The “Tourte” of a Real Estate Investment

Most people have heard of Antonio Stradivari, who likely is the most renowned violin maker of all time. Few outside of the violin world, however, have heard of Francois Tourte, who developed the modern violin bow and has been called the “Stradivari of the bow.”

People understand that a quality violin can make a huge difference in the quality of sound produced. Students will spend weeks trying different violins to find the one which is “just right” for them. In the 17th and early 18th centuries, as is the case for many today, the bow was an accessory that came as part of the “violin package.”

Francois Tourte, an 18th century French violin maker, elevated the bow so great violinists now know that finding a bow of the best material[1], weight, balance, and suppleness for the violin and the violinist can make just as much difference in the music produced as the quality of the violin, itself. Indeed, many of the advanced violin techniques found in 19th and 20th century music are not playable using a 17th century-style “Baroque” bow.

Like the violin student, some real estate investors will spend months seeking out the perfect parcel of real estate. After signing a contract, the investor will spend a month or more and thousands of dollars conducting due diligence to be sure that the property meets the investor’s requirements.

Just as the violin student may overlook the importance of the bow, the real estate investor may overlook the importance of financing options and structure. Yet, the types and terms of financing used in the capital stack for a real estate investment, like the violin bow, can make just as much difference in the returns produced by a real estate investment as the selection of the real estate, itself.

In real estate finance, the various components of the “capital stack,” which can consist of various types of debt and equity are comparable to the material from which the bow is made. A simple structure might be one where the purchase puts 30% down as cash equity and obtains a standard, fixed-rate, 30-year mortgage from a bank for the remaining 70%.  More complex structures can contain preferred equity, mezzanine debt, and even multiple tiers of ownership.

However, the types of debt and equity and the balance between them isn’t all that needs to be considered, however.   The terms of the debt and equity also are important.  If the required debt service payments and preferred equity returns are too high, then the real estate investment may not be able to survive even a small, temporary dip in revenue or a small downturn in the economy.

Aside from the interest rate, the terms of the loan can make the difference between a successful investment and a financial failure. For instance, the term of the loan generally should be at least as long as the expected holding period for the property, so re-financing is not necessary.  On the other hand, prepayment penalties should be minimized or avoided altogether, as they may provide economic obstacles to disposition of an asset when necessary.  Further, in times of low interest rates, an assumable loan which, as interest rates increase will have a below-market interest rate, can add additional value to a real estate investment.

While in general increased leverage may improve returns on equity, an unrealistic debt service ratio could lead to foreclosure. Aggressive terms for triggering a lockbox will tie up cash, reduce flexibility in handling the property and very easily spiral into a mortgage default.

A real estate lender may be willing to negotiate some flexibility in the terms to accommodate the specific needs of the investor and accommodate unexpected events. However, once the situation arises all the negotiating power is with the lender. Taking the time and spending the money to have an experienced real estate attorney review and negotiate loan documents up front when the borrower still has some negotiating leverage will save time, reduce friction, and could save a real estate investment from loss.

Finally, capital stack structure can impact the tax consequences of a real estate investment, including the amount of deductions, whether cash flow is taxed at ordinary income or capital gains rates, and whether a Section 1031 exchange will be feasible upon exist from the investment. An experienced real estate attorney can, to the extent the investor’s needs are foreseeable, structure the capital stack optimally for the individual investor.

Just as Francois Tourte enabled violinists to perform at new, higher levels, an experienced real estate attorney can help the real estate investor structure the capital stack and negotiate debt and equity terms which provide greater protection of the investment and help to maximize investment returns.

[1]  Geek Note: Violin bows come in many different materials, the most desirable of which is Pernambuco, the heart of a tree grown in Brazilian rainforests. As modernization has encroached upon the rainforest, Pernambuco has become increasing scarce. Bow makers have turned to “Brazilwood,” which despite its name comes from a completely different tree and may not even be from Brazil. More recently, manufacturers have developed bows made with carbon fiber, which can compete with wood bows in responsiveness and are virtually indestructible, making them good options for young, advancing players, like my 12-year-old son, who enjoy testing bow destructibility. Finally, beginner bows may be made from fiberglass, which is also almost indestructible, but lacks in the suppleness necessary to produce more advanced bow techniques.

© 2017 by Elizabeth A. Whitman

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