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Wharton Emeritus Professor Dr. Peter Linneman discusses the danger of having re-financing as your primary business strategy.
BRUCE KIRSCH: When we talk about refinancing this is when we take the existing loan on a property and we replace it with a new loan. And this is often the crux of somebody’s investment strategy where the basic thought is that if the property as it is cash flowing today can support a 60% loan to value and then over some interim period of years– let’s say three years, five years– that property value rises.
We can go out at that point in the future and then get a new 60% loan to value. And on that larger value that 60% will more than outstrip what you still owed on the original 60% loan to value. And so at that point you can access tax deferred capital with which you can make other investments or do whatever you wish.
But the fundamental flaw in this whole strategy is you think that property values will undoubtedly rise. And so this is one of the things that obviously a lot of people got caught without a chair when the music stopped in 2008 and 2009. Because they were basing their whole investment strategy on this big trend that, my property value was just going to continue to go up.
And that is essentially, my savior is the refinance. So how do we guard against being optimistic in a sense, when we know that as an investor you have to be somewhat optimistic?
DR. PETER LINNEMAN: Yeah, it’s a perfect point. Because over a long term values do go up even if it’s just general inflation. I mean think about replacement costs go up because of general inflation. That means that building values tend to go up because of general inflation. And over any long period values tend to go up.
There’s a big gap between tend and have at the moment I need to refinance. And therefore the thing you need to do is, yes, your business plan is for values to generally go up and I’ll refinance. I’ll take a little money out. I’ll use the rest to refinance the existing loan, and keep moving forward merrily.
That’s a great business plan. You need to allow yourself the flexibility that the plan goes wrong. That’s just Business 101. You cannot have a business plan that only allows success if everything goes perfectly.
You have to allow as a general matter business plans that, they work best when everything goes as planned, but they work adequate when they don’t work perfectly.
And the way to do that is to leave a cushion– cushion in terms of loan to value. Don’t push your loan to value to its maximum. Give yourself a cushion. Cushion in the sense of have plenty of income available in case your income gets hit, that you can continue to pay interest and principal.
If you’re a real estate company stagger your loans so they all don’t come due at the same time. That generally means taking longer term debt and staggering– say, always take out 10 year loans and have 1/10 of it due every year. Because the odds are not that everything will be coming due then when no one wants to lend. It’s taking those kind of strategies.
On the operating side if you’re highly leveraged you better be gravitating to very high credit tenants with longer term leases where there’s not as much tenant improvement work as you need.
Another dimension is borrowing long term versus short term. If I’m borrowing short term I constantly am counting on when my loan comes due the market will want to refinance it.
Whereas if I borrow longer– imagine I go get a 35 or 40 year loan on an apartment project with a HUD loan. It basically means I’ll never have to renegotiate this loan. I’ll be dead by the time this loan gets renegotiated. I locked in my spread in the meantime between the interest rate and the yield.
So none of those are perfect, but you have to allow yourself room to survive over the long term as if your business plan is leverage and refinance. One of the other things is to have a strong balance sheet. Namely, have equity available if you need the equity because they won’t fully roll over the loan. All these are just common sense but they’re really part of the business strategy.