Obtaining a Commercial Real Estate Loan
In 2008-2009, the rules for qualifying for commercial real estate loans changed. Here's how to succeed; featuring comments on cash flow.
This is written in October, 2009, a time when many investors and business owners are having a dickens of a time finding loans for the refinancing or purchase of commercial real estate of most descriptions. For some, the stakes are degrees of prospertiy. Others teeter on the fence between financial survival and disaster based on whether they can get the financing they seek.
It used to be that banks would fight to lend to a good borrower on a good property. Now, many banks have closed their commercial real estate loan departments, and those few remaining are clogged with loan requests. Service is slow as analysts, underwriters, and processors work through loan files funding what they can. Banks are being watched over by regulators such that that they have to go much further in conducting due diligence and documenting the details of a loan file prior to funding. Borrowers, sellers, and other stakeholders view the time and effort it takes as lousy service, unaware of the tough challenges a lender faces in simply lending a buck on a property.
This series of articles is intended to aid the borrower in successfully navigating this situation and getting things done and funded as quickly and easily as possible. Quite frankly, for many borrowers this means changing the way they manage their property investments. Likely, the changes in the industry are permanent.
A complete how-to-do-it treatise would fill a lengthy book; a real thriller. Let's pick one aspect to cover here. Since the repayment of a loan depends on cash flow, let's start there.
Renters rent apartments in an apartment property, and the rents are to be used to pay the expenses of the property, pay the loan payments, and make a profit for the owners. A lender needs to see that the rents are coming in steadily, and that tenants like the place enough to continue renting for a long time so the revenues can be presumed to be stable and steady. I've had to decline properties with high yearly tenant turn-over, because a credit officer will surmise that something is wrong with the property such that no one wants to live there. That's a recipe for an empty property someday. On the other hand, seeing that many tenants have lived there for 10 year or more has been a key ingredient in getting credit approvals.
The benefits of long-term tenants is magnified several times over when they stay despite regular rent increases. By enduring rent increases over time so as to be at or close to market rents, tenants demonstrate to credit decision-makers that the property is desirable. So, be nice to your tenants and respond to their reasonable service and repair needs quickly, and keep the property pretty.
Next, record all the rents and show the total amount on the tax returns. Many owners ask for rents to be paid in cash and then don't show the total rents received on tax returns so they don't pay income tax. It's common for an owner to prepare an income-expense form showing all rents received for the year, but then show a much lower rental revenue figure on the tax return. In many refinance situations and in some purchase situations, tax returns are required and the numbers on the tax returns are used in the underwriting of the loan. And, the figures on the tax returns have to match those on the income-expense statement delivered to lender. An owner's explanation of having a really good tax accountant who saves a lot of money, fall on deaf ears. Loans are declined on the basis of tax returns not showing enough rental revenue and cash flow, and because the tax return figures do not agree with those on the income-expense statement.
Too often, the expenses are overstated in order to reduce income tax. If the annual expenses are high because the owner replace the roof or all the kitchens and bathrooms and carpets, those expenses are capital expenditures. For lending purposes, I get to add those figures back to the bottom-line profit or loss which increases cash flow for making loan payments, as these are one-time occurances. That can make a deal work. What doesn't work is when the owner has his kitchen and baths redone in his home and then charges the costs to the apartment property to avoid paying income tax. That can wreck a deal, because a credit officer does not want to lend to someone being deceitful on tax returns.
Another aspect of cash flow for making loan payments is stability. An apartment property is declared stable when it has three years of rental revenues in a row with occupancy greater than 90%, with rents increasing gradually reflecting rent increases of perhaps 2-4% to keep up with normal inflation. When rents take a dip then recover, or when they trend downward, the property is unstable and needs to get restablilized. Sometimes, a bridge loan has to be used to allow it to restabilize.
Now, if an apartment property qualifies for Fannie Mae financing, stabilization is defined as it being 90% occupied for 90 days or more. A current rent roll and monthly income-expense statements for the previous 12 months (together referred to as a trailing-12 or T-12) are required to chronicle the revenue history and to demonstrate that it has been 90% occupied for the past 90 days or longer.
Recently, my attempt to provide purchase financing for a property was frustrated despite the fact that credit officer found that the cash flows were adequate for the 80% LTV loan request, based on the rent roll and claimed expenses. The trailing-12 monthly income-expense statements, though, showed that the property had occupancy of only 82% because the seller had not been paying attention to management performance. The property manager had been lax in renting out some of the apartments, distracted by other tasks. And, he had been allowing a tenant to live in a unit at half-rent for several months. Further, the seller had been combining all the income and expenses of this property with other properties he owned for tax purposes (Can't do that!), so the rents and expenses of this property could not be separated out. So, I could not use the low-rate Fannie Mae loan I had originally picked out for this purchase, and instead presented a bridge loan. Upon seeing the difficulties with the numbers, the buyer cancelled the purchase as he wanted an uncomplicated turn-key purchase.
Rents and expenses on retail, office, and industrial properties are the same as above, except that they are substantially different. The tax returns and the income-expense statements have to match, and tax returns are required for all these loans whether refinance or purchase. If a property is new or newly refurbished and re-tenanted, stability is achieved when all the tenants are moved in, occupying, and paying rent. This suggests that all the tenant improvements are completed, and nothing else need be done for the tenants to pay their rents.
Rents are either (A) full gross, where the rents include the land lord paying all utilities, janitorial, maintenance, taxes, insurance, and all other costs of the property, (B) NNN or triple-net, where each tenant pays the base rent plus additional rent to cover its share of the building maintenance, taxes, and insurance, janitorial, and other costs and pays all its own utilities, or (C) modified gross wherein each tenant pays some costs and the landlord the rest. When a borrower tells me that the annual rents are $512,480 that's fine, but I have to know how the expenses are handled. I need to back up the information by reading each lease so that I get it right the first time 'round, because if I get it wrong a credit officer will utter bad words to me.
A caveat to investors seeking to purchase a property: sellers will often fudge expenses on the low side to make the property appear attractively profitable. Investors are invited to gather the necessary information from seller and send it in for analyis. That has helped investors have an accurate picture of how the property will perform after the purchase, allowing them to buy with more confidence. It's also resulted in a few investors deciding to keep shopping.
Another ingredient of cash flow for a commercial property is the financial condition of the tenant. This week, a fellow loan officer asked my opinion of a loan request from an investor who wanted to lease a building to a single tenant. I explaned that the single tenant would have to be well established, in good or better financial condition, with good business history, and good prospects for the future. As the tenant was a healthcare provider, the building would have to be near a major hospital from which patient referals would flow. As good fortune would have it, the tenant was publicly traded so I was able to pull up its financial statements on line. It met all the tests handily with room to spare, so we were able to move on to qualifying other aspects of the loan request. Other times, I have had to decline loans because of tenant financial health.
Here's an example of one that I declined becuase a credit officer would not be able to even consider it. This was a retail center in a small midwestern city, with about a dozen tenants. The biggest tenant was a regional grocery store that occupied about 80% of the square footage of the center, and was thus the anchor tenant. My borrower wanted to purchase the property. Thing is that for reasons unknown, the grocery company had closed the store and emptied the space and locked the doors. Seller and buyer thought this was OK because the grocery tenant continued to pay the rent and its share of the expenses, and its lease had 10 year so go. Thus, the payments could be made.
In declining the loan, I explained that a credit committee would fear that the property was severely compromised by the biggest space being empty and dark. Other tenatnts would have good reason to not renew their leases, and another developer would have reason to build a property elswehere in town to which the remaining tenants would flock, leaving this one dark. Tenants want to be in a healthy setting that attracts lots of customers.Despite the continuing rents, this property could not assure that the other tenants would stay which compromised the cash flow. Besides, what business sense does it make for a company to pay lots of rent on a property it is not making money with? How long would they keep that up? What would happen in bad times when they are not making enough money to pay for empty space? They can file for bankruptcy, and the owner would loose that rent and the loan would default with no possibility of reselling that property for enough to pay off the loan. So, the cash flow source has to be adequate and robust for there to be a loan.
Another type of commercial property loan finances the ownership of a building by the owner of the company that will be housed in it. For example, right now I'm in the middle of refinancing a warehouse-type building that houses a small food processing company. The owner of the company also owns the building, and he leases his building to his company. (That's called a pock-to-pocket lease; you were wondering, I know.) This is an owner-occupied or owner-user building. A big ingredient of this loan approval is the finacial health of the business because credit committee will be approving on the basis of the company's financials and future business prospects. This company has done well, is well operated, is in a good business and a good market, so it can be expected to continue to perform well enough to keep this loan paid. This is a conventional, not an SBA-guaranteed loan.
The existance of cash flow adequate to keep the loan payments made on time, and for payment of property taxes, insurance, and maintenance of the property has to be established and documented. In order to use loans, Investors and business owners have to document the sources of revenues to their properties, and document expenses so that they can be seen as reasonable and can be backed up with historical records. Further, property owners and investors need to keep in mind that paying income taxes is a basis for loan approval at favorable rates and terms, as it is looked upon as a sign of business health.
Earl A. McCoubrey, Commercial Real Estate Loan Officer
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