Why building trust and loyalty with passive investors is at the crux of real estate investing
December 1, 2022
One topic that I rarely see discussed in multifamily real estate syndication circles is how different lenders handle CapEx draws, and how these differences can affect the operator’s ability to execute their CapEx plan and the entire CapEx process.
I am by no means an expert on loans and debt — for that, you should consult a reliable loan broker like Old Capital — but I hope my experience dealing with lender draws is instructive and may provide some useful pointers for new and prospective operators to look out for during the loan application process. This post will only address Agency lenders (Fannie/Freddie) as that is what I have personal experience with.
The most important thing I wish I knew before applying for my first Agency loan, is that all loan servicers do not operate in the same way when it comes to CapEx draws. I only learned after the fact that some lenders are much more flexible than others when it comes to what costs they will reimburse. I will not discuss specific lenders here. Instead, I will use my experience dealing with lender draws on my 172 unit property in Dallas as an example.
The following only applies if you request that the lender fund the majority of the CapEx cost as part of the loan amount. This can provide a higher LTV. However, it can also severely limit your flexibility when it comes to spending those CapEx funds.
As part of the underwriting process, we always hash out a general CapEx plan since that is generally a key component of any value-add strategy. Once we were under contract on the Dallas deal and started our due diligence, we were able to refine the plan and get more accurate cost estimates for each project.
We started the loan application process around this time as well. As part of the application process, we had to submit our CapEx budget to the lender, with amounts designated for each project. It looked something like this:
That represents our discretionary repairs — i.e., not including those required by the lender (which on this deal were substantial). At the time we submitted the budget to the lender, we viewed the amounts and general estimates. Although we already had bids for some of the projects, they were preliminary, and subject to change once we detailed the scope.
Additionally, we regarded some of the specific items mentioned in the budget as ideas or potential projects. For example, we had not decided if we would install both a playground and a soccer field — we might just do one or the other. Our assumption was that we could essentially use the funds as we liked, as long as we spent them on CapEx projects. Unfortunately, we were in for a rude awakening once we started work and began submitting draw requests to the lender.
It turns out the lender did not view our line items as general estimates or guidelines. Instead, the lender viewed them as exact amounts that were set in stone. Naturally, as we implemented our CapEx plan, it turned out that some projects cost more than we anticipated, while others cost less. However, the lender allowed no flexibility on the initial amounts for each category if any project cost more than was allocated. As a result, we had to pay those costs out of our operating funds.
In a couple instances, we did get the lender to adjust the allocated amounts for a couple categories (including foundation repairs, which was a required repair — perhaps a story for another time). However, it was an extremely arduous and time-consuming process. It involved a formal letter to the lender laying out in detail why we were requesting that to re-allocate the funds.
I later learned that not all Agency lenders operate in this way. Some lenders treat the CapEx budget as a single bucket, and will simply reimburse any expenditures submitted for draws — regardless of what category they fit into — until they deplete their budget.
Note that this is anecdotal, and your mileage may vary. Needless to say, suppose we had known about these differences at the beginning of the loan application process. In this case, we likely would have gone with a lender that is more flexible with their CapEx draws.
Ultimately, we worked out the major issues with the lender and have been happy with the implementation of our CapEx plan. But we could have saved ourselves a lot of time and grief by paying more attention to this issue at the beginning of the application process.