Private Credit Masterclass - Part 2 feat. Anton Mattli

Hello, future billionaires. Welcome back to another episode of the Invest Like a Billionaire podcast. I'm your host, Ben Frazier. Today we have part 2 of the private credit masterclass. So if you haven't watched last week's episode, you definitely need to go check it out because this is a continuation of a webinar we recently hosted all about private credit. So last week we really laid the groundwork and the support for what's happening right now, specifically in multifamily, that's creating a very unique opportunity in the world of private credit. Today's episode is part 2, and we're going to really get more tactical and practical about what is the universe of private credit, all the different options available, how do you take advantage in this market right now, and really several case studies that put a lot of color around what is actually possible in this space. And I think you're really going to enjoy it. If you have any interest at all in private credit, now is the time to be paying attention to this asset class. And again, hopefully you enjoy this educational content that we try to put out whenever we have a lot of investors interested in something. So with that, please enjoy today's episode. And if you are enjoying podcast. Always appreciate your feedback, ratings, reviews, and shares with friends. With that, enjoy the show. This is the Invest Like a Billionaire podcast where we uncover the alternative investments and strategies that billionaires use to grow wealth. The tools and tactics you'll learn from this podcast will make you a better investor and help you build legacy wealth. Join us as we dive into the world of alternative investments uncover strategies of the ultra-wealthy, discuss economics, and interview successful investors. Looking for passive investments done for you? With Aspen Funds, we help accredited investors that are looking for higher yields and diversification from the stock market. As a passive investor, we do all the work for you, making sure your money is working hard for you in alternative investments. In fact, our team invests alongside you in every deal, so our interests are aligned. We focus on macro-driven alternative investments so your portfolio is best positioned for this economic environment. Get started and download your free economic report today. What is the universe of private credit, right? Because we've said this term a lot, you've probably heard this as a buzzword because it's very popular right now. There's a lot of people jumping into the private credit space, but What does that mean? Because it can mean a lot of different things. So at its most basic level, private credit really is anything that's outside of banks, right? Because it's private and these are not regulated banks. So that can include bridge loans, CMBS, which is commercial mortgage-backed securities agency. And so there's a lot of other, you know, well-known funding sources that are not really what we're talking about, though that could be classified under that category. And then you have, you know, distressed situations, distressed debt investing, and then kind of a whole gamut here we're going to get to. But really what we're focusing on and talking about is what we call non-institutional opportunistic private credit. So this is being able to invest opportunistically lower in the capital stack through either being preferred equity or second position debt, mezzanine debt, and being able to get into a good deal with a lower at-risk basis and help that deal make it through to the next kind of turning point or new deals that are requiring additional funding because of the things that are going on where the credit is tighter. So we'll talk about all those. Here in a sec. Debt funds are not created equal. So this is a little bit of a poke in the eye to some people that are using the word debt. You know, you've seen maybe a debt fund, an income debt fund. People throw the word debt out, you know, pretty aggressively and a lot of times it's not true debt, right? So traditional debt fund is something that is secured buy the subject property and has a lien filed against it. And Anton, you mentioned the other day you saw someone talk about they have a new debt fund that they're launching, but the underlying strategy and what they're making, the investments they're making within the fund was not actually debt, right? You want to just share that real quick?

Yeah, they meant the investor, they was loaning the fund money. So that was the debt instead of investing in debt instruments.

Yeah, that's right. So it's kind of turning it upside down, right? And because they are borrowing as a fund, they call it a debt fund, but then they would invest in equities and everything else. Yes.

So you want to make sure what you're—

you understand what they mean with debt fund. That's right.

Right. So it's really important to understand, you know, the headline names, the debt fund, private credit fund, to really understand what that means is, are you going to be secured? You know, are you not going to be secure? Are you going to have any priority interests on the actual investments that you're making? Are you lending money to a fund or is the fund actually investing in debt? And then another kind of big, big category a lot of people don't think about because private credit encompasses both is business loans as well as real estate loans, right? And so there's a lot of credit funds out there that are also capitalizing on a unique credit market in businesses, right? And that's, you know, a lot of times called venture debt, venture credit. And these are loans to businesses. And so again, there's a risk spectrum across all these things. So if you're investing in, you know, non-distressed situations backed by real estate, that's on the lower end of the risk spectrum, all the way to investing in, you know, debt vehicles to businesses that are not secured by any collateral, but just the hope that the business makes it is on the other end of the risk spectrum and kind of everything in between. So it's important to understand what the underlying strategy is because the potential rates of return are very, very different and they're not equal opportunity risk here, right? It says you have to understand the risk-adjusted returns that you're going to be earning in any of these types of deals. Another example that I've seen recently is a cannabis private credit fund, right? So cannabis is that you cannot get traditional financing because of the regulations. And so it creates an opportunity, you know, for private lenders to lend to these types of businesses. But again, not real estate, it's a business, it's an emerging industry. Don't really know where it's going to go from a regulation standpoint. And so it's a very, very different set of risks. All that to say, it's very important to understand what are you talking about when you're saying private credit? And so for us, we're going to make it very, very clear. Our focus is real estate private credit. These are investments either through preferred equity, mezzanine debt, or second position loans, which we'll talk about the difference there in a minute, into real estate, right? And so this is going to be kind of the next stage here of the presentation, just explain all the nuances around this. So, Anton, you want to talk a little bit about the capital stack, right? This is a concept that you may have heard about, you may not be familiar with, but what does the capital stack mean? And, you know, what are some of the benefits here of investing through private credit?

Yeah. So I would say everyone probably understands that you have a senior lien and you have equity in a property, right? So that's through traditional financing. Whether it's for a single family or a multifamily or retail strip office building, it doesn't really matter. And that is the most traditional way of investing with debt, right? And naturally senior debt, because it's secured by a lien on the property, is at the highest priority. Get paid back, and it's also the easiest to, to actually, uh, get a hold of the property because of that lien, and one can foreclose very easily. Uh, now, uh, what is, uh, very often the case though is that particularly when you are a developer, and more recently also with value-add, uh, uh, deals, that the senior debt, uh, was not high enough, uh, to justify to bring in all common equity, uh, and generate the return for the common equity holders. So that's why, uh, mezzanine debt and preferred equity, uh, is being added in some transactions, particularly in the development space. Uh, that has been— uh, uh, pref equity has been around for a very long time.

It's— some of the benefits of this is if you're investing at this position of the capital stack, you're not, you know, the senior lender is always the first one in line to get paid, but you can come in even after the fact when a property's already been purchased, already has equity in place and come in with a priority in the repayment structure. And so you actually have a priority of payment before the common equity. A lot of times if it's an operating deal that has, you know, strong cash flow, you're actually getting current cash flow. You're getting paid a current portion of the return that you're putting out there and contracting. You're lowering the capital stacks, you reduce the risk of your capital loss. So if a property value drops, say 25, 30%, or even more, your capital is still in a position to where you're not necessarily at risk of a loss. And then many times, depending on how you structure these, you can take over the property operationally, um, or force a sale if the property is not meeting the expectations that were originally agreed upon at that, at that time from the infusion.

Yeah, good point there. Maybe one more, uh, point I want to make there, right? Uh, MERS and pref equity, uh, obviously it has priority, but it's not always, uh, making sense as a pref equity and MERS investor. If the senior debt is already a very high leverage, right? So when we, when we particularly, when we look at 2021, 2022 with a lot of these bridge loans where, uh, bridge lenders went at 80% to sometimes 83, 85% loan-to-cost, and then a sponsor was adding breath equity on top of it, uh, That private equity, yes, it still had priority, but it is so high up on the capital stack where the risk is much higher. So now the question is, well, why is it a good time now? Because senior debt lenders, so only banks, but also agencies, they have been coming down on the leverage side. They're still going up. Technically up to 80%, uh, but on a programmatic basis. But in reality, very often they are at 65, 70, maybe 75% LTV. So with the lenders, uh, tightening their credit, coming back overall with their loan-to-value ratios, that creates an opportunity to come in with preferred equity and mezzanine debt without really getting into the riskier portion that is almost quasi-common equity.

Yeah, great, great point.

So just to summarize, we've seen, you know, traditional credit kind of leave the place, and so now there's an opportunity for this opportunistic private credit to fill the gap and to be safer down the capital stack. But because there's such a shortage of capital, they actually can get very good returns. So this is the opportunity.

So I'm going to break down now the different types of situations that it makes sense, or maybe it doesn't make sense to bring in preferred equity or mezzanine debt. Right. And so you might have heard, you know, distressed situations, distressed deals, and there are funds that are focused on that. But to Anton's point, it can be very risky because a lot of the distressed deals are distressed because of their extremely high leverage.

And there's no way to fix it and there's no way to step into them. Right. And actually rescue these deals.

Right. So there's kind of two big categories here. I'm going to break it down into— there's existing deals that have already been in operation. They've already been purchased maybe a few years ago and they're trying to get through to that Survive to 25 and make it to that next step. The next are kind of new acquisitions. So the first of the existing deals, again, the goal is just to stabilize the property, and hold it until the market improves. In a distressed situation, there's a lot of reasons they need it. One is they have an interest rate cap that's expiring and they need to purchase it, that their lender's requiring them to purchase a fixed rate cap. And that's expensive right now. Sometimes lenders are saying, hey, you need to boost your reserves, your capital reserves, because your checking account's kind of low and you had a cash burn. Or they need to finish the renovation program. So a lot of times because of some certain situations that we already talked about, it may have taken longer to stabilize, longer to absorb the new units that they're renovating. And so they're running out of equity because of their cash burn. And so the goal is to protect equity in the situations. And this is the most difficult type of situation to make work because What I say, been saying recently is most of these deals have a basis problem, meaning they just purchased it at too expensive of a value with too high leverage. And there, there's not really any way that they can make it out. I mean, we looked at one deal the other day that they're looking for about a $3 million injection on a property to say worth roughly $60 million. And at today's value, that $3 million would actually be, I think it was 110% loan-to-value, meaning that all the obligations that they had with their senior debt and the new debt, not even the equity, was more than the value of the property at today's value. And 3 years down the road, they could hit their business plan, which was aggressive. It would just be enough to barely pay off that new injection of capital. That's a very, very risky situation. And it's very important to understand if you're looking at a distressed, you know, debt fund that you, they have a really good strategy going in because it's very difficult to make those work. Another way that it might work though, in an existing situation, we see this fairly frequently, is they actually have really good in-place senior debt, right? So it's the opposite of the distressed situation where they have bridge debt, but it was floating rate, very high leverage. It's difficult to make work. This is the opposite. They actually have good, low, low rate debt that's fixed currently and they don't want to refinance, right? Because say they have a 3% loan on their senior mortgage that still has another 3 to 4 years left till maturity. but they do need a capital injection for, you know, finishing renovations or increasing reserves or one of the same reasons, but they're in a much better position. A lot of times it could even be cash flowing. And the goal here is not to necessarily just protect equity, but actually keep the in-place debt. And it's, you know, increasing the leverage slightly, but you have really good in-place debt that can help support it. So that's a common scenario. I have an example here I'm going to share on that in a minute. The other kind of set of opportunities and uses of private credit, and this is really where we think the bigger opportunity is, is on new deals. And the overall goal here is to increase leverage. So as Anton mentioned, because of the credit tightening, banks are pulling back, equity's hard to raise. There's a lot of situations where it makes sense to increase the leverage slightly to generate what we think are higher risk-adjusted returns relative to the risk you're taking. And so one of the reasons is a quick close or a funding gap. And so, you know, we've seen situations where either a senior lender falls through at the last minute, you're trying to close on a new property, new acquisition, the senior lender backs out, right? They're saying, hey, we're actually not gonna do these deals right now. Their appetite changes. We've seen that happen. Or they have the senior debt, but they can't raise enough equity in time to close. And so those are short-term in nature. It's just to bridge a gap. And a lot of times, you know, they can raise out of the equity shortfall because they have the equity coming. It's just a timing issue. Another one is loan assumptions. These are really, really popular right now. This is something that we've, we've seen a lot. We've actually done several of these where there's a low interest rate on the senior mortgage, generally agency like a Freddie Mac or Fannie Mae or Freddie Mac loan that a new sponsor, new operator can assume that low interest rate, but a lot of times they're very low leverage. So that can be, you know, 40%, sometimes up to 55, 60%, but that's pretty low leverage generally. And so that's a great time to come in behind that low-rate senior to increase the overall leverage. But a lot of times they can be cash flowing in a great position and the goal here is to increase leverage. And then, Anton, you said one of the most common uses historically in especially now is on new construction because banks are already a little bit reticent to lend on new construction or development, but especially now. And so leverage rates have just plummeted. We're seeing this, you know, we're looking at one deal. I think the senior loan is around 45% leverage. You know, it's very, very, very low relative to what it has been. And so you can come in and you can increase the leverage a little bit. Without taking an inordinate amount of risk. So any general comments on some of these, these general uses?

No, that's, that's all great. Right. So again, on the new construction, historically the leverage, the senior leverage was somewhere around the 60-65% mark and then the rest had to be covered with, with pref equity or mezz, but in most instances pref equity. And then more recently, everyone was pushing up the leverage all the way to 70-75%, sometimes even higher. Obviously, there was less need for breath equity there, but now we are— have moved in the complete opposite direction, and now the leverage is actually below the historical, uh, average of where the senior lenders come in with with the leverage, right?

So I'm going to share a couple examples here. So I mentioned the capital injection, and so this is one. So the multifamily property, you can see a picture of it there, is a value-add strategy. They're about 75% through the renovation program. The first property manager poorly managed the occupancy. Occupancy plummeted in the short term. but they're back on track and they've got it, you know, actually cash flowing, but they've run out of funds because they were using their reserves to fund renovations, actually to cover their cash burn because of the low occupancy. And so they needed about $750,000 to complete the renovations. The in-place senior debt was very low, a low rate, and they wouldn't increase the funding. And so we put out a mezz loan on this one. We actually be secured on this, which it can happen sometimes. And the goal here is to help stabilize and refinance out. So we're maxing out the loan-to-value at 75%, get a secure position in the property, and we're also charging 15% interest rate plus 2% origination fee. So it's pretty, pretty strong returns relative to the risk you're taking. In this scenario. And so this is, you know, current cash flow. They have a great path to finish renovation program. They're almost all the way done. They've proven out all the market rents. It's a great example of where that case where they have the low-income place senior. Here's another example. So this was a case study of gap funding. So this was a sponsor couldn't get the equity in the account in time. They had kind of a short window to close. This is a new purchase. Was about— they needed $500,000 to close. And this one we also were able to get secured in and basically was a 90-day loan to help them close and then get paid off in from the new equity coming in just to replace that debt. And from, from our standpoint, it's great because it allows us to, to earn a really great rate of return, but then we get paid off, we can recycle that capital into new opportunities. And a lot of time generate better yields by recycling that capital in a short period of time. This was, like I said, 90-day loan. We had a personal guarantee from the sponsor, experienced sponsor here, and it was a short-term thing and already got paid off on this one. A loan assumption. So these are some of my favorite right now because they're a really great strategy. So this is a sponsor that they're assuming an agency loan with a 2.94% interest rate, but the LTV is very low at 45%. And so they're layering in preferred equity investment of $1 million that brings up the LTV slightly. It actually helps their returns to their equity investors. And the LTV on this one's only 55%. And so this one is structured as preferred equity. So it's different than the last two that were structured as loans. Right? And so there's differences we'll talk about here in a minute. And so this one, how preferred equity works most of the time is you have a, a current portion and a backend accrual. And so the current portion is actually paid out of cash flow and while the loan is current. And then once you have, get paid off, that remaining backend accrual accrues annually and then gets added to the balance and gets paid off. And so, In this situation, we're coterminous with the senior, meaning we're at the same term as the remaining maturity on the senior, which is about 3 years. And so 3 years we're going to get paid off on this one. And at a 55% LTV with a new acquisition, this is, I think the in-place cap rate on this one is in the 6% range. It's really, really strong. It's very strong cash flow. Yeah, it'd be very, likely that we're going to get paid off pretty comfortably with the refinance. And so we're earning a 14% annual return on this with origination fees, and we have a huge equity cushion to cover our position. So now we're going to talk a little bit about the different structures here. And Anton, do you want to give a little bit of context for what's the difference between mezzanine debt kind of traditionally and second position mortgages, which I'll share after this one?

Yeah, it's a good point to highlight because there has always been a lot of confusion, I think, among EAMS indicators. Is it what is a mezzanine debt? What's the difference to second lien? Very often it's being used in the wrong term. So second lien is pretty clear, right? So it's a second lien on the property secured by the property with a lien on the property. Uh, and which is really the, the right after the senior lien, that's the most preferred option that you can have as a lender, right, or as an investor. Uh, but very often you cannot have that because the senior lender does not allow to have a second lien in place. So that's where then the mezzanine structure, and in addition to that, then behind that also private equity comes into place. compared to the second lien that is secured by the property itself, the mezzanine debt is not secured by the property directly. And I think there is a lot of confusion when it, when it comes to that. It is secured by, uh, the equity pledge in the borrowing entity, right? So, uh, this obviously is not like a single-family home where someone buys that property in his or her own name. The, the borrowing entity is typically an LLC. It can also be a corporation, but in 99% cases it's an LLC. So this is an actual entity that is the borrowing entity. And as a mezzanine lender, you essentially, instead of the property itself, you have a pledge in that entity. So, uh, if the, the borrower is not performing, you can foreclose on that entity interest, and ultimately you will own that, that borrowing entity at the end. The senior loan is still there, but now you are the equity holder, uh, of that property, and that essentially is, is your security in it.

Yep. Makes a lot of sense. And so it's, it's very similar to the, to the secured loans, but the security is not in the property itself, but in the entity that is the borrower that then owns the property that you can foreclose on and execute your rights. And so the difference here is the collateral, like on second position loans, actually secured by the property. It's sometimes it's difficult to get a second lien behind a first lien, right? It's most cases it's only going to be allowed with traditional banks and, and traditional banks that are comfortable with that. And we've seen in most cases, probably what we've underwritten so far, 30 to 50% of the cases, you actually can get a second lean on the property. But again, it's not all the time and it can be structured a little bit differently. And then you have preferred equity. And so this is different than the mezzanine debt or second position loans in that your collateral is, you have no recourse to the property. But a lot of times you can either negotiate a pledge of the sponsor's equity, which kind of then blends into the mezz debt mezzanine debt type, or you also get personal guarantees from the operators or sponsors. And how this works a little bit differently, I mentioned before, is there's a contract rate of return and it's split into a current portion, a current pay portion, and a backend accrual portion. And so you can continue to get cash flow from the operations of the property and you can also accrue kind of a backend profit for once that property sells or refinances and pays off the preferred equity. And so the capital protection here, it's different in different cases. If you are not behind an agency lender, which I'll talk about in a minute, many times you can negotiate certain takeover rights. And so you can actually, if the operators are not hitting certain metrics, hitting, hitting certain things that are required by the agreement, then you actually can take over the operations of the property, take over control and decide what to do from there and become the operator. In this case, you can actually, you know, force sale property. You can charge a default interest rate. It's if you're going behind a loan assumption. So with an agency lender, So Fannie Mae, Freddie Mac, HUD, you're more limited in the rights that you can, that you, you have. But in most cases, those are much lower risk investment opportunities because of the leverage rates are usually much lower. But you also still have certain rights and primarily what's called drag to market. So you may not be able to take over the operational control of a property, but you could actually force a requirement to sell the property at any point in time if certain covenants are not being met. And so you still have kind of an ultimate trump card, so to speak, to execute your interests in that. Anything else you want to add on the pref equity side, Anton?

Yes. So maybe like you mentioned, Fannie or Freddie, they will not allow, uh, a mezzanine debt, right? So they do not allow a second lien other than their own supplemental loan, uh, that they may be granting, uh, but, uh, so only they will not allow a mezzanine debt, uh, that's why in most instances then breath equity is the, is the option there. There is some breath equity that also has kind of a hard pay, uh, element to it, Naturally, the agency lenders do not allow that. So it's really, really the traditional breath equity. As long as the free cash flow is available, then you get paid. If the cash flow isn't available, you are not going to get paid. So it's— you solely do not have the same hard pay as what you would have with a mezzanine debt or with a second lien. But as you have mentioned before, typically you would not want to come in with a high-leveraged pref equity anyhow. But particularly when it comes to these loan assumptions where the in-place senior loan might be 45% or 50%— in your case it was 45% LTV— and you add another 10% of pref equity, you have still a 45% cushion in that example you have had. So yes, you do not have that hard pay, but you have a significant cushion there. So that's your primary protection on a day-by-day basis to get paid in addition to all the remedies that, that we have talked about.

Let me just summarize here too. So we're talking about 3 areas that we really like where we think there's a lot of opportunity. It's, it's second, second mortgage debt, it's pref equity, and it's mezzanine debt. All, all of them are lower on the capital stack, so much lower risk. And all of them have different ways of protection where you're, you're actually in the driver's seat. So you're not directly in the driver's seat, but you can make things happen. You can protect your investment and by, by forcing the borrowers to do something or by taking over the property. So they all— and the mechanisms are all different, but they all have mechanisms where you're in the driver's seat. So, so all of them are great opportunities and just, you know, it really comes down to what, what are you able to do, what will the senior lender allow and what will the borrower accept to, to pick which one of these will work. But all of them can work to different degrees in different situations, and all of them are lower risk and all of them are protected.

Okay. Final, final section here. And this is, you know, what are the keys to good underwriting? Right. Because we've talked a lot of about the differences in the different risk spectrum of super distressed situations versus a new acquisition with a loan assumption, a low interest rate, right? Those two very different types of deals. But across the spectrum, there's kind of some standards that you want to look at and the keys to underwriting. This is not exhaustive, but these are what we feel are the most important things that you want to look at when evaluating whether you know, something, an investment in this type of vehicle makes sense. And so the first and foremost, and Anton, you, you know, said it several times throughout today's presentation, but cushion margin leverage ratio, talk a little bit about that and why that's so important and how also debt service coverage ratios come into play in this part of the underwriting.

Yes, sure. Right. You also have mentioned the word basis, right? And that's why a lot of sponsors are now trouble because of the, the high basis, uh, that they, that they bought at.

They paid too much.

That's right, they paid too much combined with a, with a, uh, too high of a leverage, right? Uh, we know of, of several deal sponsors that also paid maybe on the high end, right? And it's always looking back, hindsight is always 20/20, uh, but they came in with a much lower leverage instead of 80% LTC plus pref equity on top. They went in with 65% to 70% LTC. So they are still in a position to service that debt and also refinance out of that debt. And when it comes to underwriting for pref equity, mezz, or second lien, the same principle applies, right? So we always need to think of, uh, do we have the ability to actually get out of this loan or private equity down the road, uh, once the refinancing or a sale takes place? And that assumption obviously, uh, has to be really important that it's correct, right? So when we look back to 2021, everyone assumed that you would be able to get out at a roughly 4% interest rate agency loan. As we know today, those rates are at 5.5% to 6% for a larger loan. Right. So that was a complete misjudgment. And with that, naturally, the debt service coverage ratios that were assumed back then also do no longer work. Right. So This is what we talk about cushion. We need to be stress testing. We need to understand what the base case scenario looks like, but also where potentially the worst case scenario is and are we still able to get out of it.

Yeah.

What cushion on value, meaning if the, if we had to liquidate, there's a cushion where we're not gonna lose money and a cushion on cash flow.

So that's right.

They can pay our, pay our loan, um, and have a cushion.

So, so two cushions.

Yeah, right. And the other, other big one here is business plan, right? What is the use of the funds and what's the likelihood that they're going to be able to achieve the plan in the timeframes that they're, that they're shooting for? And to me, it comes down to what have they proven in the market and the property so far, right? If in the one case I shared earlier where they have the in-place debt that really good low fixed rate. They've renovated 75% of the units and they're all fully rented. They've hit all the pro forma rents that they were expecting and it's just a matter of getting the remaining 25% renovated and rented out. And they've seen a lot of market demand. They're not trying to be too aggressive on the rates they're going to hit. So that's, that's a lower risk business plan when it's already been proven out versus Hey, we're coming in and we actually have to achieve 25% higher rents than our pro forma, and we're hoping that we can get to those just to kind of get to break-even cash flow. Right? So understanding what the underlying driver of what's needed to drive that healthy net operating income up is very, very important. And then you mentioned interest rates are such a key component of this interest rate assumptions. What if interest rates don't go down in the next couple years? Right? I think the likelihood is that they'll probably start trending down. But if you've heard any of our content over the past year or so, we think interest rates will be higher for longer, and that's going to further drive this opportunity for a period of time. So when you're, when you're looking from a preferred equity position, mezzanine debt position, your primary question you ask is, how do I get taken out? How do I get paid off? Right. And a lot of times the term of your investment from a preferred equity standpoint may not actually match the full term of the business plan that the operator is planning on holding the property. For example, they might have a 5-year hold period to operate the property. We might have a 3-year term. And so at that point, we're underwriting to a refinance and being taken out and paid off for refinancing into generally some type of agency loan product. And so when you're looking at that, those, those types of products, agency lenders are, you know, whatever interest rate is at that time, they're, they're sizing it, what they call it, to the net operating income that is likely to be generated at that point. So you want to understand what's a realistic net operating income for a stabilized property that an agency underwriter will, will underwrite to, to be able to take out. And so you want to have a lot of margin, like you want to stress test it, like Anton said, and make sure there's plenty of cushion at that point when you're planning to be taken out to get paid off.

And then let me just add something there, Ben, because I think people may, may not understand this. But, you know, so a lot of times the operator will send us a pro forma, right? And they'll say, here's, here it is. We don't really use that. And you can't use that as an underwriter, right? You're coming up, you're basically saying, here's what we think is the realistic business plan. Here's what we think is the realistic assumptions. And we come up with our own kind of secret business plan that we don't really share with them to make sure that we can, to make sure the business plan is realistic and make sure the takeout possibility is actual also realistic.

Right? Yeah. And I've talked about this a lot in some of my Underwriting 101. Content on our podcast, but one of the biggest drivers of any pro forma is the inflation assumption, right? So if you just change your inflation assumption from 3% to 5%, every deal is great and every deal works, right? So what we want to look at is what's called trended versus untrended rents, right? So you want to look at an untrended pro forma, meaning you're not, you're not adding in the element of inflation into the pro forma. Which is going to make everything look better. And so you want to look at what is the current state right now. If you don't achieve any inflation in the next couple of years in your rents, what is that? What does that do to the NOI at the end of the day? So you want to, you want to look at what the untrended pro forma looks like because that's going to give you a much better sense of, you know, if the market just stays as it is, right, it's not going to increase and improve. And in some markets, that's probably going to be the realistic case. Or in the Midwest, that's actually probably conservative, but we still want to make sure that we know what is going to happen if rents don't go up. That's a very important metric to look at.

And you want to underwrite to the exit. So you'll look at, oh, if we're expected to be taken out in 3 years, well, understanding what are the interest rate and cap rate assumptions in 3 years to make sure that they're realistic, that there is a high likelihood that we will be able to be taken out.

At that time. Yeah. Yeah. So untrended just means inflation rate is zero. So this is as simple as it is. So Anton, what about sponsor strength? When you're looking at placing these loans with the lenders you're working with, you place $1 billion last year. This is a big factor, right? That is very important to understand. And what, what do you, what do you generally want to look at and see from a sponsor standpoint when trying to help with these situations?

Yes, uh, so track record, uh, has been thrown around a lot, uh, particularly during the good times. Everyone showed, oh, we doubled the money in 2 years or 3 years, and we had IRRs of 25% plus, uh, so everything looked great, right? Uh, however, what no one really was talking about is where these returns came from. And when it comes to track record, one of the key pieces is, is to actually understand the operational track record, right? So, uh, all these successes are always driven, uh, by, uh, by operational performance and the market. And over the last few years until middle of 2022, a lot of deals, uh, did not do well operationally, but they still were, uh, blazing successes because of the market. So it's important when you, and when you look at the track record, what is the true operational track record? So that's really an absolute, uh, key there. And for the similar type of property as what is being discussed, right? So if someone has, uh, let's say success with a 20-unit property, it's very different, uh, than, uh, if they look at the 200-unit property. That doesn't mean that they have really the ability to do that replicate that on a 200-unit property.

Yeah, great, great point. What about financial strength?

Yeah, financial strength, uh, from a lending perspective, we always look at it, uh, as a, as a base case scenario that the net worth should be equal to the loan amount, right? Which is, when it comes to senior debt, equal to the senior debt. Obviously, if there is an additional debt, whether it's pref or mess, that is being added to it, that should also be taken into consideration. Liquidity by the sponsorship group should also be around 10% post-closing after down payments and excluding acquisition fees, roughly 10% of the, of the loan amount, whether it's just a senior mess or second lien, everything combined. So that kind of gives a, a reasonable cushion where someone can be comfortable with that. Obviously, it's important to understand whether these numbers are, are really readily available, right? Particularly when someone has a lot of businesses that may show a lot of liquidity, but if that liquidity is tied up in other businesses, it doesn't really help.

Right, right. And then the last one is skin in the game, right? How much do they stand to lose if they have to hand the keys back to the, the senior lender? And a lot of times, you know, sponsors haven't invested any equity or any of their own cash into the deal. And, you know, the only thing they have to lose really is their reputation, which, you know, is important. But at the same time, there's nothing that speaks louder than cash that they're at risk to lose if the property doesn't perform.

Yes. Unfortunately, we have seen a lot of games that were played over the last few years when everything goes up. Why so lenders look the other way? Uh, and very often, even though on paper someone actually invested money, uh, they didn't really invest much. And if you have 5 general partners in a deal, sometimes even more, uh, maybe the combined investment is 5% of the total cash equity contribution. But if you split it up among 5, 6, or 7 people, it's not really enough that it would hurt any of them, right?

Right.

So, uh, so I think one really, as a lender or private equity provider, one really needs to understand whether that skin in the game is making an impact on that individual, and is that individual willing, if there are issues, to really work hard to, to keep that deal alive.

All right. Well, that was a lot of information. We appreciate you all sticking around and this is really, really great to have you all here. This will be recorded and available to watch on demand. And really from here, we encourage you, if you're interested to learn more about this, sign up for our Investor Club. You can take a picture of this QR code here on the screen. That will take you straight to our Investor Club page where you can sign up to be notified and ultimately get early access to deals. And so There will be a lot of information coming out soon about our latest private credit fund that we'll be presenting here very shortly. And so if you want to get first notified about that, please be sure to sign up for that. And appreciate you all sticking around. And thanks so much.