New Educational Videos

RealData founder Frank Gallinelli teaches real estate finance at the Columbia graduate school, as well as investment analysis in public and professional seminars. For the benefit of visitors to www.realdata.com we will be posting a series of video clips from some of his public classes. The first two clips cover due diligence (i.e., doing your homework before you make an offer) and basic real estate investment terminology, wrapping up with a discussion of the APOD form.

You can find these clips on the Learn page at realdata.com. Be sure to come back often to catch new clips as they become available.

If you would like to discuss having Frank address or teach a seminar to your group, contact him directly via email at seminar.realdata at gmail.com.

Commercial Real Estate Financing — What to Do Now

An Interview with George Blackburne

We hear something like this from our customers almost every day: “It’s really a great time to buy property, and if I could get the financing I would certainly do more deals.”*

We hold ourselves out to know a few things about real estate finance, but we must confess that we don’t know where the treasure is buried. So we decided to ask an expert: George Blackburne, III , founder of C-Loans and Blackburne & Sons Realty Capital Corporation.

RD: George, we know you’ve been in commercial finance for decades. Give us your boots-on-the-ground assessment of where we are now.

GB: Clearly, it is much more difficult to finance commercial property than it has been in a very long time. But I don’t agree with the conventional wisdom that you simply can’t get a loan. It’s going to require a lot more digging, but if the deal is a good one then it’s not impossible.

RD: Who’s lending now?

GB: It’s pretty much the hard money lenders and the banks. Gone are the conduits, mortgage REITS and other players.

RD: But a lot of our customers say the banks they’ve always done business with don’t want to talk to them.

GB: They have to understand that it’s a whole new ballgame, a sea change. You can’t rely on your usual lenders anymore. Perhaps most important, you have to forget about visiting just two or three lenders and expecting to get a loan. Plan on submitting your deal to 30-50 lenders. That’s what it will probably take right now.

RD: 30-50?

GB: Yes. I know one guy who approached 112 lenders – but he got the loan and closed the deal.

RD: I want to ask you more in a minute about what borrowers should be doing when they approach these lenders – how they can improve their chances of success – but first I want to ask about terms and underwriting.

GB: Interest rates are still attractive. They depend very much on the deal, but probably somewhere in the 6.5% to 7.375% range. A term of 25 years with a 5-year balloon is typical. Also, expect to be asked for a personal guarantee.

RD: What about LTV and DCR?

GB: DCR is still around 1.25 for most property types, but loan-to-value is likely to be about 60%. Most banks will use whichever of these is more limiting.

RD: Are buyers willing and able to put down 40%?

GB: Sometimes, of course, a couple of investors pool resources. Another technique I’ve been seeing is this: The seller agrees to take a second on some other property that is owned by the buyer – not on the property being sold. That way the buyer gets his secondary financing, and the bank is still lending on a property that has 60% LTV.

RD: Getting back now to the topic I was on earlier: What does the borrower have to do to maximize his or her chances of getting the loan?

GB: There are several things you can do. One of the most important is to create an executive summary of your deal – property info, financial info, photos – and put it into a pdf file that you can submit as part of your loan request.

RD: George, you just gave a pretty good description of some of the reports we produce with our Real Estate Investment Analysis software. Thanks for the plug.

GB: That’s good, that’s the kind of stuff you need to send.

RD: What else can a borrower do to improve the chances of getting a loan?

GB: It seems to me that banks are much more interested than they were in the past in having a deposit relationship with the borrower. Go talk to the bank president or someone high enough up the food chain about bringing over some of your accounts – personal, business, IRAs. These can make a difference.

RD: So where should we be looking for these 30-50 banks to approach?

GB: In general, you have a better chance with banks that are local to the property being financed. Here’s a quick-and-easy: Go to maps.yahoo.com and put in the property address. Where it says, “Find a business on the map,” type in “bank” and click search. Then zoom out the map until you have a big enough radius to give you a nice list. You can click on “view results as a list” to print out your shopping list.

RD: Why didn’t I think of that? If you have a crystal ball, would you care to give any forward-looking advice?

GB: Sorry, no crystal ball, but I will say this: If you currently have a commercial loan that’s going to balloon in the next two years, don’t sit around. I would start looking now to stretch as long as possible.

RD: George, I really appreciate your sharing your expertise. Can you to tell us just a bit about C-Loans and how it might help our readers in their search for financing?

GB: C-Loans.com is a commercial mortgage lender databank, a portal where you can submit your commercial loan to 750 different banks and hard money lenders. It’s also free. Just go to c-loans.com.

RD: Thanks again.

You can contact George Blackburne at

C-Loans, Inc., Blackburne & Sons, and Realty Capital Corp.
Plymouth, IN 46563
(574) 360-2486 Cell (Best)
(574) 936-6387 Office
george@blackburne.com

Give us your comments. What’s your take on the present and future of commercial financing?

Copyright 2010, RealData® Inc. All Rights Reserved
* See related interview from Realty Times with 2010 CCIM President Richard Juge, where he says “…for the first time in many years our members, our own CCIM members, are saying, “This is the time to buy.””
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Real Estate Partnerships and Preferred Return

Q. Can you explain more about how preferred return works in a real estate partnership? Does it always have to go only to the limited partner or non-managing partner?

A. The first point to make about real estate partnerships – whether limited, general or LLC – is that there is certainly no single, pre-defined structure used by all investors. In fact, you may be hard pressed to find two partnership agreements whose provisions are exactly the same.

Not all partnerships include a preferred return but, in those that do, its purpose is to counterbalance the risk associated with investing capital in the deal. Typically, the investor is promised that he or she will get first crack at the partnership’s profit and receive at least a X% return, to the extent that the partnership generates enough cash to pay it. In most partnership structures, the cash flow is allocated first to return the invested capital to all partners. The preferred return is paid next, before the General Partner or Managing Member receives any profit.

There are some variations as to exactly how the preferred return might be set up. If the partnership does not earn enough in a given year to cover the preferred return, the typical arrangement is to carry the shortfall forward and pay it when cash becomes available. If necessary it is carried forward until the property is sold, at which time the partners receive their accumulated preferred return before the rest of the sale proceeds are divided. Again, that assumes that the sale proceeds are in fact sufficient to pay the preferred return. If not, the limited partners have to settle for whatever cash is available.

The return may also be compounded or non-compounded. In other words, if part or all of the amount due in a given year can’t be paid and has to be carried forward, the amount brought forward may or may not earn an additional return (similar to compound vs. simple interest). The usual method is for it to be non-compounded. Hence the unpaid amount carried forward does not earn an additional return, but remains a static amount until paid.

An alternative but less common approach is to wipe the slate clean each year. If there isn’t enough cash to pay the preferred return, then the partnership pays out whatever cash is available and starts over from zero next year.

Real estate partnerships will typically define percentage splits between General (i.e., managing) and Limited (i.e., non-managing) partners for profit and sales proceeds. These splits do not come into play until the obligation to pay the preferred return has been met.

For example, let’s say that a limited partner invests $100,000. She is promised a 5% preferred return (non-compounded), 90% of cash flow after the return of capital and payment of preferred return, and 70% of sale proceeds. In the first five years, the partnership generates just enough cash to return the invested capital to all partners. Hence, all future cash flows represent profit. The partnership has a $16,000 cash flow the sixth year, a $20,000 cash flow the seventh year and also sells the property at the end of the seventh year with total proceeds of sale of $150,000. Here is what happens:

year 6 and 7 distributions to LP

The Limited Partner should receive a preferred return of $5,000 per year (5% of her $100,000 investment). By the end of year 6 she hasn’t received any of this return so she is owed $30,000. In the sixth year the partnership cash flow is only $16,000, so that is all she gets; the balance due is carried forward to year 7. In that year the partnership cash flow of $20,000 is sufficient to pay the $14,000 owed from year 6, the $5,000 from year 7 and still leave enough ($1,000) to split 90/10 with the General Partner. Finally, the property is sold at the end of year 7 with $150,000 proceeds to split 70/30 with the General Partner.

Regarding the question, “To whom does the preferred return go?” it is of course possible to structure a partnership so that it goes either to the General or the Limited partner or to Donald Duck if you think that’s a good plan. The presumed purpose of the preferred return is to encourage non-controlling investors to risk their capital in your project; and that encouragement often takes the form of a conditional promise of a minimum return, the “preferred return.” It seems to me that you would have a difficult time raising money from investors if your underlying message were, “This deal is so shaky that I need full control plus first dibs on the cash flow. If there’s anything left, you can have some.”

Run the numbers, but think beyond them. A good partnership is one where all the parties can enjoy a reasonable expectation of success.

Copyright 2009, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Managing for Value – A Guide for the First-Time Landlord

Most of our articles have dealt with the analysis, development and acquisition of income property. It is easy to get wrapped up in the metrics of this process and to forget that eventually you’ll have to engage in the human and sometimes demanding business of actually managing the property you buy.

How you fulfill that task can go a long way toward determining the financial success of your investment. Property management is a complex subject, but if you observe some basic principles you can maximize your long-term profit and minimize some of the burden.

It’s business, nothing personal

Existing tenants will naturally harbor some suspicion about a new owner. Ignore it. Eventually you won’t be the New Guy or they won’t be the tenants, so it doesn’t really matter. Conduct yourself in a businesslike manner starting on day one. Treat your lease agreements like the business contracts they really are. Don’t simply ask a new tenant to sign the lease. Explain the terms and translate the legalese. Doing so establishes the fact that the lease terms matter and you expect both sides to observe them.

The Aretha Franklin Principle

In more than 30 years of owning rental property (and watching others do the same), I have found one principle that has proved consistently valid: Don’t expect your tenants to treat your property with respect unless you treat it with respect. As I urge in my book, Insider Secrets…, “If something is broken, fix it. If something is dirty, clean it up. If something is dangerous, make it safe. You can be certain that very few tenants will put forward any special effort to take care of the property if your attitude is one of neglect.” The converse of this principle is also true. If you behave like a slumlord, you’ll get what you deserve.

Not only does this principle occupy the ethical high ground, it also makes very good business sense. Deferred maintenance is ultimately more expensive than aggressive maintenance and it will eat away at your investment return from several sides. The postponed repair will typically ring up a larger bill later. Consider the small plumbing leak you ignore today versus the additional damage you must repair when you finally fix the leak a few months hence.

A property with deferred maintenance also diminishes the amount of rent you can expect to collect. First, because few tenants will pay top dollar to occupy a poorly maintained property. And second because those who do, but feel they are not getting what they bargained for, are more likely to default in their payments.

Finally, on what should be your big payday – the day you sell the property for a handsome profit – you’ll find yourself making price concessions because of the property’s poor condition and its below-market revenue stream. By operating on the cheap you’ve bought your way into a lose-lose-lose trifecta.

Managing for Maximum Return

Buy Right

Your goal should be to manage the property for the greatest long-term gain. If you’ve read some of our earlier articles about Net Operating Income, capitalization rates and Internal Rate of Return, you understand that an income-property’s value is directly related to its income stream. Hence, your best chance to maximize that gain is to grow the property’s Net Operating Income. Doing so translates into at least two benefits: It’s likely to help your year-to-year cash flow, but even more important, NOI is fundamental to the valuation of the property. Hence, by increasing the NOI you create equity.

One way to optimize the growth of the property’s NOI is to buy it right. That’s not code for “look for properties you can steal.” It is not at all uncommon to find properties that earn below-market rents. This may happen because they have the kind of deferred maintenance discussed above, but it can also occur because the owner has simply not kept pace with the current market. Some landlords, especially those for whom real estate is a sideline, find it easier to renew the leases of good tenants at a nominal increase rather than demand market rents and take on the work and risk of finding new tenants.

When you locate such a property, you must not lose sight of the fact that you should purchase only if you can do so at a price that is very close to what its current income justifies. The seller will tell you that it should rent for more and therefore it is worth more. You could rephrase the seller’s position as, “Do my job and assume my risk, but pay me as if I had done it myself.” If you purchase a property with below-market rents at a price consistent with those rents and then proceed to bring them up to market, you will almost always create additional equity.

Implement Management Improvements

Unless the property you buy is a text-book case of managerial perfection, you can almost enhance it revenue stream (and therefore its value) by making management improvements. Not to beat a fallen horse further, start by cleaning up the previous owner’s deferred maintenance. After that, begin looking for ways to make the property more appealing to your pool of potential tenants. For example…

Common Area – For apartment and office properties, make sure the hallways and stairways are clean and well-lighted. Some artwork on the walls and furniture or other decorative items in the halls creates a more welcoming and less institutional atmosphere. They convey that the owner cares about creating a quality environment.

Security – For better or worse, we’ve become a very security-conscious society. Don’t take that concern for granted, but rather deal with it in a way that distinguishes your property from other with which it competes. The appropriate level of security varies a great deal from one type property of to another, but look for ways to improve whatever you have now. Exterior lighting, higher quality doors and door locks, controlled access to parking, and monitored fire and smoke detectors are just a few of the steps you can take.

Amenities – What do tenants really want? Can you wire the building for high-speed Internet access? Provide pooled secretarial and reception services for small office tenants? Pay for a series of newspaper ads promoting the businesses in your strip shopping center? Your goal is to maximum your income stream and to do so you need to distinguish yourself and your property from your competition. The numbers will add up quickly. Do the math:

Value = Net Operating Income / Capitalization Rate

Let’s say that, in your market, the prevailing cap rate is 10% (that is, if investors are buying properties for 10 times the NOI). You purchase such a property, make some of the management improvements suggested here and increase the Net Operating Income by $1,000 per month, or $12,000 per year.

Increase in Value = 12,000 / 0.10 = $120,000

By making management improvements, you created $120,000 in additional equity. Did you spend some time accomplishing this? Yes. Did you spend some money to make those improvements? Certainly. Did you spend $120,000? Not likely, probably not even close.

People who buy single-family homes with intention of “flipping” them quickly for a profit in a hot market are relying on economic forces beyond their control to create that profit. Those who invest in equities are also relying on outside economic forces as well as the competence and integrity of company management.

The bottom line with income-producing real estate is this: If you manage your property intelligently, ethically and responsibly with an eye toward providing the kind of quality environment that can command optimal rent, you can do something that you could never accomplish with a stock or bond investment or even with a flip. You can use your own initiative and skill to create value. In the most literal of terms, you can make money.

Copyright 2010, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

 

Continuing Ed.: Is an Investment Class Right for You?

From time to time I teach a series of continuing education classes for Connecticut brokers and agents.  The courses are entitled “Understanding Real Estate Investments” — there is a Level 1 (introductory) and Level 2 (intermediate), each for 3 credit hours as electives. I’ll be doing so again from late March to mid-May, 2010.

Something I often hear is, “Oh, I’m a residential agent so I guess that’s not for me.” Of course I have just the opposite in mind. The residential agent or broker is the ideal candidate for these classes. 

To explain why, I’d like to share a few observations I make to my students before I get into the meat and potatoes of my classes’ subject matter: What are these courses about? Why do I teach them?  And, why should you even care?

Making the best seller list at realtor.org

To my surprise and delight, when I opened my Twitter account this morning (twitter.com/fgallinelli) I found news of one of my books making the 12/31/09 best seller list at Realtor® Magazine.  There will be no living with me today!

What Every Real Estate Investor Needs to Know About Cash Flow… was released by McGraw-Hill six years ago, and in a second edition last fall.  It covers what I believe are the key concepts and calculations that every real estate investor ought to understand when making a decision to buy or sell.

I tried to make the book accessible and useful to beginners, students, and experienced investors alike.  It works well for me when I teach my continuing ed classes and my grad-school course in real estate finance at Columbia.  I hope it has been or can be helpful to you as well.

Many thanks to Realtor® Mag for the plug!

Frank Gallinelli

P.S. Speaking of plugs, I have a sequel: Mastering Real Estate Investment

Making the Case for Your Commercial Refinance, Part 2

In Part 1 of this article, you learned what information you need to assemble to get started with the process of refinancing your commercial property — information about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You also learned to use some of that information to estimate the current value of the property, then learned to take that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement.

You got acquainted with Debt Coverage Ratio and mortgage constants and saw how to combine those to test your property’s income stream to find out if it’s strong enough to support your loan request.

Now you have some idea of what your property is worth and how likely it is to appeal to an equity partner or to satisfy a lender’s underwriting requirements. Your next task is to convey your evaluation to that potential partner or lender. You need to make your case with a professional presentation that is easy to grasp but also provides enough detail to support your evaluation of the property and your request for financing.

Unless you’re a “flipper,” you can expect to be involved with this property for the long haul, more or less. It should come as no surprise, therefore, that a lender or investor will appreciate getting a sense of how you believe this property will perform over time. You’re not going to predict the future with precision, but in most situations you should be able to make some reasonable and realistic “pro forma” projections of future performance. There is no hard-and-fast rule, but I believe your projections should go out five to ten years. With commercial properties that have long-term leases in places, 20 years would not be unthinkable.

As we develop the pro-forma presentation through the rest of this article, we’ll be using the Standard Edition of RealData’s Real Estate Investment Analysis (REIA) software. Those readers who are familiar with the software will also note that I’ve taken a few liberties with the material I display, editing some of the images (for example, removing multiple mortgages) to allow you to keep your focus on just the key elements of this example.

Where to start? You’re dealing with rental property, so a rent roll would be a good place to begin. And let’s assume that “today” is January 1, 2009. List your rental units (or groups of units, if you have a large number) with the current rent amount and your estimate of how those rents will change over time. You’ll recall from the APOD you constructed earlier that you expect the total gross scheduled rent for this property to be $219,600 in the first year. For the sake of making this example worthwhile, assume that the property contains both residential and non-residential units, and therefore the total amount of revenue is divided between the two types.

With residential units — apartments, for example — the process of building your rent roll will be fairly straightforward. The rent for each unit of this type is usually a fixed monthly amount. Residential tenancy agreements are seldom long term, most often a one-year lease or even month-to-month occupancy. It’s reasonable to assume that you will try to increase your overall rents on an annual basis. For the first year, you have the following:

sample residential rents, first year

Demand for your apartments has always been strong, but you decide you want to be conservative in your estimate of how much more you can charge each year so you decide to project that these rents will rise at an annual rate of 3%.

sample residential rents, five years

This is a mixed-use property, which means it contains commercial as well as residential rentals. At street level, below the apartments, you have two retail spaces. The first of these is a hardware store, Nuts & Bolts. This store occupies 1,000 rentable square feet and currently pays $21.60 per square foot per year. Its lease calls for a rent increase to $23.50 in July of 2011 The second tenant is Last National Bank, which occupies 2,800 square feet at $25.00 per foot. This tenant’s rent is scheduled to rise to $28.00 per square foot in September of 2012.

Note how your handling of commercial rentals differs from residential. One difference is that you typically charge rent by the square foot rather than by the unit. In most U.S. markets, the rent is expressed in terms of dollars per square foot per year, although in some it is per square foot per month. A second difference is in the length of the lease. As noted earlier, a residential tenant’s commitment may be as little as month-to-month, and generally is not more than one or two years. Commercial tenants, in order to maintain and operate a business from their space, need the certainty that they can continue to occupy for a reasonable length of time. They also need to be able to plan their future cash flow. Hence a commercial lease will usually run for at least a few years, up to as many as 20 or 30.

With the information you have in hand about these commercial leases, you should be able to project the rent from the two commercial units for next several years.

sample commercial rents

The image above is a screen shot from a data-entry portion of the REIA software. This is one image where I haven’t done any editing, i.e., I haven’t removed line items unrelated to our example. I’ve left it complete so you could see that there are other considerations you might need to take into account when you deal with a commercial lease, such as expenses passed through to tenants, leasing commissions, and improvements to the space made by the landlord on behalf of the tenant. We don’t want this article to morph into a full-scale textbook, so we’ll continue to keep our example relatively simple. However, for more information on these and similar topics, you can view our educational articles at realdata.com or refer to the software user’s guide forReal Estate Investment Analysis.

You now have a forecast of the revenue from both the residential and commercial units, and can consolidate this data to include as part of your presentation to your lender or potential partner.

sample combined income

Recall that when you were estimating the value of the property you used something called an Annual Property Operating Data (APOD) form. That form displayed the total rental revenue, an allowance for vacancy and credit loss, and the likely operating expenses for the current year. To fit the needs of your extended presentation you can expand this form to as many years as you want.

For the purpose of this discussion you’ve been projecting out five years, so you’ll do the same with the APOD. You may want to refine your estimates on an almost item-by-items basis. For example, if property taxes, maintenance and insurance are among your greatest expenses, it makes sense to estimate their rates of growth individually. You probably have some history with these items that you can use for guidance. For some other expenses, such as accounting or trash removal, you may want to apply a general, inflation-based estimate. In this example, property management is one of your biggest costs. You know that it will be billed at $15,740 for the first year, but then as a percentage of collected rent — 7% in this case — for future years, so your estimate will just require that you apply the same rate. If you estimate the future rent reasonably well, then the property management fee will follow.

Let’s say you believe that property taxes will increase at 5% per year, and insurance and maintenance at 4%. For all other expenses, you project a 3% annual increase. Your extended APOD should look something like this:

sample APOD

If you owned this property debt-free, your analysis would be nearly complete. But in fact, your objective here is to build an effective case for refinancing your existing loan, so you really need to demonstrate what kind of cash flow this property will throw off with a new loan in place. You need to take this at least one step further.

Recall from the first section of this article that you estimated the value of the property at $1.45 million, and that you need to refinance your $975,000 loan at 7.75% for 15 years. With that information in hand you can complete the taxable income and cash flow sections of your pro forma.

sample taxable income

sample cash flow

These projections should help you make a strong case for approval of your new loan. With that new loan in place, your debt coverage ratio is more than ample in the first year, and improves each year thereafter. Your cash flow is strong, and it too grows each year. It’s strong enough, in fact, that you could even survive the loss of one of your commercial tenants without plunging into a negative cash flow.

Your Net Operating Income is also going up smartly. Perhaps your lender is concerned that the current prevailing cap rate of 11% will rise to 14% by 2013, possibly reducing the value of the property dangerously close to the amount of the mortgage. Does that look like a genuine cause for anxiety?

Remember your cap rate and LTV formulas for the first part of this article.

Value = Net Operating Income / Capitalization Rate
Value in 2013 = 177,839 / 0.14
Value = 1,270,279

So, if cap rates rise to 14% and your NOI is indeed 177,839, then the property should still have a value of about 1.27 million. This is not good news for you, but does the lender have reason to lose sleep?

What will your loan balance be at the end of 2013? You will have been dutifully paying it down from now until five years hence, so surely you will have made a dent. If you return to the REIA software, you’ll find that it includes amortization schedules for all of your property loans. It also tracks the end-of-year balance for each loan as part of its resale analysis, so let’s look at that:

sample mortgage payoff

You will owe $764,719 at the end of 2013. Your property, if cap rates do rise to 14%, will be worth about $1,270,000. Recall that your lender required a Loan-to-Value Ratio of 75% when you applied for the loan. Will it be time to reach for the antacids?

Loan-to-Value Ratio = Loan Amount / Property’s Appraised Amount
Loan-to-Value Ratio at EOY 2013 = 764,719 / 1,270,000
Loan-to-Value Ratio at EOY 2013 = 60.2%

Your LTV looks even better at EOY 2013 than it did when you originally applied for the loan. It’s time to find a polite way to tell the lender to stop looking for excuses. Your loan request is solid and needs to be approved.

You’ve assembled a good deal of data to support your loan request, but don’t forget that a major part of your objective here is to present it in the most effective way. Start by trying to boil it all down. Simplify and summarize. Think of this part of the process as the real estate equivalent of the “elevator pitch.” Ultimately you’re going to need to provide the loan officer with every detail, but you may not get a chance to tell the whole story unless you can convey the essentials in the time it takes to ride the elevator. You need an executive summary.

sample executive summary

This report gives a very direct one-page summary of basic information about the property and its financial metrics. Your lender can see immediately the amount of the loan you’re looking for, the LTV and Debt Coverage Ratio, the Net Operating Income and the cash flow. This report doesn’t supply the underlying supporting data to justify these numbers — that’s why it’s a summary — but taken at face value it tells the loan officer whether there is any reason to give your request a serious look.

An alternative is a report we call the “Real Estate Business Plan,” and it too looks very different from the rows and columns of numbers usually associated with a pro forma. You might assemble information into a report like this in a situation where you still want to make your initial approach with what is essentially still an overview of the property, but one that provides a bit more detail than the one-page summary. Just as with the Executive Summary, you want to provide enough information to be effective, but not so much that you discourage the recipient from actually reading the document.

We designed this report to focus on property description, sources and uses of funds, financing, cash flows, and rates of return, and to simplify its presentation by displaying only the data that is pertinent to the holding period you specify. So, even though the software can deliver projections of up to 20 years, if you want a report based on a five-year holding period, you get a nice, clean presentation with no extraneous labels or data, as you see in this excerpt:

sample business plan, part 1

 

sample business plan, part 2

 

sample business plan, part 3

 

At the beginning of our discussion of pro formas and presentations, I said that you needed to deliver a package that is easy to grasp but also provides enough detail to support your evaluation of the property and your request for financing. You may have already inferred from the progress of this article that the process of building the presentation runs in a direction that’s essentially opposite from the process of delivery. You need to begin, as we did here, at the most granular level of detail: defining individual unit rents and item-by-item operating expenses, first as they currently exist, then as you project them to grow.

That is why you built your rent roll first, then your extended APOD, then your cash flow projections. Next, you distilled this information into summary formats — the Executive Summary and the Real Estate Business Plan.

You built your case by going from the specific to the general. You’ll typically present your case for financing, however, by going the other way. You start with the Summary or Business Plan type of report, which provides enough information to introduce your request without burying the loan officer in a mountain of tiny numbers. When that loan officer says, “Where did you get these revenue projections?” you’ve got your rent roll. When she says, “How did you come up with this NOI?” you’ve got your APOD. And you can do the same for your cash flow and debt coverage, and resale value and rates of return, and more.

You’ve got it all covered.

Before we conclude this discussion, a brief reality check is in order. The example we just worked through was a happy case study because the property’s income stream justified the financing you sought. All the number crunching in the world, however, won’t transform a troubled investment into a good one. A detailed analysis can, however, still be helpful because it can show you what level of revenue you need to reach, or what level of cost-cutting you have to achieve to bring the property into positive cash flow territory and get it back on its feet. But whatever you do, don’t try to “enhance” the numbers to make the property look good. You’re not going to fool the lender and there’s not much point in fooling yourself.

So, what did you learn in Part 2 of this article? You learned to build a rent roll, one style for residential units and another for commercial. You learned to develop pro forma projections by extending your current-year estimates of revenue, operating expenses, and cash flows into the future. Perhaps most important, you learned about creating presentations out of those pro forma projections — presentations that are readable and effective, and that can help you make you case for financing your investment property.

Copyright 2009, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

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

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

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)..