anticipated being a portfolio piece, they turn into a merchant builder and just sell it off. Others, the rents increase so much that they, they want to hold on to it. Their cost base is so low they don't want the income, they'll just hold on to a low cost basis and just collect that reoccurring revenue. Into perpetuity. And so that does change for the positive and negative throughout the life cycle of the project. More so on the commercial side than on the residential side.
[00:15:32] Speaker C: I could see that.
[00:15:32] Speaker D: But even on the residential side, you know, over the past four years we've seen a huge uptick in BTR build to rent product. For the first time in the history of the United States, we've had more product being built that is intended to be rented than intended to be sold. We have never had that happen before just a few years ago.
So that really changes how borrowers are going about it. What we want to do is make sure that it's not pigeonholed into one area where they didn't subdivide the property and therefore they can't sell them off into individual units or they didn't individually meter the units and therefore they can't sell off the unit without selling off the building. In some cases it's required by municipalities to be done that way. But where it's not and where we have the ability to, we will really put our foot down and say no, you need to spend these extra costs to give yourself a two pronged approach on the sale. Yeah, you can sell the whole building or now you can actually sell individual units. And we don't know what's going to be more profit. You don't know what's going to be more profitable when the project's all said and done. But now you can monetize it two different ways.
[00:16:42] Speaker C: So let's talk about that for just a second. Because an exit strategy could be one sided if we allow it to be.
I think you know where I'm headed. So if there's a project that, you know, strip malls are probably the best example because they have the ancillary pieces and those can be very valuable, Even more valuable than the entire project itself.
How do you make sure that the borrower doesn't walk away with those valuable pieces sold off, pocket it and then we're left with the bag. How do we make sure that we balance that? Or can we.
[00:17:21] Speaker D: Yes, we can balance that out and we do it through accelerated pay downs. We require more to be paid off on a per unit basis than is required by the loan. So if you had 10 units on a $10, we gave a 10, $10 loan for 10 units. So $1 per loan. When they sell off one loan they have to pay us back $1 and by the end they will be paid off in full. Well, what if we require them to pay back a dollar and ten cents every time they pay off a loan. You know, once they come down to the end, they'll own those last ones free and clear.
Some borrowers use that to hold on to those last ones and hold them in their portfolio into perpetuity. Others will simply use it a way for them to pay less interest and use it just as a requirement of the lender to pay down that loan in an accelerated fashion. But what it really does is twofold. One, it pays it down quicker for the borrowers. They pay less in interest, which means the project costs less, which means the equity that they have in increases. From the lender, from the investor's perspective, the loan to value decreases with each sale of a unit. So we have some investors that look at the tranche loans and try to plan things out based on that. We have others that look at it on how many units have been sold.
[00:18:40] Speaker C: Yeah.
[00:18:40] Speaker D: What was the pay down schedule associated with it? Was it at par or was it accelerated? This is accelerated. How much? And now if I know how much it was accelerated and how many it's been paid off, we can figure out how much that LTV has decreased.
And in some of our deals it goes down substantially. This last deal that just paid off last week, we advertised it at a 68% loan to value. By the last tranche it was down to four.
[00:19:06] Speaker C: Yeah.
[00:19:06] Speaker D: Four percent.
[00:19:07] Speaker C: Yeah.
[00:19:08] Speaker D: What are the chances a borrower is going to default on a 4% loan?
[00:19:11] Speaker C: Not happening. Yeah.
[00:19:12] Speaker D: Close to zero. Yeah. You can't say never in this world.
[00:19:15] Speaker C: And even throughout the duration of that loan, it becomes less likely and less likely and less likely and less likely. Yeah.
[00:19:20] Speaker D: So once you get that first unit to sell, everybody, all of investors should be breathing a sigh of relief because we do it internally and every unit that comes in thereafter is just reduces the risk.
But what better way to have an investment that reduces the risk along the way? But your rate of return stays the same.
[00:19:40] Speaker C: Yeah.
[00:19:40] Speaker D: So the risk goes down, but your reward stays the same. Come on.
[00:19:44] Speaker C: It kind of goes up.
[00:19:45] Speaker D: If you really think about it, the risk reward does.
[00:19:47] Speaker C: Absolutely, Absolutely. Interesting. Okay. As far as, you know, selling the assets or selling them outright, do you find that sometimes it puts us in a situation where the borrower needs time outside of their original loan terms?
[00:20:04] Speaker D: Yes. And we've seen it more happen during COVID and Post Covid than any other time in our history. And from what I've researched, any time ever. Ever. Yeah. The construction delays have been no joke. It has really bitten every borrower that we have and really as the industry as a whole.
So there, there's this adage of extend and pretend. There's, there's a lot of lenders that just extend loans to pretend that there's not an issue with them. But for ours, when we extend a loan, it is for a specific reason. And usually that specific reason is to give the borrower time for one of two things to get it sold. It's already under contract and the borrower, the buyer needed an additional two months of due diligence or whatever the case may be, or number two, that they just need a little bit more time to finish the project because of construction delays.
So if we know specifically why they need it, we will extend the loan. Whether, if the loan has it, it'll just be a normal extension. If it is outside of the loan terms, then we ballot it to investors. We'll let the investors know what the borrowers have requested and kind of lay it out for them as to the pros and cons of each.
And it'll be fairly evident what that best decision should be on whether or not to allow the borrower to extend and pretend or to call the bluff.
[00:21:27] Speaker C: Well, Patrick, we can go down the default rabbit hole if we want, but I'm pretty sure we have a four part series on that on our website.
So if they want to listen to that and they want to hear about what we do as it pertains to defaults, I'm going to leave that for the four part series that we've already done because I think we've covered a life cycle here.
We've taken it from dirt to the door.
It took us a little bit longer, but I think the segmenting aspect of that might be good for individuals to hear and for our borrowers, maybe sometimes our borrowers listen to these podcasts as well. So if you're listening, thank you. But from, from an investor perspective, I think this helps them definitely. I hope this helps them kind of break some of this stuff down. So I appreciate you spending.
How long did we spend?
[00:22:17] Speaker D: Seems like about four and a half minutes. Was that about right?
[00:22:19] Speaker C: Wow. Yeah. Four and a half minutes. Yeah.
[00:22:21] Speaker D: Time flies when you're having fun.
[00:22:22] Speaker C: I mean, it's been 15 years, so I mean, what's another 15 minutes?
[00:22:25] Speaker D: What's a little less hair?
[00:22:27] Speaker C: Who.
Don't blame that on me.
[00:22:29] Speaker D: Sorry. Your fault.
[00:22:31] Speaker C: Is it my fault?
[00:22:32] Speaker D: It really is. Yes, no doubt.
[00:22:35] Speaker C: From dirt to a bald head.
We're out of here. Deeds in the desert is Carrie Cook. Pat Vassar here. Thank you so much for joining us. We'll see you next time.
[00:22:45] Speaker D: Thank you.
[00:22:48] Speaker A: Thanks for joining us this week on Deeds in the Desert, where short term investments meet long term investors. We hope you enjoyed the content so much that you share it with all your friends. Who doesn't like learning about passive fixed income, right?
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