Scholastic Capital Update #10: Debt

“Money often costs too much.”

It’s a famous quote by Ralph Waldo Emerson. He meant it in the context that making money requires sacrifices, including time with family and friends.

However, he indirectly hit on a critical element of real estate investing. The vast majority of real estate transactions require borrowing money via a mortgage. And, it very often costs too much.

When used correctly, debt can amplify returns and pay for your kid(s) college education. When used aggressively, it wipes out your entire equity investment.

The problem with real estate funds/syndications is that aggressive use of debt can make the General Partners a lot of money in a short period of time.

It’s a classic example of the Principal-Agent problem: Limited Partners want conservative debt to protect their equity and GP’s are incentivized to think shorter-term.

We firmly believe that this is the exact opposite way to approach debt.

In today’s post, we’re going to take a deep-dive on debt. To do so, we’ll talk about 5 principles of debt that we firmly believe in and how it impacts Scholastic Capital.

At the end, we’ll talk about a brief fundraising update and next steps for Scholastic as a fund!

Debt Principle #1: Match Real Estate Strategy to Debt Strategy

There are countless ways to make a dollar in real estate. There are similarly countless ways to apply leverage to real estate.

By matching the risk profile of the dollar with the risk profile of the leverage, you can avoid introducing unnecessary risk.

For example: Scholastic Capital is a “high floor” real estate fund (in our opinion). We believe our returns are safer than a development or multifamily deal, but our upside is also likely lower.

Short term, adjustable rate debt that is 300 Basis Points above SOFR is very high risk debt and best suited for a high-risk real estate strategy that can deliver outsized returns.

Pairing that debt with a strategy like ours makes no sense and introduces unnecessary risk.

How this principle impact’s Scholastic’s plans:

We are a much better fit to use 30 year fixed debt. For that reason, we will strive for 30 year fixed debt and speak with any lender who proposes those terms.

We currently have several lenders on the table who can offer us 30 year fixed debt.

Debt Principle #2: Never plan for a Refinance

A common real estate strategy is to assume a refinance 2-3 years after the acquisition of the property.

The hope is the property will have appreciated in value, either organically or inorganically, at that time. That enables the real estate fund or syndication to pull equity out of the property.

Funds like to do this because a refinance is generally not a taxable event. That enables the fund to return tax-free money to investors.

In theory, the investors now have 100% of their capital back at that point. Every additional dollar they get is now “profit.” The GP is also likely earning their “promote” since they have returned all investor dollars.

The problem is: it is impossible to know at purchase if you’ll be able to profitably refinance in 2-3 years!

If rates jump up a few hundred basis points, then a profitable refinance probably isn’t possible.

Even worse, the fund might not be able to profitably operate at the existing debt. They could have borrowed adjustable rate debt or higher-interest rate debt due to an assumed refinance.

As an example, it appears like a famous real estate podcaster buying mobile home parks just got caught in this situation earlier this week.

How this principle impact’s Scholastic’s plans:

We do not plan for or assume a refinance at any point in Scholastic’s future.

If rates were to drop down to a low number such as 3%, we would absolutely refinance to take advantage of that.

If rates were to increase up to 13%, we would be OK because we’d stick at our fixed rate debt well below that mark.

Debt Principle #3: Avoid Unforced Errors in the name of IRR

Most real estate investments are measured based on their IRR performance.

Going back to the principal/agent problem: funds are therefore incentivized to fiddle with numbers in order to boost IRR.

Two easy ways to boost IRR:

• Use floating rate debt (since floating rate debt is often a lower interest rate than fixed rate debt)

• Use short term debt with a balloon payment at the end (since short term debt is often a lower interest rate)

In our opinion, both of these are unforced errors on the part of the real estate fund. Both involve taking on substantial risk in the name of a few percentage points boost to IRR.

The reason why this is a substantial risk is that both of those tactics here rely on a refinance, either if the floating rate gets too high or on the day the balloon payment becomes due.

Let’s introduce Moses Kagan, a real estate GP for whom we have a ton of respect and whom we have learned a lot from afar. (To be clear, Moses has no affiliation with Scholastic. We are just admirers of him and how he thinks. His Twitter account is a must-follow.)

Here, he succinctly summarizes the risk of relying on a functioning debt market.

If a fund needed to refinance in April of 2020, then it may have lost 100% of their investors’ money. No one was lending in the beginning of COVID, especially during mass layoffs.

If a fund’s balloon payment was due in late 2023 when commercial mortgage interest rates were in the 8’s and 9’s, they may have lost all of their investors’ money.

The punchline is simple: we believe that assuming a refinance (principle #2) is foolish, but needing a refinance (principle #3) is even worse and an unforced error.

How this principle impact’s Scholastic’s plans:

Again, we want fixed 30 year debt without any assumed or needed refinance.

A refinance can be a beautiful tool, but only if on the borrower’s terms!

Debt Principle #4: Law of Big Numbers

The Law of Big Numbers is one of our favorite concepts.

It goes like this: even if an outcome has very low odds, it will eventually happen if the scenario happens enough times.

For example: the odds of finding gold in your backyard is extremely low. But if you search every backyard in the world, you’ll strike gold.

The law of big numbers applies to debt as well.

A fund that buys and holds real estate for enough years will see multiple real estate cycles. There will be times of significant value growth, and times of significant value loss.

To protect the equity investment in times of contraction, we believe it’s important to have significant equity in every asset.

That provides a significant cushion to ensure we are very unlikely to be underwater on a mortgage.

Buying real estate at a very low downpayment is ignoring history and the law of big numbers.

There are always real estate down markets. It is mathematically easy to wipe away low equity in a down market, which means buying with low equity is an another type of unforced error.

How this principle impact’s Scholastic’s plans:

To preserve flexibility, we believe a target of 65% LTV is appropriate.

This means we borrow less money on an absolute level, and may have more protection against real estate market shocks on a percentage basis.

Debt Principle #5: Once Following 1-4, lock it for as long as you can

If there is one consistent theme to our approach, it is this: we believe debt markets and lenders are extremely fickle.

They can change interest rates daily and their risk appetite for new loans on a weekly basis.

We’ve seen real estate investors lose a fantastic loan term because they waited too long or tried to squeeze just a bit more margin out of the loan.

In our eyes, that’s risky and it’s worth taking the “bird in hand.”

How this principle impact’s Scholastic’s plans:

For that reason, when we have a term sheet on the table that follows principles 1-4, we take it and lock it for 30 years.

If we don’t, the terms might change suddenly. By signing on for 30 years, we guarantee those terms are the worst possible terms we could have.

Our downside is now capped and risk minimized.

Fundraising Update

The past ~10 days have been the best 10 days in Scholastic’s history from a fundraising perspective.

Investors are coming into the fund at a greater rate. We believe this is due to timing. We are getting very close to our buying season, which we’ll talk about in the next section.

If you are interested in joining Scholastic this year, then now makes the most sense to begin a conversation. In that case, feel free to grab time HERE to get to know each other.

If not, then we understand and appreciate you following along with these newsletters!

Next Steps

Our investors will wire their investment over to Scholastic in the next ~45 days. At that time, we’ll begin placing offers on homes.

Through the summer, we’ll close on those homes and lease them up. Our profit distributions are planned to begin this fall for the investors.

We apologize in advance for likely shorter and fewer newsletter updates over the summer.

Things will be busier and we will personally be in every home before closing on it! That will lead to much less time behind the computer.

Wishing you all the best!

Other posts:

We’ve now written 10 different posts regarding real estate, Scholastic, and our approach to investing. If of interest (or if you’re new here!), you can find all of them at the below link!