Part 4 – Get Better Loan Terms: Margin of Safety in Lending

How can you apply Warren Buffett's "Margin of Safety" to lending?

Be your bank’s favorite customer.

📢 PART 4: Margin of Safety

THE NEED

• When you are projecting future cash flows for your real estate investment, you will be wrong somewhere.

• The only question is: by how much?

That's where "Margin of Safety" comes in.

M.O.S. = giving yourself cushion when you are wrong.

APPLIED TO LENDING

The lending world applies this idea already. Which is why you'll get:

1. 65-80% LTV instead of a 100% LTV.

2. 1.25x DSCR instead of 1.00x DSCR

➡️ But is this enough cushion?

It depends on the deal.

1. Stabilized Properties - for multifamily in most instances, YES.

2. Value-Add Properties - NO.

➡️ Why NO for Value-Add Properties?

• The cushion you have is misleading!

• If you are projecting a year 3 DSCR of 1.25x, then you have...NO CUSHION.

• Why? Because most stabilized lenders require a 1.25x DSCR. If you miss, and your cash flow in year 3 results in a 1.20x DSCR, you'll have to pay down your loan to get to 1.25x, also known as a "Cash-In" refinance.

THE MATH

• 1.25x DSCR (requirement) - 1.25x DSCR (actual) = 0.00x DSCR (cushion)

• What you should really be aiming for is greater than the requirement, not equal to the requirement.

• By how much? Depends on your risk appetite.

• I like deals that have at minimum 1.35x DSCR, but prefer 1.40x DSRC and above.

• That gives the borrower 0.10x-0.15x DSCR cushion.

📌 BOTTOM LINE

• The more "Margin of Safety", the better.

• In practice, if you build too much M.O.S. into the deal, you probably won't win the bidding process, because your offer will be too low.

💡 OTHER CONSIDERATIONS

Of course there are a lot of other variables that would warrant a deep dive when analyzing your "Margin of Safety". To name a few:

1. how conservative your cash flow assumptions are

2. exit valuation assumptions

3. interest rates and general lending environment at time of stabilization, etc.

▶️ Upcoming

This is Part 4 of the series: "Be your bank's favorite customer."

This will help you:

1. Get you better loan terms

2. Exceptions that other customers at the bank don't get.