Borrowed Money Multiplies Everything, including Your Mistakes...
Risk, Leverage, and Financing
Debt is a critical part of any real estate transaction. Without leverage, most real estate deals would likely have worse returns than simply investing your money in bonds. At the same time, leverage is volunteering to take on more risk; you can easily lose far more than you invested. Leverage exposes you to price volatility risk, but that is only where we start taking on risk. Along with leverage, every project faces condition risk, finding something after purchase that was unaccounted for. And last but not least, revenue risk. Sometimes tenants do not pay. These are the three main ways that your investment property can become an anvil tied around your waist as you swim to shore.
No matter what you do with your money, you face some level of risk. Even if you keep your money safe in the bank, your identity may be compromised and your funds might get drained; incredibly unlikely, but not impossible. So, the real question is: am I getting appropriately compensated for the risk that I am taking? One of the easiest ways to tell how much risk you are taking is by trying to borrow from the bank. It is one thing to accept the risks you face when the money invested is your own; it is a whole different story when you have investors. When you borrow money from the bank, they become your investor. The good thing about getting the bank to lend you money, also known as becoming your investor, is that now you have access to an expert team whose whole job is to measure real estate risk, the bank’s underwriting team.
If you are seeking traditional financing, a thirty year fixed interest loan or something similar, the bank is likely more conservative than you are when it comes to trying to avoid losses. In the simplest of terms, if the bank will not lend you money, they think you are not a good risk. If they think that, you should very carefully reconsider your plans. Bank underwriting teams have far more experience and more accurate information than their borrowers. It is like choosing to follow a chef’s recommendations when looking for new restaurants to try. The banks have no emotional connection to your choices and sometimes ignore many of the very things that make us fall in love with a property. But as an investor with partners, profitability is always more important than likability. In our current Troy project, the underwriting banks do not care if we use linoleum or hardwood floors, fit in showers versus tile surrounds, or the level of finishes. They simply use the number of bedrooms and the square footage to estimate revenue potential. As my investor, the bank will not lend me the money for the fancier finishes.
When the bank lends you money, you get leverage, the ability to get higher returns with the same investment. If your down payment was ten percent, and the bank will lend you money at seven percent interest, but you can use it to make a ten percent return, your cash on cash return is thirty seven percent. You get nearly four times higher profits than simply investing your down payment without a loan. At the same time, it also means that every one percent decline in the price of your property will cost you ten percent of your original down payment. Those are the two sides of the risk you are taking, upside risk, profit, and downside risk, loss. Keep in mind, you are doing this on the back of a bank that is borrowing that money from its depositors, adds two to three percent on top of what they pay depositors, and lends it to you, with the added interest as their fee for making the loan to you. Put that in perspective, a bank gives you a one hundred thousand dollar loan, but they will only make two to three thousand in revenue per year. There is not a lot of room for mistakes here; the bank really does not want to lose money. That is precisely why most banks require a twenty to twenty five percent down payment for investment properties.
So, when it comes to getting money from the bank, you have to provide a bunch of documents and prove exactly how much risk the bank is facing in lending you these funds. Needless to say, the process of getting funding from a traditional bank is very much an exercise in bureaucratic paperwork hide and seek. They always want lots of documents, sometimes to a point of invasiveness. It is not trust and verify, it is verify and do not just trust. You start the process by pricing the loan. If you are taking a simple thirty year fixed mortgage, or any other conforming mortgage for that matter, all you really care about is the interest rate. Conforming mortgages will all basically have the same terms. If you are purchasing an investment property with a commercial mortgage, the terms will be different for each bank’s offer to lend.
For the Troy project, we reached out to four local banks. In a town like Troy, the local banks have a vested interest in the community and will give you better rates than the big banks. More importantly, they understand the local market dynamics in a way that the big banks never will. A local bank has a local underwriting team that is seeing local deals day in and day out. If you think the opinion of the bank is an important milestone in understanding how good a deal is, local underwriting teams are an invaluable source of knowledge. Of the four term sheets we got on this deal, two were competitive and the others were just too expensive. With two serious contenders in hand, it was time to share the term sheet information and compete them against each other.
After asking for their most competitive rates, longer terms, and reduced prepayment penalties, we landed on a winner. The real choice came down to all of the terms surrounding the construction loan and funding process. While both banks were fairly similar in terms, one was far more flexible in our ability to manage our own funds throughout the construction process. So I signed on the dotted line. We got thirty day SOFR, secured overnight financing rate, plus two point seven five percent for the duration of the construction, converting to a fixed rate at FHLBNY, federal home loan bank of New York, plus two point four zero percent, for a combined term of ten years. But the negotiation is just the end of the beginning.
Once the loan closes, everything changes. The numbers that looked clean and rational in a spreadsheet suddenly turn into obligations that show up every single month, whether your project is going well or not. The bank does not care that your contractor is a week behind schedule or that you are waiting on a permit that some clerk forgot to stamp. They do not care that you uncovered something inside the walls that no inspection could have realistically caught. The payment is due when it is due, and the interest keeps accruing whether you are making progress or standing still.
This is where a lot of people confuse getting access to capital with actually knowing what they are doing. Just because a bank agreed to lend you money does not mean you have somehow passed a test of competence. It just means that, based on the information they have and the structure of the deal, you fall within a range of acceptable risk. You are one of many loans in a portfolio they expect to behave in a certain way. They are not betting on you because you are special. They are betting that, across enough deals, the math will work in their favor.
It is rarely one catastrophic failure that derails a project. It is usually a series of smaller things that stack up faster than you expected. A delay here, an unexpected cost there, a contractor who slightly oversold their ability to deliver. None of these things individually kill the deal. But stacked on top of debt, they start to eat away at your margin for error. What felt like a comfortable cushion begins to disappear, and suddenly you are managing pressure instead of managing a project.
Risk is the thing that never shows up in the pro forma. The model assumes things move forward in a relatively straight line. Revenue comes in when expected, costs land within a defined range, and the timeline behaves itself. In reality, everything drifts. Tenants do not pay on time, units take longer to lease, materials cost more than they did six months ago, and approvals take twice as long as anyone promised. None of this is surprising if you have been through a few projects, but that does not make it any less impactful when it is your deal and your capital on the line.
What becomes interesting is how much information the bank is actually giving you throughout this process, if you know how to interpret it. Most borrowers look at underwriting as an obstacle to clear, something to satisfy so they can move on. In reality, it is one of the few objective filters you will encounter. When a bank pushes back, lowers their loan amount, or refuses to participate, it is not personal. It is a signal. Based on the data they trust and the deals they have seen, something about the risk profile does not meet their threshold.
You do not have to blindly accept that conclusion. Banks are conservative by design, and they miss things just like anyone else. But choosing to completely ignore that signal is a bit like ignoring a weather warning because the sky looks clear at that exact moment. It might work out once or twice, but over time it tends to catch up with you.
On our Troy project, the difference between the competing banks was not dramatic in terms of the headline rate. A few basis points here or there simply does not move the needle enough to justify overthinking it. The real difference showed up in how each bank structured the relationship, how quickly we could access funds, how restrictive the draw process would be, and how flexible they were in letting us manage capital through construction. Those details do not look exciting on a term sheet, but they end up mattering far more once the project is underway.
After a while, you start to adopt a simple rule that cuts through a lot of noise. If a deal only works because of leverage, it probably does not work at all. The loan should enhance a solid foundation, not create one. A good project should be able to absorb mistakes, delays, and underperformance without collapsing. It does not need to thrive under those conditions, but it has to survive them.
Because at some point, something will go wrong.
That is where leverage stops being a trick for higher returns and starts becoming a responsibility. And that shift, more than anything else, is what separates the people who last in this business from the ones who do not.
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