Peter Pays Paul

Commercial real estate is a great addition to the savvy real estate investor’s portfolio. One of my previous employers said that he would only invest in commercial real estate and not in residential. He reasoned that commercial real estate that housed a business would always be better maintained than a leased residential unit. “A business must keep up its workplace or their customer’s will stop patronizing the business.”

Commercial real estate is financed more stringently than residential real estate. Often more capital is required to invest in a commercial property than in a residential property. Most banks and institutions require a minimum of 20% of the purchase price as a down payment. This can be a hefty price with the value of many commercial properties.

Commercial income producing real estate is also valued differently. Residential real estate is valued by the price the market will bear. A home is much more of a commodity than it is unique (though this contradicts much teaching in real estate textbooks). Not many people are willing to pay $50,000 more for a house, if the exact same house with the same features is available next door for less. Hence, the value of a home is much more a product of the supply of like homes, and the demand for those same homes.

Unlike homes, commercial real estate (CRE) is often valued by the income it produces. CRE, for the most part, is viewed as an investment. Owners want a return on the money that they invest in the project. The value of CRE is derived from the rental income from tenants.

Often a capitalization rate (cap rate) is used to value the property. The cap rate is a measure of the return on the purchase price of the asset. Capitalization rates vary from geographic area to geographic area and are directly related to the amount of perceived risk. Areas with high vacancies or other problems command a higher capitalization rate. More stabilized rentals with fewer problems often are capitalized at a lower rate. In many parts of the country a cap rate from 6-8% is used. Currently, in San Francisco a cap rate in the 4-5% range is common, due to high home prices and a high demand for rental units.

The cap rate is calculated by dividing the properties net income (not gross see note below) by the value or cost of the property. So, a property that costs $125,000 and generates $10,000 in net income would have a cap rate of 8%.

By reversing the formula above, knowing the appropriate cap rate, you can determine the value of an income producing property based on the net income the property produces. This is done by dividing the current net income by the cap rate. For instance a property that generates $10,000 in net income divided by a cap rate of 8% produces a value of $125,000.

By changing the formula again we can determine the assumed net income for a property based on the asking price.

Other factors like property condition, location, and tenant characteristics may increase or decrease the cap rate. All these factors should be taken into consideration when determining the appropriate cap rate to use for a given geographic area. I recommend using a knowledgeable, experienced, and local commercial broker to help you determine appropriate cap rates and property values.

Commercial income property is a solid investment for the long term. Commercial real estate should generate consistent income over the life of the asset. Many savvy investors use commercial income properties to generate income during their retirement years. Investment in this type of property requires due diligence and capital. However, for the savvy investor with the right investment team it can be a powerful wealth builder.

Note: It is very important to base these calculations on the net income of the property and not the gross income. It is also important to verify the net income figures through the use of a rent roll, copies of the leases, and the previous two years’ expenses. Unfortunately, unscrupulous persons have been known to increase actual rental income and to decrease actual expenses to increase the net income in order to command a higher property value.

How Commercial Mortgages are Underwritten

Commercial mortgages are underwritten differently than residential loans, hence the loan package needs to be assembled in a different fashion. When dealing with improved commercial real estate the property’s net income is the most important factor in underwriting the loan.

Debt Service Ratio

The property’s net income determines its ability to pay the monthly mortgage payment. This is commonly referred to as the debt service coverage ratio (DSCR) or the debt service ratio (DSR). For this reason a borrower’s income is less important than the commercial property’s net income. Some lenders will take into account the borrower’s income and apply it as a global debt service coverage ratio.

Common Mistakes

Commercial mortgage brokers do themselves a disservice when they fail to acquaint themselves with the loan they are submitting. Often a mortgage broker will call saying that they have a construction loan on a piece of property. When the lender reviews the documents, they see that the loan is actually a development loan on a piece of raw land. This casts a bad light on the broker, lenders are busy people and see many deals in a day. If a lender is only making construction loans, yet they are submitted a development deal it is often a waste of their time. Broker’s that don’t understand the deals they submit are perceived as lazy, unintelligent, after a quick buck, or some combination of these elements.

Required Documents

Individual commercial lenders will give different weight to different elements of the loan package. It is best to assemble a complete package before submitting a loan to a lender. Knowing in advance what documents and information a lender will want is also helpful.

Executive Summary

Writing an executive summary is always helpful. A complete package may include hundreds of pages of data. It can be difficult to extrapolate the loan amount and the purpose of the loan from all that data. The executive summary should include a description of the property including square footage, number of units, location, and the lot size. The loan amount, property value, and purpose of the loan should also be stated. An income summary should also be included in the executive summary of the commercial loan.

Standard Documents

These documents should be included in all submitted packages:

• Loan Application
• Borrower’s Financial Statements
• Borrower’s Resume
• Borrower’s Tax Return for 2 years
• Borrower’s Credit Report
• Preliminary Title Report
• Property’s Operating History for 2 Years
• Property’s Rent Roll
• Property’s Tax Return (if not included on borrower’s)
• Purchase Contract (if a purchase money loan>
• Current Appraisal - Before paying for an appraisal you should determine if the lender only accepts appraisals from “approved” appraisers.

Other Documents

Construction loans, rehabilitation loans, acquisition and development loans may require additional documentation and you should be prepared to submit the following:

• Proforma Revenue Schedule - What will the income be after the repairs or development?
• Construction Cost Breakdown - How will the construction funds be used?
• Construction Costs-to-Date - Have funds been invested in the project and where did they go?
• Current Lender - Who are they? What is owed? Why won’t they stay on?

Useful Information

When seeking commercial loan refinancing it is also useful to know:

• Current Loan Amount
• Original Purchase Price & Date
• Use of Additional Funds (if a cash-out refinance)
• Justification of Value - If the property value has increased dramatically, why is that? Better tenants? Capital improvements? Appreciation?

Summary

Commercial lenders want proof that they should make the loan. The property’s income or future value should justify the loan amount requested. Commercial lenders are not allowed to make loans based on a broker’s enthusiasm or the borrower’s need for the loan. The numbers don’t lie and often tell the true story of the loan. As Joe Friday says, “The facts ma’am, just the facts.”