Making the Case for Your Commercial Refinance, Part 1

Since we released the original version of our Real Estate Investment Analysis software in 1982, our focus has been on pro forma financial analysis of real estate investments and of development properties – projecting the numbers out over time to help users gain a sense of what kind of investment performance they might expect from a particular property or project.

And for lo, these many years, our customers (and from time to time, we ourselves) have used the software to help make decisions as to whether or not to buy a property, and at what price and on what terms. Customers have used it to model how things might play out in the worst case, or in the best case, or somewhere in between. They have used it also to compare alternative investment opportunities.

This type of decision-making process has by far been the most common use of our software. More and more, however, we’ve seen an increased use of these pro formas for the purpose of making presentations to potential equity partners and to lenders.

Which brings us at last to the point of this article. When the economy is blazing away at warp speed, everything is – or at least seems – a bit easier. Forecasts are easier to meet, and partners and lenders are easier to find. But sometimes the economy is not so good, and presents us with new challenges. At this writing, we find ourselves in the middle of a bad case of credit lockjaw. Nothing lasts forever (which in this instance is a good thing), so eventually our credit markets and overall economy will rediscover their equilibrium.

This is all fine, unless you’re holding a property today with a mortgage that will balloon in the near future. In that case, you need to find a new loan, and you’re probably going to have to work for it. That means doing some homework, understanding the process, and building the most compelling case you can for approval of that new loan.

If you were trying to refinance your home, you would be dealing with recent sales of comparable houses, your personal income and debt, and your credit score. With the possible exception of working to get your credit report in order, there’s not a great deal you would do personally to build a case for your re-fi. With an income property, however, a carefully prepared presentation can go a long way in helping you convince a lender – or even a new equity partner – that you have a viable investment.

Re-enter your friend, the pro forma analysis. You may have thought he was on vacation until sales of real estate revived, but in fact he’s as busy as ever with financing and partnerships. If the numbers do indeed work for a property whose balloon is coming due – and sorry, don’t expect to transform a bad investment into a good one with just a pile of color charts – then a detailed pro forma may be that property’s best friend.

Don’t even think about starting that pro forma until you’ve done a bit of legwork and preparation. First you’re going to need some information that is external to the property itself. You need to know the prevailing market capitalization rate for properties of the same type as yours (i.e., office, retail, apartment, industrial, etc.) and in the same market. This information will be critical to estimating the current value of the property. Perhaps the best place to seek this information is from a local commercial appraiser. The bank will certainly use an appraiser, and the appraiser will certainly use a cap rate, so don’t get left out of the party. For the sake of the example we’re going to construct here, say that the commercial appraiser tells you the prevailing cap rate for properties like yours in your market is 11%.

Next you need to learn about underwriting criteria from your potential lenders. Specifically, you need to know the probable interest rate and term of the new loan; the lender’s maximum Loan-to-Value Ratio; and the lender’s minimum required Debt Coverage Ratio. Don’t assume that these criteria will be identical across all lenders or across all property types. In fact, they probably will not. It should not surprise you that different lenders quote different interest rates, but you must also recognize that the same lender may be willing to lend 80% of the value of an apartment complex, but only 65% of the value of a shopping center. Know the lender’s terms before you ask for the loan.

For the purpose of this example, let’s say you’ve called your current lender and found that their maximum Loan-to-Value Ratio for a property like yours is 75%. They require a Debt Coverage Ratio of at least 1.20, and if all looks good, they will loan at 7.75% for 15 years.

We’ll discuss these criteria in detail in a moment, but for now let’s stay focused on collecting information, this time about the property itself. You need to assemble the amount of actual current rent income from each unit and identify the market rent of currently vacant units. You need to make realistic estimates of rental income for the next several years, taking into account the terms of leases now in place. You must figure your current year’s operating expenses, keeping in mind that certain expenditures such as debt payments, capital improvements and commissions should not be included. Nor should you include depreciation or amortization of loan points, which are deductions but not operating expenses. Once again, you have to make some realistic estimates as to how these expenses may change over the next several years. Finally, of course, you have to learn the balance of your current mortgage, so you’ll know how much of a re-fi you require.

Let’s return now to the underwriting criteria you identified, and start with the Loan-to-Value Ratio (LTV):

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price

If this is a re-fi, then there is no “selling price,” so the value here will be the amount for which the property is appraised. If your financial institution has not taken leave of its senses (in general, if it has not appeared in the headlines or before a Congressional subcommittee in the last six months), then it should be reluctant to loan you or anyone else 100% of the value of a property. They expect you to have some skin in the game, and the question is merely how much.

The lender will quote you their maximum LTV, and before you get anywhere near an application form, you are going to perform your own calculation with your particular property. How much of a loan do you need to replace the existing financing, and how does that relate to the current value of the property?

It should be clear enough that the lower your actual LTV, the more likely you are to secure the loan. The lower the LTV, the more you, the borrower have to lose and the less likely you are to walk away. A low LTV may even earn you more favorable terms. You know how much of a loan you need, so to determine the LTV of your proposed loan, you must estimate the value of the property. Find that value with the same method the lender’s appraiser is likely to use: by applying a capitalization rate to the Net Operating Income (NOI). You already called around to find the prevailing market cap rate, so now you need to calculate the NOI. The most direct way to do this is with the venerable APOD form, where you list your annual income and expenses:

sample APOD for commercial refinance

The total of your scheduled rent income for this year should be $219,600, but because of vacancy and credit losses you will actually collect $210,816. Your various operating expenses total $51,050, leaving you a Net Operating Income of $159,766.

Remember that an appraiser told you the prevailing cap rate for this type of property in your market area is 11%. You have what you need to estimate the value of the property:

Value = Net Operating Income / Capitalization Rate
Value = 159,766 / 0.11
Value = 1,452,418

Round that off to $1.45 million.

You’re ready now to perform your first underwriting calculation. Recall that your lender’s maximum Loan-to-Value Ratio is 75%. Your current loan – the one that is about to balloon – has a balance of $975,000.

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price
Loan-to-Value Ratio = 975,000 / 1,450,000
Loan-to-Value Ratio = 67.2%

Assuming the lender’s appraiser agrees with your estimate of value, you’ve cleared your first hurdle. Being a cautious individual, however, you want to know your worst-case scenario. What is the lowest appraisal that would still allow your $975,000 re-fi to meet the lender’s LTV requirement? Simply transpose the formula to solve for a different variable:

Property’s Appraised Amount = Loan Amount / Loan-to-Value Ratio
Property’s Appraised Amount = 975,000 / 0.75
Property’s Appraised Amount = 1,300.000

Any appraisal over $1.3 million will be good enough to satisfy the 75% Loan-to-Value requirement.

You will want to build a pro forma that goes out a least five years, so you can demonstrate to the lender that your anticipated cash flow and debt coverage are solid and likely to stay that way. Before you do so, however, there is a formula you can use that will give you a quick estimate of the maximum loan amount that the property’s current income can support. Remember that the strength of an income property lies in the strength of its income stream. This is how the lender will look at your proposal, so it’s what you need to do as well. Here is the formula:

Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Monthly Mortgage Constant x 12)

You know that your Net Operating Income is $159,766, and the lender has told you the Minimum Debt Coverage Ratio is 1.20. But what’s this Monthly Mortgage Constant?

A mortgage constant is the periodic payment amount on a loan of $1 at a particular interest rate and term. If you know the constant for a loan of $1, you can multiply it by the actual number of dollars of the loan to find the payment amount.

Readers of my books have access to a web site with a variety of tools, including a table of mortgage constants. You can also calculate the Mortgage Constant using this formula in Microsoft Excel:

=PMT(Periodic Rate, Number of Periods, -1)

In the Excel formula, the amount of the loan must be entered as a negative number. In the case of a mortgage constant, we want to use a loan of $1, hence the -1. In the case of a loan at 7.75% for 15 years, the formula would look like this:

=PMT(0.0775/12, 180, -1) = 0.00941276

Since this loan is going to be paid monthly, you express both the rate and the number of periods as monthly amount. Format your answer to display at least eight decimal places.

Now you have all the elements to plug into the formula for maximum loan amount: the Net Operating Income, the minimum Debt Coverage Ratio, and the Mortgage Constant.

Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Monthly Mortgage Constant x 12)
Maximum Loan Amount = 159,766 / 1.20/ (0.00941276 x 12) Maximum Loan Amount = 133,138.33 / (0.00941276 x 12)
Maximum Loan Amount = 133,138.33 / 0.11295312 Maximum Loan Amount = 1,178,704

Keep in mind that rounding could alter your answer by a few dollars.

(An aside: If you’re the sort of person who does not like to play with long formulas, or who tends to tap calculator keys with a closed fist, we have a solution for you. The RealData Real Estate Calculator – Deluxe Edition, will do all of these underwriting calculations for you, as well as perform a host of other useful real estate functions, including amortization schedules for loans with a variety of terms. There are sixteen modules in the Calculator. Find more info at http://realdata.com/p/calculator.)

Your lender will surely round this result, probably down to something like $1.175 million. But you’re looking for just $975,000, so it appears that your income stream will support this loan request. You will want to verify this by calculating the property’s Debt Coverage Ratio going out five or more years. You’ll do that as part of your property pro forma, in the next installment of this article.

Up to this point, however, you’ve accomplished quite a bit: You learned what information you need to assemble about your lender’s underwriting process, about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You’ve learned to use some of that information to estimate the current value of the property, then taken that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement.

You’ve learned about another underwriting metric, Debt Coverage Ratio, and about mortgage constants. You’ve seen how to combine those to test your property’s income stream to see if it’s strong enough to support your loan request.

Not bad for an hour or two of work.

Next time you’ll see how to assemble this information and more into the kind of professional presentation you can give to a potential lender or equity partner.

Copyright 2009, RealData® Inc. All Rights Reserved

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New: “Express Edition” of Real Estate Investment Analysis

We’re excited to announce the release today of a new software product, Real Estate Investment Analysis Express Edition.

We designed REIA Express with several audiences in mind. Perhaps you are…

— a broker who needs to create presentations for potential sellers or buyers;

— an investor who deals with residential or small- to medium-sized commercial properties;

— a person who is new to real estate investing, or a student in the fields of real estate development or finance;

— someone whose specialty is to buy, rehab, and then re-sell property for a profit.

If any of these describe your situation, then the Express Edition of REIA may be just the ticket for you. It has new capabilities and features, and offers presentations that can be customized with your company logo and property pictures. Get more info on the Express product page.

Free Shipping

For a limited time, we’ll include a software CD with every order over $50 and send it to you via USPS First Class shipping at no charge. Just place your shipped order and select “Free First Class Shipping” as your delivery option during checkout. Purchasing your software for download? You can still get a free CD – just email us after placing the order.

– Applies to U.S. and Canada addresses only.
– Total of items ordered must be greater than $50.
– Does not apply to calculator and e-course.
– Regular fees apply to other shipping methods (i.e., Fedex, Priority Mail)..

New version 6 of ‘Commercial / Industrial Real Estate’ released

Our big news today is about a major upgrade to one of our top software apps. Since 1983 income-property developers have been using “CID” to help them with project cost analyses and budget pro formas for build-and-hold as well as build-and-sell scenarios.

So — if you’re developing an apartment building, shopping center or other commercial property from the ground up — or if you’re renovating or expanding an existing property — take a look at this new version and check out its new features. It can help you plan your project, evaluate its feasibility, solicit partners, and make your case for financing.

You can get all the details here.

CCIM magazine cites Frank Gallinelli’s latest book

I was pleased to see that Commercial Investment Real Estate, the magazine of the CCIM Institute, featured my latest book, Mastering Real Estate Investment in their May/June 2009 issue Buyers Guide (p. 45). The piece is entitled “Beyond the Basics,” and I think they were right on the money, so to speak, when they said that I was “Responding to a call from readers for less theory and more practice…” Thank you, CCIM.

10 Ways Green Construction Can Improve Your Bottom Line

I had the good fortune to attend a real estate conference at my alma mater, Yale University, on April 3, 2009, where I got an opportunity to tour their new state-of-the-green-art building, Kroon Hall.

So-called “green” design and construction of commercial buildings aim to save energy and water, create healthier work environments and reduce the environmental impact of construction.  But does it make economic sense?  Conventional wisdom holds that green design currently adds about 2% to 5% to the cost of new commercial construction, although that premium is likely to decrease as both techniques and material become more mainstream.  The payback period on that investment, however, can be quite quick and the long-term economic benefits significant.  Here’s my short list of bottom-line reasons to go green:

1. Look for tax incentives:  Most states offer some sort of tax incentive to developers of energy-efficient buildings.  Check for the possibility of federal incentives as well.

2. Get a ton of publicity: Ok, maybe you didn’t choose to follow the green-brick road for the fame and glory.  Still, you’re going to want to rent or sell this building and a little profile-raising can go a long way.  One sure way to stand out is by achieving LEED certification for your project.  LEED (Leadership in Energy and Environmental Design) is a rating system developed by the U.S. Green Building Council.  It provides recognized standards for green construction, and four levels of certification — Certified, Silver, Gold, and Platinum — based on design.  Their certification is a mark of distinction worth earning.

3. Find a friendly ear at the bank:  Green construction is “sustainable,” which means it should last longer than your financing, and should give you an edge in attracting and keeping tenants.  In today’s financing markets there are no guarantees, but these are advantages that should work in your favor to find financing and secure the best terms.

4. Reduce demolition and materials costs: If you’re building on a site with existing structures, reuse some of the materials.  You’ll save on the cost of materials, carting and disposal, while at the same time reducing impact on landfills.

5. Reduce construction costs:  Passive solar heat and reduced electric lighting will generally mean you need a smaller HVAC system — less costly to install and to maintain,

6. Reduce heating costs:  Orient the building to take advantage of passive solar heat.  Windows can be recessed or otherwise configured so that they allow full sun to enter in the winter, but are shaded when the sun is higher in summer.

7. Reduce electric costs: Increase natural daylight and thus reduce the number of bulbs and amount of electricity needed to run them.  Add daylight sensors to minimize use when unneeded.  Add photovoltaics to reduce purchased power.

8. Reduce water costs by collecting rainwater and/or recycling “greywater” from dishwashers, clothes washers, etc. and use this for landscape irrigation and toilet flushing.

9. Increase rental revenue and improve tenant retention:  There is evidence to suggest that the healthier environment in green buildings improves worker productivity and reduces absenteeism.  A workplace like that can improve a business’  bottom line and hence is more attractive than a similar but not-so-green space.  Translation: The potential exists for higher rental rates from the green space, and fewer vacancies as well.

10. Increase property value: Increased revenue plus decreased operating expenses equals a higher Net Operating Income — and a higher NOI translates into a greater property value (read my books, do the math).  To sweeten the deal even a bit further, here’s a bit of speculation: Watch for the day when commercial appraisers employ a bonus reduction in cap rate for certified green buildings.

Extend RealData Programs To Fit Your Investment Property Or Development Analysis

One of the great advantages to using Excel as a development platform for our software products is the ability for you, the user, to make customizations to fit your analysis objectives.  We encourage our customers to add to the software rather than changing formulas so the base product remains unchanged.

It is very easy to add a user worksheet.  All RealData products have an “Add User Worksheet” feature in the RealData menu.  Just add your own worksheet and begin adding your own formulas which link back to our product.

In our Learn section, we have an article on expanding our popular development program, On Schedule, to accommodate long term rental income when analyzing distressed, partially-built development projects such as housing developments and condominium buildings.

Support is included with the purchase of RealData’s products.  If you would like advice on creating your own extension to your copy of our software, open a support ticket or give us a call.

Spring Thaw for Real Estate?

The first sign of of happy news, of course, was that the stock market actually went up recently more than one day in a row.

Then, on St. Patrick’s Day, Reuters reported that housing starts jumped an unexpected 22.2% in February, “the biggest percentage rise since January 1990 and the first gain since April.” It’s enough to make us want to drink green beer.

In a related article, they suggest that the economy may be showing some signs of life, and note, “Sensing that the worst may soon be over, investors have begun putting a bit more money into some of the hardest hit sectors, including retailers and home builders.”

Still more: The Federal Reserve took the financial markets by surprise with a plan to pump about $1 trillion into the economy by buying treasuries and mortgage-backed securities. Whatever else we may think about this plan’s effect on the dollar and future inflation, it is likely to drive mortgage rates down just in time for what would usually be the springtime home-buying season. Just one day before the announcement, pundits were saying that mortgages rates had surely gone as low as they could; now they’re saying 4% is not unthinkable.

And — back in January, an article in Forbes saw incipient signs of a “resurrection in real estate.”

All this doesn’t exactly add up to the return of a roaring bull-market economy, but at least it’s a relief from the relentless drumbeat of bad news to which we’ve become accustomed. It’s food for thought, and worthwhile reading.

Like winter, recessions eventually end. It would be nice to say good-bye to both.

This post is an excerpt from our March, 2009 RealData Dispatch newsletter. To view past issues, or to subscribe: http://realdata.com/newsletter/newsletter.shtml

Cash Flow Analysis — Annual or Monthly?

A reader of one of my books wrote to me recently with a very worthwhile question.  When we build a pro-forma analysis of future cash flows from a real estate investment, why do we annualize those cash flows instead dealing with them on a monthly basis?  After all, rent is typically collected and bills paid monthly.

The quick and facile answer, of course, is because we’ve always done it that way. Back in the day, we didn’t have powerful personal computers and sophisticated real estate software, so one might argue that this annual approach is just a holdover from a golden age that has passed us by.

Then again, there may be some wisdom inherent in this approach. To make monthly estimates of future cash flows requires monthly, rather than annual, estimates of income, expenses and debt service. The task is not impossible, but collecting, organizing, and deploying this amount of data will surely take much greater time and effort, presumably up to twelve times as much. And we all know that time is money.

Is it practical to do this, and if so, is it worth the effort?  It’s important to keep in mind that you’re not performing an accounting function but rather making projections about what’s going to happen in the future. It’s often difficult enough to estimate your annual cost for heating fuel or electricity five years hence. Trying to estimate such costs by the month can be even more problematic and time-consuming.

Assuming that someone else hasn’t already closed on this property while you were playing Hamlet, did you in fact gain any additional insight or advantage as a reward for your extra effort?

A monthly projection of future cash flows substantially increases your “degrees of freedom” in making estimates, so the monthly estimates are not only more difficult to make, but they also provide you with many more opportunities to be wrong. To put it another way, you are just as likely to introduce errors in timing as you are to add precision, thus offsetting at least some if not all of the benefit of your considerable extra effort.

Having said all this, it is also true that a dramatic skewing of cash flow toward the beginning of a year could make a noticeable difference in a particular discounted cash flow calculation. One might feel that is justified to handle such an atypical income stream differently.

For what it’s worth, my opinion is that the conventional wisdom here actually makes sense. Forecasting the future is an imperfect art; in most situations, annualizing the net cash flow is a reasonable compromise with reality and a task of more manageable proportions.

Frank Gallinelli

RealData