Many people think of second mortgages as an option reserved for riskier deals or under-capitalized borrowers.
The truth is it’s a tool used by a wide cross-section of investors to serve many purposes. Cap rates continue to sink lower and drive prices higher.
In this environment most loan amounts are limited by Debt Service Coverage Ratios (DSCR) constraints.
Loan amounts can’t always follow
So where sale prices rise, the loan amounts can’t always follow. This has the effect of reducing Loan To Purchase ratios. Into this void steps the second mortgage.
If you asked a random selection of people at a real estate conference to free associate with the words “second mortgage” it would not take long before somebody blurted out “high interest.”
While many second mortgages do carry interest rates considerably higher than firsts, let’s examine those that are priced according to much more moderate risk.
The mortgages in this category are usually below a combined 75 per cent Loan To Value (LTV), have a combined DSCR of 1.20, are in primary markets with excellent tenants and come with strong sponsorship.
The interest rates for the absolute best examples of these types of second mortgages would be approximately 5.75%.
A fictitious property purchase
A fictitious property purchase yielding 6.00% demonstrates the power this type of second mortgage can have on your investment.
Placing a 65% LTV loan at 3.50% interest raises your Internal Rate of Return (IRR) up to 8.69%. Adding an additional 10% LTV at an interest rate of 5.75% pushes the IRR up to 9.63% while reducing the amount of equity required from the borrower.
The more traditional view of second mortgages is high-leverage and higher interest. You’ll typically see LTVs of 85% and interest rates of 9.00%.
At this level, almost all investments will experience negative leverage from the second mortgage.
While they don’t enhance investments from a yield standpoint, they can be necessary in order to close transactions, bridge gaps in equity availability, provide funds for other investments, fund necessary renovations/capital expenditures or pay down other debt that has a higher interest rate.
The Vendor Take Back (VTB)
The prevalence of Vendor Take Back (VTB) mortgages has increased as commercial real estate markets have become more heated. Most second mortgages will have a negative impact on investment yield, which will deter prospective buyers from paying top dollar for a property.
This is where the VTB comes into play with their overly friendly terms. Interest rates for these are usually around 4.00%, but I’ve seen them as low as 0.00%.
Yes, that’s an interest-free loan. Tacking on this cheap debt to an investment increases yield and brings more buyers to the table.
Let’s re-examine the fictitious investment property from above. The market has tightened and the sale price is no longer based on a 6.00% capitalization rate, but it is now 5.00%.
Loan amount has remained unchanged
The available first mortgage loan amount has remained unchanged. The moderately leveraged IRR from our first example was 8.69%, but with the compression in the cap rates this has been reduced to 5.56%.
This would deter many investors, but our aggressive vendor really wants to achieve a sale price based on a 5.00% cap. He decides to market the property with an available VTB second mortgage that would bring total leverage up to 75% of purchase price at a very attractive 2.50% interest rate.
The IRR on the property is now 7.55% and investors will start circling. There can also be tax advantages to a vendor in receiving the payment over time, but I will leave the detailed explanation of that to a qualified expert.
Is there an increased risk with second mortgages? Absolutely, but second mortgages exist on a risk spectrum and can serve a variety of purposes. Used effectively, they can help smart real estate investors achieve their goals in a tight market.