Commercial Loans Blog

Commercial Loans and the Profit Ratio

Posted by George Blackburne on Sat, Feb 16, 2019

Fairfield Inn-3You may recall from an earlier blog article that I am putting together a $2,000,000 syndicate of equity investors to help a developer build a brand new Marriott Fairfield Inn in Roseburg, Oregon.  Our investors are projected to earn a 25.4% annual simple interest return.  Are you an accredited investor?  Here is a one page summary of the offering.

Now I made a mistake.  I have been marketing this deal to stress that it is only 60% of cost.  Dumb.  I should have been marketing it as an opportunity to own a beautiful, brand new hotel whose takeout loan is only about 50% loan-to-value.

 

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So how did I jump from a deal where the mortgage was just 60% of cost to one where the first mortgage was just 50% loan-to-value?  

Answer:  When a developer builds a commercial property, that property is almost always worth materially more than it costs to build; otherwise, why built it?  Why would you spend $15 million to build a hotel that was only worth $14 million?  That makes no sense.

In fact, the bank will insist that the deal have some profit built into it.  The bank does this by applying the Profit Ratio.  The Profit Ratio takes the increase in the value of the property upon completion and divides it by the Total Cost.  That profit over the cost of construction must usually be around 20% of the Total Cost.

 

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Example:

A hotel costs $15 million to build.  While the bank is underwriting the construction loan, it will hire an appraiser to estimate the value of the hotel upon completion and stabilization.  Stabilization means that the hotel has been operating awhile, and its  occupancy rate and average daily rate ("ADR") have leveled off.

Let's suppose the appraiser values there hotel at $17.5 million upon completion and stabilization.  What is the Profit Ratio?

Profit Ratio = (FMV - Total Cost) / Total Cost

Profit Ratio = ($17.5 million - $15 million) / $15 million

Profit Ratio = $2.5 million / $15 million

Profit Ratio = .167 x 100% = 16.7%

 

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Now a Profit Ratio of 16.7% is slightly less than the desired 20% indicated above, but the bank is still likely to approve this construction loan.  Why?  Because the construction loan is only 60% of cost.  The developer has plenty of skin in the game.

Here is what happens when the Profit Ratio is not high enough:

Example:

Billy Bad-Timing is a real estate developer.  At the top of the market, he unwisely bought some land to serve as the site of his next apartment building.  He overpaid for the land.  By the time he got ready to develop the land, apartment rents had stopped climbing and construction costs had risen by 7%.

 

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When Billy the Developer applied to the bank for a $4 million construction loan, the bank looked at and used his actual cost of the land; i.e., $1 million in cash.  In truth, the apartment building site was now only worth $600,000; but neither the bank nor the appraiser caught it.

The appraiser did notice, however, that the apartment building was only going to be worth $5.1 million upon completion, but it would cost $5 million too build.  Loan Committee looked at the $1 million in cash that the developer had contributed to the project (the cost of the land) and figured that Billy would never walk away from a half-completed project when he had $1 million invested.  Loan Committee approved the $4 million construction loan request and construction got underway.

During construction Billy noticed his costs kept increasing over budget.  Finally Billy took a step back and asked himself, “Why am I busting my chops every day to finish this apartment building?  I am not going to make a penny of profit.  With the recent cost overruns, my total cost is going to be $5.8 million, not the $5 million that I had projected. 

 

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"That means," Billy thought, "I am going to have to contribute another $800,000 of my own dough just to finish the project.  The most I can get for the building upon completion is $5.1 million, and after selling costs of 6% and closing costs of 2%, the most I can walk away with is just $692,000 after paying off the bank."

"I have to work hard every day for another six months, contribute another $800,000 of my own cash, and then I have to walk away from my $1.8 million investment with just $692,000???  Forget this!  I’m outa here.  I’m going to take my last $800,000 down to Texas, where the construction business is booming.  If the bank wants to sue me, they’ll have to come chase me there, where the bankruptcy laws are very favorable to debtors.”

Now the bank really has a problem.  The project is half-completed, and the developer has left the state hauling away much of the construction supplies.  No one can find the latest copy of the plans, and the subcontractors are screaming to get paid.  The rainy season is coming soon too.  Looks like big trouble in River City.

 

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The bank should have caught this dangerous situation in underwriting.  Remember, the Profit Ratio is supposed to exceed 20%.  What was Billy Bad-Timing’s Profit Ratio?  Remember, his projected profit was only $100,000 -- $5.1MM value upon completion minus his $5 million projected Total Construction Cost.

Profit Ratio = ($100,000 / $5,000,000 ) x 100% = 2%  (Just 2%!!!)

Oops.  Somebody at the bank goofed up.

 

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Now I am hoping to catch with this article a few more wealthy investors who are attracted to the idea of earning 25.4% and owning a brand new Marriott Fairfield Inn with a mortgage that is only around 50% loan-to-value.  For a development equity deal, this is a fairly low-leveraged deal, which greatly reduces the risk.  Remember, our developer on this deal is a general contractor who has specialized over the past 23 years in building franchise hotels.  He has already completed 60 hotels.

Once again, here is the deal.

 

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Topics: Profit Ratio

Pretty Cool Syndicate That I Am Assembling

Posted by George Blackburne on Mon, Feb 11, 2019

Fairfield InnThis month I am syndicating a fantastic deal.  Please do not interpret my enthusiasm as any sort of guaranty of success or safety; however, let's face it.  Some investment deals are better than others.  

I predict that this syndication will be the single best investment offering we have ever made in almost 40 years.  The projected return to our accredited investors, over seven years, is projected to be 25.4% annually.  Here is a link to the offering.

 

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Here is what is happening.  A very experienced hotel builder is building a Marriott Fairfield Inn in Roseburg, Oregon.  The Fairfield Inn is a very popular hotel franchise, with over 900 of these hotels worldwide.  The proposed hotel is adjacent to Interstate 5, which runs from the Canadian border to the Mexican border, through central Washington, central Oregon, and Central California.

The reason this opportunity is so promising is because our builder-developer has built sixty (60!!) hotels over the past 23 years.  Wow.

This is also a low-leverage investment.  The construction and takeout loan will only cover 60% of the total cost of the project.  This helps to assure that there will be plenty of cash flow left over after making the mortgage payment.  Obviously numbers like this assume that the hotel gets built on-time and on-budget, and that the hotel will meet its projections for occupancy and average daily rate.

 

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If this was a newbie builder, the construction cost issue would be a source of serious concern; but after building sixty hotels, most of them flagged hotels, it's reasonable to believe that our builder knows what he is doing.  In addition, Fairfield Inns are proven franchises with large followings.  For example, when I used to travel with Culver Military Academy's fencing team, we always stayed in Fairfield Inn's.  They were everywhere.  

In the old days, banks would provide construction loans of 80% loan-to-cost to finance flagged hotels.  Then the Great Recession hit, and commercial construction lenders got slaughtered.  Nowadays, most banks limit their commercial construction loans on hotels to just 60% of cost.

Since the total cost of the project is around $15 million, this means that the developer has to raise almost $6 million in equity.  Our investors will be contributing about $2 million of this required equity.

 

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The 25.4% deal is about half-subscribed as of today.  If you happen to be an accredited investor, and the idea of earning 25.4% annually sounds interesting, please contact Angela Vannucci at 916-338-3232.  You may be reassured to know that Blackburne & Sons has been in business since 1980.

The above deal will soon be sold out, and we will be looking for our next equity investment deal.  Please be on the look-out for deals.

We are looking for development deals, and our maximum equity investment is $2 million.  We want the developer to have plenty of skin in the game, so we really don't want to contribute more than 40% of the required equity.  We like the four major food groups - multifamily, office, retail, and industrial - plus self storage and hospitality. 

 

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If you have a potential deal, please do NOT call or send me some huge package.  Just please send me three sentences.  "I am building a 46-unit apartment building in Des Moines, with a total cost of $12 million.  The bank will only make an $8 million construction loan.  I am short $1.6 million in equity."

Please make the subject line of this email to be exactly, "Equity Contribution Request".  The reason it has to be exact is that I get 1,200+ emails per day.  Please write to me at george@blackburne.com.

 

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Different subject:

You can still get our nine-hour video training course, How to Broker Commercial Loans, for free by assembling a list for me of 20 commercial loan officers making commercial real estate loans.  Each of these loan officers must work at a bank or a credit union.  Sorry, but we do NOT want anyone other than bank loan officers or credit union loan officers.  Here is how.

 

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Topics: development equity

Use the Commercial Loans Blog As a Reference Library

Posted by George Blackburne on Tue, Feb 5, 2019

LibraryThe Commercial Loans Blog now has over 300 training articles on the subject of commercial real estate finance ("CREF").  I have covered so much material in my blog that I often have trouble thinking of new topics to write about regarding the commercial loan business.  If my goal was to write down everything that I had learned in my 40 years in the commercial loan business before I died, well, I've largely succeeded.

Therefore the C-Loans Commercial Loans Blog is a pretty decent research tool.

 

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Let's suppose the term "cap rate" comes up during your negotiations on a commercial loan.  You kinda know what the term means, but maybe you could use a quick refresher course on cap rates.  

Assuming you like the way that I train - using everyday words, lots of examples, and lots of funny pics, you could use Google to search my vast library of blog articles.  In the Google search field, you would simply type:

"C-Loans blog cap rates"

Voila!  A half-dozen of my commercial loan training articles on the subject of cap rates will appear.

 

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Perhaps you are trying to place a $6 million permanent loan on an older office building in Detroit, and you are working with a conduit.  Suddenly the conduit commercial loan officer throws out a ratio that is Greek to you - the debt yield ratio.  Clearly this new debt yield ratio is different from the debt service coverage ratio.  How do you learn about this new ratio without looking like an idiot?

Simply go to Google and type in -

"C-Loans blog debt yield ratio"

By the way, what is a conduit?

"C-Loans blog conduit"

 

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Okay, so you're trying to place an apartment loan, and the commercial loan officer says, "Your operating expense ratio is too low."  Operating expense ratio?  What the heck is an operating expense ratio?

Simply go to Google and type in -

"C-Loans blog operating expense ratio"

And if you ever search my blog, and you do NOT find an article on your subject, please write to me at george@blackburne.com.

 

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Topics: research tool

Attention Developers, We Want to Invest Equity in Your Commercial Construction Deal

Posted by George Blackburne on Fri, Feb 1, 2019

small apartment building-1Are you building a small apartment building, office building, or flagged hotel?  Is the bank demanding that you contribute an insane amount of equity to your deal?  We may be able to help.

Blackburne & Sons Realty Capital Corporation can raise relatively small amounts of equity for new construction deals.  We are looking to invest in fairly standard property types - the four major food groups (multifamily, office, retail, and industrial), plus self-storage and hospitality.

 

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Sorry, but we will NOT consider residential development projects at this time.  It is too late in the economic cycle.  Homes will be slow to sell during a recession.

Example:

Davey Developer wants to develop a small apartment building in Indianapolis.  The total cost is $10 million.  Davey has contributed $2 million to the project, and normally that would be enough.  Two million dollars is 20% of the total cost of the project.  Historically banks have been happy to make construction loans of 80% loan-to-cost.

But when Davey Developer sits down with Louie the Loan Officer for Nearby Bank*, Louie says, "I'm sorry, Davey, you've been a great customer of the bank for years.  Your two deals, for which we provided the construction loan, went off without a hitch.  Your new buildings were gorgeous, and the quality was obvious."

 

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"However, like a great many banks, Nearby Bank got seriously hurt in construction lending during the Great Recession.  In fact, Davey, we almost went under.  Yikes.  As a result of pressure from regulators, we can now only make construction loans if the developer contributes 35% of the total cost of the project.  Every other bank in Central Indiana is subject to the same bank regulations, so it will do you little good to try to find another bank."

"In this case," continues Louie the Loan Officer, "the total cost of your project is $10 million.  You'll need a total of $3,500,000 in equity.  You only have $2 million to contribute to the project, so you'll need to somehow raise another $1,500,000."

*For training purposes, I have used the name of Nearby Bank for the construction lender.  Remember, commercial construction loans are almost always made by commercial banks, and the closer the bank is located to the proposed project, the more likely it is that the bank will approve the deal.

 

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Davey's deal is just what Blackburne & Sons is seeking.  The fact that he has built two prior projects shows that he has experience, and the need for $1.5 million in additional equity is right in our sweet spot.

Our sweet spot is to contribute up to $2 million in equity.  Raising equity is a lot harder than raising hard money loan dollars because the investment is immensely riskier.  An equity investor can easily lose 100% of his dough if the construction lender forecloses.  

On the other hand, equity investors have a chance to earn much higher yields, on the order of 18% to 30% annualized return on their investment (ROI).

 

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Think about this from a developer's point of view.  The bank will loan him capital at just 6.5% interest, but an equity investor will want a 18% to 30% ROI.  Obviously, the developer will want as many loan dollars as the bank is willing to give him.

Mortgage brokers, if you are trying to place a construction loan, and the developer is short a little equity, you should bring in Blackburne & Sons to provide the last piece of equity.

We are not going to provide 100% of the equity in a commercial construction deal.  We want the developer to have a ton of his own skin in the game.  We certainly don't  want him walking away.  As a result, we will not contribute more than 40% of the required equity.

 

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Got a deal?  Please do NOT call me.  Please do NOT send me a package.  I probably won't even look at it (too long).  Instead, please just send me, George Blackburne III (the old man and father of George IV) a ONE paragraph pitch that mirrors the following:

Sample Equity Contribution Request:

George,

I am building a spec office building in Billings, Montana, where nearby oil exploration has driven the office vacancy rate down to below 5% (give me a little sizzle here).  The total cost of the project is $8 million, and my construction lender will only go 60% of cost.  I need a total $3.2 million in equity, and I am short $1.3 million in equity.

Love,

Donny Developer (no relation to Davey)

Important Note:

I get 1,500 emails every single day, so it is critical that the subject line read exactly, "Equity Contribution Request"; otherwise, it will be too easy for me to miss your important email.  

If your deal looks like a good fit, I'll ask for your package, and I'll send you my phone number.  Thanks! 

 

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Are you a wealthy and accredited investor?  Does the idea of earning 18% to 25% on your money sound attractive?  Blackburne & Sons (est. 1980) started out as a hard money lender that recently expanded into syndication.  Our accredited investors (about 2,000 of them) receive both first mortgage investment opportunities AND equity investment opportunities from us.  If you fill out the form below, we'll add you to our investment distribution list.  We are actually going out for sale on an equity deal that is projected to yield 25.4% to our investors, and the builder has built SIXTY hotels.  Wow.  Yum.

 

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Topics: construction equity