Episode Transcript
[00:00:00] Speaker A: Really starting off, you want to ask, well, what is inflation actually really directing directly impacting in real estate? And I would say the two biggest things are property valuation and the exit strategy associated with those properties. So we'll dig into all those in just a second. But those are really the kind of the high level ideas behind it, right Pat?
[00:00:18] Speaker B: Absolutely. You know, that's really the drivers of, of real estate to begin with, right?
[00:00:22] Speaker A: No doubt.
[00:00:22] Speaker B: What does it cost, what's the overall value of it and what are my holding costs associated with it, that is interest rates.
[00:00:28] Speaker A: How does inflation impact property values? Biggest way inflation impact impacts real estate is two ways. It's property valuation and the exit strategy. Starting off with property valuation in an inflationary environment, costs are increasing everywhere. What that really looks like is property values will be slowly increasing. Tracking with inflation for us, we need to consider is this a permanent increase, is this real or is this a nominal increase? Is this something that will be increasing in the short term, but in reality property values are going to come back down to a certain standard level. And when we're underwriting we want to say, okay, are the property values we're underwriting at today? Are those going to be the same values that will actually be exiting at in one to two years once these properties are executed? With that in mind, Property valuation does not always come from a direct analysis of saying, okay, what's this property worth? A lot of our properties are cash flowing. Whether they're going to be cash flowing or they already are. With that in mind, there's rents being paid to create these cash flows. Typically rents will track with inflation as well. And you want to understand are these rents increasing in a reasonable sense?
[00:01:39] Speaker B: You know, one of the most important things with ignite funding and how we underwrite our properties is really a two pronged approach. We want to make sure that the exit strategy associated with the borrower isn't reliant on just one way of going about it. Most lenders will look at what's that property going to be worth on the back end, how much can they sell it for and what is my loan to value there? For us, we want to obviously look at that, but in addition to that we want to make sure they can get it refinanced. Maybe the sale market isn't quite as deep as it once was and velocity of sales isn't is quite as high. So we want to make sure that they can refinance this out. Best way to do that is to look at the debt coverage ratio associate associated with the property no doubt. What is the dcr, Jaden? How do we calculate that? And what's the most important thing to look at in two years from now when they'll be paying off a loan?
[00:02:27] Speaker A: That's a great question. So starting off with what is a dscr? It's a debt service coverage ratio. Typically what that means is when you're looking at a long term cash out refinance, how much will this lender be willing to give me? Typically these lenders are looking at it from multiple approaches and they'll take the lowest valuation across the table and typically run with that. What that generally looks like is a percentage of the value known as a loan to value. These numbers vary depending on what the asset class is of the property. But typically for our commercial properties, we're seeing about 65% loan to value as the cash out number. And then in addition to that, they'll say, okay, here's 65% loan to value.
Now what is the debt service coverage ratio maximum we're willing to hit, and then which of these two is the lowest? With that in mind, typically the number is 1.25 for the debt service coverage ratio. Now what this means is, okay, what is the yearly noise of these properties and then what is the yearly debt service for these properties, also known as an interest payment? With that in mind, they're saying, okay, can the debt OR can the NOI of the property cover this interest payment by 125%? If it can't, then will they'll lower the cash out number to get to that point?
[00:03:41] Speaker B: Absolutely. And kind of one of the things to consider There is the two numbers that you stated, the 1.25 DCR as well as the roughly 65% loan to value. You said that the lenders will typically look at the lower of those two valuations.
The probably the most important thing to consider is those aren't set in stone. It's not set in stone over a period of time through markets, through asset classes, or even through different lenders. Each lender is a little bit different. Each market and asset class is a little bit different.
Previously, you know, maybe two years ago, we saw the best or the lowest DSCR associated with multifamily and industrial. You could get down to under 1.1%.
Now that's not the case and you're looking at 1.25. So when we underwrite our deals, we don't have to look at what that coverage ratio is today or what loan to values are today. We have to anticipate what they're going to be in 18 months from now, 24 months from now, 36 months from now, when that project is actually completed and ready for sale or refinance.
So what, how do you go about that? You know what that is today, but how do you know what it's going to be in the future? And what are some safeguards or rails that you put in place to ensure we don't run into, you know, a situation where they can no longer refinance because it no longer makes economic sense?
[00:05:02] Speaker A: No doubt, and that's a great question. I'd say the biggest thing is we don't know. We can never predict where the interest rates are going to go. But with that said, we can always make our best educated guess, really try and put our investors in a position where if things do move towards the worst case scenario, are we protected? That's the whole point of underwriting really is risk mitigation. We're not in it for the equity upside. We're here to protect our investors in a worst case scenario. And are we still covered? Now, with that in mind, how does the DSCR even get impacted by interest rates? Well, really, it's a pretty straightforward answer. In a high inflationary environment, typically they're going to look to raise these interest rates to slow down the economy and hopefully curtail inflation. With that in mind, when these interest rates are projected to be increasing due to this high inflation, what that'll mean is our borrowers are going to have to pay more every year in interest on a long term note. And what that'll mean is the DSCR amount that they can actually cover is going to be decreasing. So when we see this inflation, you know, potentially starting to ramp up, or maybe we're already even in a high inflation environment, we'll say, okay, what do the rates look like now? Do our best research, read as many articles as we can, just try and understand the markets, understand where people think things are going to go and say, okay, these are today's interest rates. What do we think? 12 months, 24 months, 36 months from now, what do we think these are going to look like in a worst case scenario?
[00:06:26] Speaker B: Right. And so that worst case scenario is really what we're looking for, not necessarily to predict where they're going to be, exactly where they're going to be on the high end. And so what that usually means is increasing the DSCR from today's environment and decreasing the loan to value that investment that takeout lenders are willing to accept.
[00:06:46] Speaker A: I think the biggest thing Is understanding the historical context. What actually happened in these inflationary cycles in the 70s, the early 2000s, even a little bit during COVID doing a little bit of research into this, I think the biggest thing to note is the significant increase in the commercial real estate and even residential real estate asset prices. Back in the 70s. Home prices nearly tripled over the course of roughly 10 years. And in the early 2000s, similar things occurred where, you know, what is this real estate truly worth? And I think when you look at that historical context and say, okay, what can we actually learn from this? And where did other lenders potentially even go wrong? I think it goes back to Pat's initial comments about loan to value and looking at your long term takeout financing opportunities. If you're basing it off of today's inflated values, you may be get, you may get caught holding the bag when you're looking to exit in the sense of you're in it at a basis where sure it said 65% loan to value, but if this is 300% higher than it was five years ago, you're significantly over leveraged. And so us at Ignite, we look, well, we do take into account third party valuation and it's very important to understand what can this trade for today.
We also really look at what is the historical context, what has this been trading for and do we think these values are accurate? Because sure, we could get a BPO that shows potentially any number under the sun from a third party valuation. That could be their opinion. However, that may not be the most accurate opinion. And at the end of the day, everyone has their own opinions. And it's really important to take it with a grain of salt, while also doing a lot of your own research into the specific asset class where the asset drivers are for value and then where you expect it to be 10 to 12 months from now or whenever we look to exit on a property.
[00:08:32] Speaker B: Right, Absolutely. And during those inflationary times that you mentioned, the 70s, 2000s and kind of COVID era, really, we take a look at what asset classes perform the best and where. Where do they not perform well? And one of the best performing asset classes is real estate. That's because it's a tangible hard asset, a real asset, as it were, that does extremely well during inflationary times for two reasons. One is the the rents that they're charging the noi, the net operating income associated with the property is increasing.
When those property noise increase, that means valuations increase. When valuations increase, that's better for everybody on that side of Things.
The second component, and looking at real estate more specifically to ignite funding, is because we're a short term lender, we don't have to worry about marking to market with our debt instruments. They get revolved and turned fairly quickly. And because of that, your loan to value actually decreases throughout the life cycle of the project given these inflationary times.
So normally when an investor thinks inflation, you think of that instrument being bad and normally that is for long duration product. Fortunately for ignite and more unfortunately for investors, we don't offer long term duration notes. These are all short term notes that are not mark to market and therefore will be paid back at the end of the duration period when inflation is higher than normal, we will adjust our loan to values and debt service coverage ratios to be a little bit more conservative. It's not necessarily because rates are high or inflation is high. It's because of the unpredictability associated with them. And so we want to put in a little bit of buffer to ensure our loans and more importantly our investors aren't negatively impacted by surprises in the future.
[00:10:29] Speaker A: Kind of going back to the initial ones we've talked about, debt service coverage ratio, loan to value will always get a significant and thorough pass through, really understanding where we stand and then also being a little bit more conservative in nature, really tuning these up. So in a tougher scenario we'll still be covered. In addition to those things we will really look at is the strength of the borrower that we're working with. Do they have reserves in play? Are they willing to use them? In addition to that, something else that really matters to us always, but especially in environments where things may a little bit be a little bit more uncertain is the equity a borrower has in a deal. So not just okay, this is your purchase price and this is what you anticipate to sell and so your sweat equity in the deal. But true dollars in a deal, I feel like that really matters in a sense of what is their commitment to this deal? How much are they willing to lose should things go bad? I feel like that's one of the biggest things we'll look at when we're going into a deal. In addition to that, we will also look at other things such as the construction timeline and the cost of materials. Are they looking at today's costs and will those be tomorrow's costs as well? Because you know, say you get midstream and construction and then inflation starts bringing up these material costs in a significant manner.
Are we still on budget and will we still be on Time.
[00:11:43] Speaker B: Right. One way to kind of curtail that risk is hedging. Right. How did the borrowers hedge their, their exposure to increased rates, increased inflation, increased construction costs? One way to do that is to prepay for materials which we allow our borrowers to do during construction loans and development loans. It's a way to solidify what that cost is going to be and not have it kind of in the open market. For example, if we are building a house, help helping a borrower build a house. We'll allow them to pre order cabinets, appliances, countertops, some of these he load items on the budget will allow them to prepay it early. It does cost them more money in interest to do so. But it's a guaranteed of what that price is going to be because you already bought it and you're just waiting for it to be delivered. That's one way to hedge. The second way to hedge is when you look at interest rate exposure. Our borrowers for the most part not only are building projects, but also have assets with loans on them. We want to make sure those are fixed debt loans and if they're not, they have hedges against rising interest rates to make sure those inflation adjusted rates don't come back to haunt them in the end.
You know, normally when investors think about inflation, you think of volatility. The VIX spikes the uncertainty, the market increases, option premiums are on a rise. And so the, the uncertainty is something that the market does not like. With our particular type investment, given the short term nature of the investment, a lot of that risk is mitigated simply because of the short term nature of it. Another way we mitigate that risk is using prepays or guaranteed max contracts with general contractors to the borrowers to hopefully hedge out some of the uncertainty associated with the volatility on inflation.
[00:13:41] Speaker A: No doubt. And in addition to that, in these high inflation environments, typically we may see interest rates increase and as a result the cost of traditional debt will increase as well. What this means is a lot of borrowers, we aren't able to compete with some of these more traditional banks and lenders as far as interest rate goes. When these interest rates are increasing, we potentially can see even more borrowers being able or being priced into our debt structure, which is something that you know, you wouldn't expect in an inflationary environment that is actually making us more competitive. But I think it's, it's really interesting to conceptualize that and then actually see it occur as well.
[00:14:17] Speaker B: Absolutely. It's one of the things that most investors, and maybe even some People at the company don't really grasp and that is we are price sensitive not because of our product, but because of our competitor's product. When the differential between us and a bank decreases, the marginal buyer, marginal borrower is more likely to come to us for financing than elsewhere. And when that happens, we have a bigger bandwidth to a lend and B the depth of borrower, the experience associated with that borrower, the expertise and their know how the years in industry, they just become more credit worthy type of borrowers that come to us during those inflationary times because our rates become more competitive to banks.
[00:15:04] Speaker A: One of the benefits we really just directly discussed of there's actually potentially even a bigger borrower pool for us to work with. In addition to that, we'll also see the types of deals that are coming across our table slightly change in a high inflationary environment.
As we've discussed, sometimes it's a little bit more expensive to take on long term debt. And as such, people that traditionally would be looking to take on this long term debt will say okay, maybe we'll wait it out a year, two years and see if these rates will decrease, see if we'll see some stability. And as such they'll come to us for a short term.
Sometimes people call it a short term bridge loan that'll cover them for the next nine to 27 months while they wait for these rates to drop. A great example of this is an office building we actually did out in Vegas probably six, seven months ago. We initiated a refinance on. It's a fully leased out commercial office building where they had a long term debt, it was coming to maturity and they said it's too expensive to refinance into long term debt right now. We don't want to lock ourselves into something that is more expensive than we really need to pay. So we'll take a short term hit, we'll pay a higher interest rate for the next 18 months or so and wait for these rates to drop. I thought that was a really interesting case of, you know, real life seeing the impact of it.
[00:16:18] Speaker B: Absolutely. And it's not an isolated case that happens all across America and all across asset classes.
We are in a luxurious position, not only the strip behind us, but being well located in the United States where we're kind of a go to destination for many of these borrowers that know that we have the certainty of fund and the certainty of close.
[00:16:43] Speaker A: Well, what is interest rate risk for investors? And the really the short answer is how can interest rates harm your investment? And the most direct Answer would be the exit strategy and the viability of it for your borrower. Now, how does interest rates impact a borrower's exit strategy? Well, either they'll be looking to refinance this project into long term debt, or they're going to be looking to sell it to a third party who theoretically is going to do the same. They'll buy it and then refinance it in a long term debt and hold it for a certain period of time and really do whatever they like to with it. Whichever way you cut it, somebody is going to need to be taking on debt at the offloading or the exit of this property from our end.
With that in mind, in an inflationary environment with interest rates potentially rising, what it'll really do is compress the amount of money we'll be able to get when our loan pays off.
And with that in mind, typically what we'll look to do is just be a little bit more conservative on the metrics that are used when calculating this cash out refinance. So as we discussed Pat, the debt service coverage ratio, are the values of the property accurate and if so, do we foresee these being stable or even increasing or appreciating values over time or do we see some sort of coming back to the ground level of these values are a little bit overstated?
[00:18:00] Speaker B: Yeah. And with the complexity associated with interest rate, it's not a binary environment. It's not. If this happens, then this will happen. So if rates go up, DCRs go down or values will go up because of the complexity associated with with the markets in general, when we do see inflationary times, we also see typically an increase in that noi, which typically offsets some if not all of the interest rate increases associated with that, the inflation. In addition to that, the values of that property also increase. So the loan to values, even if they come down by lenders, we typically see borrowers actually able to pull out more money because of the asset prices appreciation.
[00:18:49] Speaker A: When we're coming into a deal and looking for potential red flags, I'd say the first thing is does the borrower have any skin in the game? Are they actually committed to this project in a monetary value? Have they been putting in their own money in the due diligence process while they're getting different things put into place? Are they working on entitlements? Are they funding it themselves up to the point where they're ready for us to come in for a potential acquisition or construction loan?
I think there's a large amount of deals that come across our plate that seem like a home run, but then when you look into it, we're paying for everything and they're getting all the upside. For me, that's a huge red flag.
[00:19:24] Speaker B: Absolutely no doubt about it. We are part of the capital stack. We are not the entire capital stack. We are simply the debt associated with it. So one of the key points you brought up is the skin of the game. What equity do they they have?
Because we don't finance the entire capital stack merely just the debt component of it, which is usually about 60, 70%.
[00:19:45] Speaker A: Of the overall cost.
[00:19:46] Speaker B: Who's coming up with that other 30%? Is it directly out of the borrower's pocket? Is it through friends and family on their end that's coming up with that? Or is it a syndication where they're raising money, much like Ignite Funding is.
We want to see how that money is coming, about how it's being placed and more importantly, who's going to be overseeing that money. What is that experience of that developer? Have they done it before? Have they used this type of debt before and how were they handling that? Was it successful? What went wrong? And so one of the key components of what we do is on the origination side we come up with our determination of what we believe the project will happen, whether it's what the sales price will be, the duration of time, and most importantly, when it pays off. We'll go back and take a look at what we underwrote and we will say, were we accurate? What did it cost more, did it cost less, did it take longer? And if so, do we need to adjust what we're doing in the future to mitigate the risk of under calibrating our matrix and our models to what is really happening in reality?
[00:20:50] Speaker A: That's a great point. I think you touched on something there that I really want to highlight and that's borrower experience. I know we talk about it all the time and it seems like a gimme almost. There's so many people out there that say, hey, I've built thousands of townhomes, let me start building luxury homes or let me move into a nice corner piece on Intersection and let me do retail. If you haven't done it before, it's. It's not always as easy as it might seem. If you're in real estate, I know real estate, but do you know this asset class? And I think that's something that, that may not even be talked about enough of. Do you truly understand what is necessary to execute this project from start to finish? And are your budgets and are your timelines in check? Because in an inflationary environment where things are a little bit tighter, potentially there's just that much less of a margin for error. And to the original point of, you know, margins are very important, kind of plays into that as well.
[00:21:44] Speaker B: Absolutely.
Best way that we change our policies and procedures here is to build in a buffer.
When we underwrite a deal, we look at what the takeout strategy is as of today, and then we'll build in a buffer for decreases in the future, whether that's decreases to valuations, decreases to the amount of coverage needed associated with takeout financing. And that buffer will mitigate some of the downside risk for us and more importantly, our investors.
[00:22:16] Speaker A: No doubt. And in addition to that, I think the biggest thing is being flexible, understanding that not all deals are created equal. Just because you see one deal at 65% loan to value based on a third party valuation and then another at 60% doesn't inherently make that 60% a better deal. There's so many more things that go into all of these projects. Borrower strength, their ability to execute. What are the underlying, what is the asset class they're working in? What are the exit strategies for that asset class? How do all these things play into each other? And really just saying, you know, not just a cookie cutter sense of if it's below this loan to value, it's a good deal, or, you know, it's X or Y. To your point, there's a multitude of different factors that play into it. You really need to consider each deal on a deal by deal basis. But then also look at all the things that play into each one of those in order to, to truly make a decision of what makes a good investment and what is something we may pass on. For now, absolutely.
I mean, that's a great question and I think I would say everything.
But at the same time, I think some things that have really stood out to me is just the importance of being incredibly thorough in the due diligence process, not just taking information from somebody and saying, okay, I've got the valuation, okay, I've got the zoning, but I actually double checking their work. Is this truly what it, it actually is meant to be? Is this an accurate evaluation? What went into all of this? Is this accurately Zone, I'll call the city and confirm. Do they actually have these permits pulled? We'll call the city and confirm all these different things where if you just take what somebody hands you, there certainly could be gaps that you may not realize until you Dig into it a little bit deeper. And I think when you're looking through these deals and there's so many different moving parts, it can be really easy to just kind of want to sit back and let work that's already been done, stay done. But when you start digging into is when you can really find the things that can make or break a deal. And in addition to that, I think something else that's really important is just relationships into industry.
While we do underwrite every deal on a deal by deal basis, relationships here are incredibly important. And especially in, in high inflation or moderately high inflation environments, we typically may even see a consolidation of borrowers where when the bar is a little bit lower, when times are a little bit better, everybody wants to be in real estate. But when times get a little bit tougher and you really have to know what you're doing, the cream rises to the top. And when you have those relationships already in place, it makes it that much easier to trust what they're giving you. And while we're still verifying everything, just makes it better from start to finish.
[00:24:52] Speaker B: Absolutely. And that's the key, really. Trust but verify. We'll believe everything you say, but we're going to double check it as well.
[00:24:59] Speaker A: No doubt.
[00:25:00] Speaker B: You know, we're pessimistic by nature. We're always looking for the downside and we're always taking what people say with a grain of salt because at the end of the day, they're the ones in the need of the money. We're not necessarily in need of deploying capital. And so what we will do is take a more conservative approach until the cream does rise to the top and we get the best of the best and we are confident in the deals that we put out to our investors.
[00:25:26] Speaker A: I think it really boils down to really working to communicate with our borrowers and understanding what they want versus what they truly need. A lot of these time, a lot of times these borrowers will come to us with deals and they'll say, hey, we want everything under the sun. Can you please supply it to us and we'll pay you debt level returns.
And while in a perfect world, the deal technically does pencil, we're taking on way more risk than we're being compensated for. And it's really finding that balance of how can we come into a deal, how can we add value and make things function efficiently and smoothly for our borrowers while also mitigating risk for our investors and making sure from when we come into a deal until when we exit are we covered all the way throughout. And while the loan to value may slightly vary through the life of a loan based on what improvements are being done to the property, where, where it's at in the timeline and execution of what needs to be done to take it from where it's starting at to a finished product that they're going to look to sell or refinance. Just really important to consider, you know, how can we actually come into this deal? How can we make it make sense for both of us and really be all on the same page?
[00:26:37] Speaker B: You know, when we look at economic cycles, it's most important to understand kind of where we are and where we've been, because without that perspective, it's hard to really navigate where we're going. And so we want to look at historical times where we've been in the same type of situation, although history may not repeat itself and most of the time rhymes. And because of that rhythm associated with it, we want to really have a good understanding of what has transpired in the past, where we are, and try to prognosticate where we're going. And in doing so, there is room for error. No one knows the future. I don't care how sophisticated you are or how much you think you know, no one knows exactly what's going to happen. And the people that do probably want to run away from them because they don't.
And because of that, we have to build in a margin of safety with everything we underwrite. That pessimistic nature that we talked about previously really has to come through on our underwriting and valuation process.
[00:27:34] Speaker A: I think at the end of the day, there's no clear cut. This is what we need to do in the future in order to be better. It's really just to Pat's point, understanding how do we do things a month ago, a year ago, what are we doing differently today based on what we've learned? And then what we're doing today, once it goes through its life cycle, potentially pays off, we exit. Then we look back at our work and say, okay, what lessons do we learn now? How do these compare to lessons we've learned in the past? And then really combining it all while taking into account what people are forecasting, what the economy is looking like today, what we think it may look like in the future, and say, based on the trends we've learned in the past, how can we be better and how can we always be more conservative while also sourcing the best quality and quantities to an extent, deals for our investors to put their money into I think all three of those things are incredibly important. I'll start off with the stress test because that's something that we do many, many times through many iterations on every single deal we do. We'll always start by saying, okay, these are the base things the borrower needs. Let's include all of the money they're requiring even outside of our own debt. Does the deal even pencil now? Does it pencil at today's standards? Potentially. If so, what will it look like a year from now based on worst case projections while still also being reasonable? Because, you know, if you predict the economy is going to disappear, then what are we even doing here? Right. And so when you look at these stress tests and really say, you know, in a, in a darker scenario, is this still going to be a good investment? That's something that's incredibly important. And I think a great example of it is a deal we're underwriting today or really yesterday. And then we discussed this morning, we're looking at how much does the borrower need to take him all the way to an exit strategy. With that in mind, his cash out that he potentially would be able to get based on interest rates that we think will be accurate in about a year from now. He'd have to bring about a million and a half of his own equity at closing to pay off our note. Now, while he may have the bandwidth to do so, we don't think it's realistic to, you know, just earmark one and a half million dollars a year from now and say, hey man, you're gonna have to bring this to the table. And as a result, we tuned back our loan a little bit. We tinkered with it a little bit and said, okay, how can we find a sweet spot where he's getting pretty much everything he needs? We'll discuss that with him. Say, can you cover it and then kind of move from there?
[00:30:03] Speaker B: Absolutely. We want to make sure that the equity needed from the borrower is put in up front, not in the back.
[00:30:08] Speaker A: Exactly.
What asset classes are the strongest during in high inflation periods? And real estate is arguably one of, if not the best asset classes to own during a high inflation environment. This is truly due to when people are spending more and seeing their purchase power erode assets that will gain value and appreciate as inflation goes, be it through their rents or just their straight up sale price.
You want to be in on those things. While real estate is not the only asset class that can experience that, it is one of the strongest. And to Pat's point, it is tangible. And that really does matter.
[00:30:46] Speaker B: Absolutely. And some of the other products that that also benefit are commodities. Commodities tend to rise with, with inflation as well as equities, typically value oriented equities.
And it's also important to look at the other side of it. What asset classes do you want to stay away from? What asset classes do not perform well, or at least historically have not performed well? And those are long term fixed rate debt. And it is a lot of times having to do with growth stock growth stocks. Growth stocks rely on future earnings of companies. And when you discount that back to today's value using higher interest rates, it makes them less valuable and therefore there's some more uncertainty there. Although debt, long term debt is historically performed poorly, short term debt is somewhat isolated from that which we are. We're on the short term side. We don't have a mark to market issue. We don't have ability to resell the loans you're already involved in. And so you as the investor get to be involved on a deal that has asset values increasing while still keeping your same rate of return. And that kind of mailbox money received on the 15th of every month, no doubt.
