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Commercial Real Estate Financing Basics

Published on Tuesday, December 9, 2008, 12:55 PM Last Update: 1 year(s) ago by Howard Dutra

Getting a loan for your investment property has become a real challenge. During the last six months, we have watched as lending criteria have morphed and Lenders are scrutinizing loan applications with missionary zeal.

There is hope, however! Money is available and loans are being funded. It is important to know that as an investor, to any lender, you are a borrower first. That is to say, you represent risk. If you have a track record with that lender or as an investor, that shows stability and knowledge. This reduces the appearance of risk, as viewed by a lender.

During the last few months, some borrowers have not lived up to their obligations. It has been easier for lenders to treat all borrowers the same, to paint them all with the same brush. But there is hope. There is money to lend. And, after all, lenders only make money when they find good people, like you, who want to use their money to buy income producing assets, things we know as apartments or as office buildings.

The process is simple, if somewhat complicated. For buildings with 1 to 4 units, financing a building is similar to financing a personal residence. The borrower’s personal credit history is critical. The borrower’s FICO scores (usually all three,) and sources of income are reviewed by the lender. This can include income from the building, as well as the borrowers other sources of income. Loans for these buildings are eligible for sale by Freddie Mac and Fannie Mae as part of a loan portfolio. FHA criteria can even apply, in some circumstances.

Multi-family buildings with greater than four rentable units are treated as commercial properties. So are office buildings, commercial/industrial properties and retail space. The lending process is somewhat different.

1. Banks will usually not finance more than 75% of the appraised value of the property. Frequently that number can be as low as 65% of the appraised value.

2. Properties must show sufficient debt-repayment ability by way of a ratio of 1:20X or higher. (See last months newsletter for a discussion of this topic).

3. In case that the property financed is occupied by a sole tenant (commercial warehouse) the lender might want to take a look at the financial strength of the tenant.

4. Owners will need to provide an updated rent roll to the lender, which might require this drill every year.

5. The term of the loans are shorter, generally 20 to 25 years.

6. If the property is not residential in nature, the lender might require an environmental audit (phase-I) to find out any possible contamination of the site.

For an owner occupied building, the costs will be very similar to those for a loan given for the home the owner lives in. A loan decision is made on an assessment of the credit worthiness of the purchaser. While income from the operation of the building can be considered in computing the purchaser’s income profile, it is considered with all of the borrower’s income sources.

While a similar credit evaluation is made for a non-occupying purchaser, there are three differences to be aware of in the loan and its costs. 1st, the points charged will be higher, 2^nd, the LTV (loan to value) ratio allowed will be lower as the size of the down payment will be larger, sometimes approaching 35%, for an LTV ratio of 65% and, 3^rd, the loan’s interest rate will be higher.

The good news is that there are lenders looking for qualified buyers. Money is available. Just be ready to provide documentation to support your application. And as is now the new rule, more skin in the game leads to a loan approval.

Analyzing the debt Repayment ability of Income Producing Property

In order to give you an idea of the analysis that Banks do for Income Producing Property, take a look at the following cash flow analysis for a 2nd Mortgage request that I prepared a while back, (Names have been changed to protect the innocent)

Cash Flow Analysis for the Utopian Apartment Building

located at 1234 Main St. Anytown, FL.

This analysis retains the 1st Mortgage as per borrowers request

Gross Rental Income

(Less Vacancies)

Net Rental Income

Less Operating Expenses:

Taxes (from 1996 tax return)

Insurance (from 1996 tax return)

Utilities (from 1996 tax return)

Maintenance (from 1996 tax ret. and estimate)

LandScape (from 1996 tax returns)

Net Operating Income:

Debt Repayment:

Existing First Mortgage (Competing Bank.$300,000)

Our Facility ($500,000 at Prime + 2%)

Total Annual Debt Burden

$139,260

($6,963)

$132,297

($24,178)

($8,040)

($3,744)

($2,500)

($1,380)

$92,455

$60,000

56,650

$116,650

Debt Repayment Ratio: 0.79X (Insufficient)

As you can see the property could not pay the debt. The most important number in the above analysis is the Debt Repayment Ratio ( Net Operating Income / Total Annual Debt Burden ). A smart borrower will know what kind of a debt repayment his property can carry in order to obtain the most money from the Bank. To calculate the maximum loan amount you need to know the answers to the following questions.

1. Your Net Operating Income?

2. The interest rate that the Bank will charge?

3. The lowest debt-repayment ratio that the institution will accept (this is usually 1:20X)

4. What kind of an amortization schedule is used for this type of facility.

Let's use the above information to find out the amount of money that can be borrowed against Utopian Apartments.

We have talked to the loan officer, and he has told us the following:

a) The bank charges Prime + 1% for this type of facilities when it is secured by a first mortgage, and Prime + 2% when it is secured by a second mortgage.

b) The Bank tries to approve loans with a debt repayment of ratio of 1:25X, but the credit policy states that the lowest is 1:20X.

c) The Bank uses various amortization schedules but the most favorable ones for this type of facility are based on a twenty-five (25) year amortization with a seven (7) year balloon.

Armed with that information you do some math:

$92,455 / 1.20 = 77,045 <==== Maximum Debt Burden.

Using an amortization table you find out that $734,000 at 9.5% (Prime+1% as of July 1998) is the maximum debt based on a twenty-five (25) year amortization.

You got in your hands a powerful weapon. With those numbers you could go back to the Bank, and instead of asking for a second mortgage for which your property does not qualify for anyway. You could ask for a 1st Mortgage refinancing in the amount of $734,000 which gets you almost the $800,000 which you were looking for, and lowers the proposed debt burden dramatically. Needless to say, that if the Bank decides to offer you the $150,000 2nd Mortgage that your property does qualify for, you should not take it.

Finding out the Market Value of Income Producing Property

Obtaining a loan without an appraisal is very difficult, expect to have to pay for one (most commercial appraisals are at least $1,000 with the average being $1,500) A professionally prepared appraisal will use all three methods to come up with an estimated value for the property.

There are three methods of estimating a market value for a property.

1. The Cost Approach: This approach adds the cost of constructing the building, deducts the depreciation, adds the value of the land, and adds the value of the improvements. It is used mostly for newer buildings since there would be very little depreciation.

Ex:

This is the Cost of building Utopian Apartments

You add the A/C system & Other improvements

You deduct depreciation

You add any tax or impact fee

Your reproduction cost is

You add the land value

This is your value

$600,000

100,000

(50,000)

50,000

$700,000

300,000

$1,000,000

2. The Sales Comparison approach: Self-explanatory! The appraiser will go around looking for comparable sales, it will assign a certain modifier to each in accordance to how much they resemble the property to be appraise and come up with an average.

3. The Income Capitalization approach: which is the one that concerns you as an investor of Commercial Real Estate is calculated the following way:

You obtain the Net Operating Income for the Property in the case of Utopian Apartments this is $92,455. After that you obtain the capitalization rate which is a combination of the interest that you will pay the Bank, and the required rate of return that you demand for your investment.

You might only pay 9.5% interest on the Bank Loan, but you might require that your investment pays you 10%. You would calculate the Capitalization rate as follows:

9.5% X .75% = 7.13

10% X .25% = 2.50

Cap. Rate 7.13 + 2.50 = 9.63%

Then it is a simple matter of dividing your Net Operating Income by your capitalization rate:

$92,455 divided by 9.63% = $960,072

This is the value of the building, and it is the most you should pay for it in order to obtain a 10% rate of return on your investment.