A Banker, a Broker, and a Hard Money Lender Walk Into a Deal
A term sheet is nice when you get one during the deal-making process. It means that you have a potential investor interested in your project. The question is, how good are the terms? If, like me, you are not an expert at evaluating term sheets, start by looking for a simpler approach to think about the deal.
Before you read the first word of a term sheet, you start by considering who you are getting this term sheet from. Is it a bank, a credit union, a mortgage broker, a private lender, or a fund? It helps to know if your investor is conservative or aggressive in their expectation for returns. For our deal, local community-focused banks had the right mix of fiscal prudence and an appetite for a little more risk in quickly growing local neighborhoods. These banks really don’t want to own your property; they genuinely want you to succeed so you can pay them back. They are very careful picking the deals they want to lend to. So, if you found a good bank and got a term sheet, it means the bank believes in your deal.
If you give it a bit more thought, you quickly realize that the bankers do this all day, deal after deal. Since they want to keep their jobs, they are probably pretty good at picking winners. So, if you are concerned that your project is a bad investment, a conservative bank will let you know very quickly.
Mortgage brokers are an entirely different business model. A mortgage broker is not lending you money. They are selling access to other people’s money. Their job is to shop your deal around and find someone willing to fund it. This can be very valuable when your project does not fit neatly into a bank’s underwriting checkboxes. The challenge is that brokers are often compensated when the deal closes, not necessarily when it succeeds. In other words, they can help you find financing for a deal that a local bank would reject. Whether that is a blessing or a warning depends entirely on the quality of the deal.
It all depends on how profitable your deal will be. The bigger the payoff, the more you may choose to take on more aggressive financing terms. That is a risk that can only be measured against the chance of success. The more sure you are of the outcome, the more you are willing to pay to ensure that it happens. That is one of the core decisions you make as an investor based on how successful you think you will be and how much you are willing to bet on yourself. Those are hard questions to answer.
With the knowledge and understanding of who you are getting a term sheet from in mind, you can start to review the responses. You may have different offers through a mortgage broker, you may have found a few lending firms online, maybe a couple of banks, or maybe a mix of all of those. Either way, it’s now time to negotiate. The term sheets are offers to “buy” your mortgage from you. Compare the offers, do some research on what other institutions are offering. How else would you know if you got a fair rate?
So, how do you read a term sheet? Like I said, start with the author. Think about who is presenting you the deal and what kind of deals this firm or type of firm is known for doing. If you are getting money from a private firm that is in the business of lending their own money but does not take customer deposits, you are likely dealing with a hard money lender. In our case, we are dealing with a bank, so the key terms are the size, length of the loan, interest rate formula, amortization schedule, fees, and prepayment penalty. At a first pass, we are trying to get a general sense of how expensive or cheap this mortgage is.
Before whipping out a calculator and a spreadsheet, we want to get a comparative sense of the different term sheets. Look for the easy stuff: higher rates, shorter amortizations, and higher penalties. Now start to add things together. For example, if you got a higher rate, did you get a lower prepayment penalty? We’re still not at the calculator phase. We are just looking for pluses and minuses on each term sheet and how they may cancel each other out. A good deal happens at the intersection of all these variables. There is always time to get into the finer details. At first, though, let’s not lose the forest for the trees.
With an overall sense of the term sheets and a rough sense of better and worse, we can start to dig into the details. (If you can only get one term sheet for your project, you should seriously reconsider, and I will leave it at that.) There are so many variables to consider when reviewing term sheets that making a conscious decision to slow down was the only way to create the needed space to be able to think through the implications of all these different terms. For some people, a side-by-side chart comparing terms is helpful. For me, it’s time.
With the big picture settled, it is time to get out the calculator. The most important first question is what will your monthly payment be? (Interest, principal, and escrow.) The calculation is simple: rent - mortgage payment - expenses = cash flow. Compare the different offers, figure out the variations in terms, and set up your talking points for each potential funder to ready yourself to negotiate. Set up your ideal ask and put on your negotiating pants.
Now the funny thing about negotiation is that most people think it starts when you pick up the phone. It doesn’t. Negotiation starts long before that. It starts the minute you understand what you are looking at. If you do not understand the term sheet, you have no idea whether you have a good deal, a bad deal, or somewhere in the middle. And if you do not know where you stand, you are not negotiating. You are guessing.
The first place I always start is with the monthly payment because that is where fantasy meets reality. It does not matter how attractive the interest rate sounds if the resulting payment destroys your cash flow. A lender can give you the most beautiful term sheet in the world, but if the payment leaves you with no room for error, that deal is already fragile. Real estate is difficult enough without putting yourself in a position where every broken appliance or vacant unit becomes a financial emergency.
Once I know the payment, I start looking at the timeline. How long is the term? How long is the amortization? Is the loan fixed or floating? These questions sound technical, but they are really asking something much simpler. How much pressure is this lender putting on me? A ten-year term with a thirty-year amortization feels very different from a five-year term with a twenty-year amortization. The difference is not just mathematics. The difference is flexibility.
One of the easiest mistakes to make when reviewing a term sheet is focusing entirely on the interest rate. Banks know that borrowers do this. Mortgage brokers know that borrowers do this. Everyone knows that when a borrower receives a proposal, their eyes immediately drift to the interest rate. What borrowers often miss is that some of the most important terms are buried deeper in the document.
Take prepayment penalties as an example. Imagine one lender offers a rate that is one-quarter point lower than another lender. Sounds great. But what if that same lender charges a hefty prepayment penalty for five years? Suddenly that lower interest rate is not quite as attractive. Maybe your plan is to refinance after the renovation is complete. Maybe rates will come down. Maybe the property value will increase enough that another lender becomes attractive. A stiff prepayment penalty can quietly eliminate all of those options.
Then there are fees. Commitment fees. Origination fees. Processing fees. Legal fees. Construction monitoring fees. The names vary, but the result is the same. They all reduce the amount of money that ends up in your pocket. Whenever someone tells me they got a great rate, one of my first questions is, “What were the fees?” Sometimes lenders have a funny way of giving with one hand and taking with the other.
The next thing I look for is flexibility. This becomes especially important on construction and renovation projects. In our Troy project, one of the biggest differences between lenders was not the rate. It was how they would administer the construction draws. How often would inspections happen? How quickly would they release funds? How much paperwork was required? None of these items show up in a simple payment calculation, but they can dramatically impact your ability to execute the project.
The reason I care so much about flexibility is simple. I have never seen a project go exactly according to plan. Not once. Contractors get delayed. Materials go on backorder. Inspectors disappear on vacation at the exact moment you need them. The weather becomes uncooperative. Something always happens. It is not a question of if. It is a question of when.
That reality creates an interesting question. What is the purpose of financing? Most new investors would answer, “To get the money.” But that is only partially true. The real purpose of financing is to give you the ability to complete the project. If your lender creates unnecessary obstacles along the way, then the financing itself can become a project risk.
Once I have gone through all of these terms, I start preparing my response. This is where many investors become unnecessarily timid. They receive a term sheet from a bank and assume the terms are fixed. They are not. Some terms are highly negotiable. Some are somewhat negotiable. Some are effectively set in stone. The only way to know is to ask.
When we were working through financing for Troy, we asked for better rates, longer terms, reduced penalties, and additional flexibility. Not every request was approved. Some were immediately rejected. Others were partially accepted. A few were surprisingly easy. The point is not that you get everything you ask for. The point is that if you do not ask, you guarantee yourself a worse outcome.
One of my favorite lessons from real estate is that leverage applies to conversations just as much as it applies to money. If you have two lenders competing for your business, your leverage increases dramatically. If you only have one lender interested in your deal, your leverage decreases dramatically. This is why getting multiple term sheets is so important. Competition changes behavior. The same lender that was unwilling to negotiate on Monday suddenly becomes much more flexible when they learn someone else wants the deal.
At the end of the day, reading a term sheet is not really about understanding finance. It is about understanding risk. Every term inside that document exists because someone is trying to control risk. The interest rate controls risk. The fees control risk. The covenants control risk. The guarantees control risk. The lender is trying to create an outcome where they get their money back with a reasonable return.
Your job, as the investor, is to make sure that the lender’s effort to reduce their risk does not create too much risk for you.
That is why I always start simple. Who wrote the term sheet? What is the monthly payment? How much flexibility does the loan provide? What happens if things do not go according to plan? If you can answer those questions, you will understand more than most borrowers.
Because the truth is that a term sheet is not just an offer to lend you money. It is a blueprint for your relationship with that lender for years to come. The document tells you how they think, what they fear, and how they intend to protect themselves. If you take the time to read it thoughtfully and negotiate carefully, it will tell you almost everything you need to know about whether they are the right partner for your project.
And like most things in real estate, success usually belongs to the people willing to slow down, think clearly, and ask one more question than everyone else.
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