Peter Pays Paul

I get at least one phone call a day requesting construction financing. (Owens Financial Group does fund commercial construction projects on a limited basis.) Underwriting a construction loan is handled differently than a typical commercial loan.

Lenders desire to know that a developer has enough money invested in the project to motivate the developer to overcome the headaches and hassles that are bound to arise during development. A developer with too little invested, is likely to cut their losses and run, if construction problems arise, permits are not obtained, or weather is not favorable. Many lenders will underwrite a construction loan on a Loan-to-Cost (LTC) basis, as well as a Loan-to-Value (LTV) basis.

Loan-to-Cost

LTC is a ratio of the loan amount to the total project cost. Included in total project cost are all of the costs from the time of acquisition to the close of escrow.

Cost Categories

Costs can be divided into two general categories Pre-Development and Development costs. Pre-development costs are those costs incurred before any actual construction work has begun on the property. This includes architectural fees, engineering, survey, legal, entitlement, and permit fees. The property acquisition price, site work, and utility installation may also be included in this cost section. Development costs are those incurred during the actual development of the property. Development costs include site work, material costs, labor costs, overhead, loan fees and interest, landscaping, insurance, and taxes.

Sources and Use of Funds

Many lenders will ask for a spreadsheet or report that details where money was spent and the source of that money, borrower’s funds or loan proceeds. Again, this is used to determine the developer’s investment in the project.

The Devil is in the Details

Different developers account for costs differently and lenders might view developer “costs” differently. Commonly this occurs when a developer has little actual cash left in the project. The developer is trying to appear more invested in the project.

Below are some common cost “red flags” for underwriters:
Interest during the pre-development period. This is indeed an expense, however it has not added value to the land or property. Interest has no value to a future buyer, while entitlements, site work, or utility installation may.
Property acquisition price vs. property “value”. Borrowers on construction loans will often state the property cost based on a current market value. Asking when the property was purchased and the initial purchase price is a key to unraveling this knot. Value can be attributed if the borrower has taken the property through entitlement or assembled multiple parcels of land and is developing a larger project.
Management or supervision fees during development. Most lenders expect the developer to get paid upon completion and sale of the project, not before the construction lender’s risk is paid off.
Single builder/developer projects. If the developer is also acting as the builder, the cost figures might be lower than market costs for similar construction. Should the developer be unable to complete construction, the lender is going to incur a higher construction cost to bring the project to completion.

The Wrap Up

Lenders are always trying to mitigate their exposure to risk. A well capitalized developer, that is invested in the project is more likely to bring the project to completion and to mitigate the lender’s exposure to risk.

Funding construction projects requires gathering the proper detail from the borrower. It also takes an understanding of lender requirements. Different lenders will ask for different documents and schedules. Knowing in advance what they require and acquiring that information from the borrower will speed your loan approval process.

Happy New Year and Success in 2008!

Not many mortgage brokers live consistently in the world of hard money. It is a subject despised by some and feared by others. When I call on brokers for the first time, many of them report, “We don’t do that here.”

I believe commercial mortgage brokers, often times, don’t understand the role hard money lenders can play in serving their clients. Anything new can be intimidating. Especially, something that if not handled carefully can injure your business. Hard money is like a sword: wielded by an experienced broker it is a valuable tool. Wielded recklessly by an amateur, the user is likely to lose a limb or a valuable client.

Below are some hard money hints to help you avoid cutting off a limb.

1. Beware of application fees. Most hard money lenders will require a good faith deposit or an application fee. This when used properly protects you the broker and the lender from a “window shopping” borrower. A good lender will refund this deposit if the loan is not funded, less any expenses incurred by the lender for legal fees, travel, appraisal, etc. However, there are some unscrupulous lenders that collect application fees as a source of revenue with no intention of refunding the fee. Others charge a due diligence fee to even review the loan scenario and underwrite the loan.
2. Beware of hard money brokers. Some hard money “lenders” are really hard money brokers. By this I mean that they do not personally or corporately directly lend the money. They have a list of investors that they broker deals for. These investors may have anywhere from $25,000 to millions to invest in trust deeds or mortgages secured by real estate. Each of the investors has a different appetite for property types and individual lending ability. The “lender” matches the loan request with the proper investor or investors. Sometimes a loan is too big for one of the investor and multiple investors must be sought.
   This may cause problems on larger deals or when time is of the essence. It takes time to match borrowers to investors. Investors may want to review the underwriting themselves. This can delay the loan process until the contract has expired and your client has lost their deal. You may have lost the client.
3. Beware of staged construction funding. “Staged” funding occurs when the “lender” cannot raise enough capital initially to fund the entire cost of the construction loan. The lender is betting that as construction is completed they can raise the additional capital to fund the balance of the construction loan. This tends to happen more frequently with hard money brokers described above. The danger arises when a “lender” cannot raise the additional capital required to complete construction. Your borrower is left with a half-finished project and no money to pay for the remaining construction.
   Often whatever the total amount of funds initially obtained by the “lender” is deposited into an account accruing interest at the borrower’s expense. The borrower has not used the funds, but the borrower is already paying interest on those funds. This is because the “lender” has promised a return to the investor and must start charging interest to maintain that return. Most banks and some hard money lenders only charge interest on the amount of funds used, not on the total loan amount.
4. Cheaper is not always better. I had a boss that consistently told me “Peter, you get what you pay for. You pay for quality, you get quality. You pay less, you get less quality.” This axiom, though not always true, is often true. Though, you may get the loan for a lower price or lower rate, what is being sacrificed to achieve a lower rate? Can the lender perform on time? What is the hard money lender’s reputation? Can they guarantee the funds will be there? Will they be true to their word when it comes to the closing table?
5. Make friends with a hard money lender. You never know when one of your clients is going to need money in a hurry or have a problem with their credit. If you can’t get the deal done for them, your client will look for someone that can. You may not need a hard money lender more than once a year, but it will be nice to know who to call. It never hurts to close one more deal a year.
6. Don’t charge an exorbitant fee, because it is “hard money”. Lenders have underwriting criteria and a risk tolerance level. If a client is willing to pay a broker 10 points to place a hard money deal, something might be wrong with the deal. We tend to raise our eyebrows a little. Please understand that in know way do lenders begrudge you making a commission. Understand that from the lender’s perspective you are not undertaking risk warranting 10 percent of the loan amount. You provide a valuable service and should get paid, just don’t be miffed if lender’s are turned off by a large broker fee.
7. Avoid daisy chain loans. A deal comes across your desk from another broker, who got it from another broker, who got it from another broker, so on and so forth. Usually, every commercial broker in the chain wants a fee and the borrower or lender gets cold feet. These deals can be extremely frustrating because there is a lack of control. If you are the last broker on the chain, you get whipped back and forth by the other end. It will save you a lot of stress and time to avoid the majority of these deals.

This list is by no means exhaustive. It is meant to be a useful tool to get you on the right track to using hard money wisely. I hope that it does.

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.”