Commercial Loans Blog

Commercial Loans and Tips on Preparing Pro Forma's

Posted by George Blackburne on Sun, Mar 1, 2015

The commercial loan broker most likely to get paid is the one who gets his client the largest loan.  The commercial broker (commercial realtor) most likely to sell an income property is the one who can show his prospective buyer the highest, honest cap rate.  Therefore this article is very important to you because I am going to show you how to honestly, legitimately, and believably calculate and display the highest possible net operating income.  I could make a good argument that no blog article I will ever write might make you more money than this one, so, as your 8th grade teacher said, right after - BAM! - slapping her yardstick on the desk of the dozing student in front of her, "Pay attention!  This is going to be on the test."  Ha-ha.

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If you are trying to sell a commercial property, you want the buyer's cap rate to appear as high as possible.  You will recall that a cap rate is just the return on his money that a buyer would earn if he paid all cash for an income property.

If you are trying to place a commercial mortgage loan, the limiting factor to the size of your new commercial loan is often the debt service coverage ratio ("DSCR").  You will recall that the debt service coverage ratio is merely the net operating income divided by the annual debt service (principal and interest payments) on the proposed new commercial loan.

DSCR = (Net Operating Income / Debt Service) x 100%

 

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Even though the results are better (the DSCR appears higher) if you compute the debt service coverage ratio on a monthly basis, commercial lenders require that you compute the DSCR using annual numbers; i.e., the NOI from the pro forma operating statement and the annual debt service on the proposed new commercial loan.

Debt service coverage ratios are normally expressed out to two digits to the right of the decimal; e.g., 1.27 or 1.42.  Expressing a DSCR of 1.1 would be wrong.  It should be 1.10 or 1.12.  A debt service coverage ratio of 1.00 is what is known as a breakeven cash flow.  Less-than-breakeven cashflows should be expressed as -

0.96  ($112 per month negative)

Notice that I showed just how much or how little the negative cash flow is per month.  This allows a banker to say, "Yeah, well, this buyer is a physician, and he makes $300,000 per year.  He can afford a lousy $112 per month negative cash flow."

Let's get back on track.  We are trying to make the net operating income appear as high as possible on the pro forma operating statement.  You will recall that a pro forma operating statement is merely an operating budget for the upcoming year, with reserves for the eventual replacement of the roof and the HVAC system, along with a reserve to resurface the parking lot and to repair and repaint the exterior.

Okay, here is the good stuff:

  1. You can use the contracted rents that will be in place for the upcoming year (use next year's projected rents), rather than last year's actual rent receipts.  For example, let's suppose that one of your industrial tenants has a $500 per month increase in his lease payments spelled out in his already-executed lease.  You get to use the higher rent.

  2. When preparing your Pro Forma, you use last year's actual expenses, even if next year's expenses are probably going to be higher.  This is the custom and practice in the industry.  Sometimes being forced to use last year's actual operating expenses really hurts you because, for example, last year was unusually cold and your heating bills were extremely high.  Sometimes, however, using last year's actual expenses can help you.  For example, perhaps your water company just announced a dramatic increase in water rates for the coming year.  Remember, the custom and practice in commercial real estate finance (CREF) is to always use next year's projected rents and last year's actual operating expenses.

  3. If some of your units are vacant, use the market rent of any vacant units.  So many brokers forget to do this - especially if there are sixty or more units in the apartment complex, and the borrower hands you this very long rent roll.  A Rent Roll is just a long list containing the units by unit number, the size of each unit, the name of the each tenant, and the amount of the rent.  This allows the appraiser to ask Mr. Jones in Unit 17 whether he is really paying $1,300 per month in rent (rent roll audit).  Rent rolls are used for apartment building and self storage projects.  The equivalent document for office buildings, strip centers, and industrial centers is called a Schedule of Leases.

  4. Don't forget to use the market rent of the manager's unit.  If an owner pays his on-site property manager a salary, that owner has to pay painful employment taxes on this salary.  Therefore, in order to cheat on their taxes, a great many (most?) property owners will give their on-site managers a free apartment, instead of a salary.  The Rent Roll given to you by the owner will therefore often understate the property's true Gross Potential Income (top line of the Pro Forma) by as much as $1,800 per month - the market rent of the manger's unit.  The manager's unit is usually the largest and most desirable unit in the building.  This is huge!  An extra $1,800 per month in income could mean a loan amount that is a whopping $160,000 larger.  Commercial mortgage brokerage is NOT about finding the lender with an interest rate that is a lousy 0.25% lower.  The commercial mortgage broker who closes the deal, gets paid, and kisses the pretty girl is the one who gets his borrower the LARGEST LOAN AMOUNT!!!  It's NOT all about that base - that base.  It's about who gets the borrower the largest loan amount.

  5. If the market rent of a vacant unit is legitimately between $1,150 per month and $1,225 per month, use the larger number.  Duh.  For you commercial loan brokers, the larger your NOI, the higher your DSCR and the larger the commercial loan that you can deliver to your client.  For you commercial brokers (commercial realtors), the higher your NOI, the higher your cap and the more attractive your property appears to a prospective buyer.

 
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Okay, now a really sophisticated issue.  How do you prepare a Pro Forma Operating Statement when part of the building is leased on an industrial gross basis and part of it is leased on a triple net basis.  An industrial gross lease is one where the landlord pays the real estate taxes and the fire insurance, and the tenant pays the rest - repairs, utilities, etc.

Answer:  You prepare the Pro Forma as if the entire building was leased on an industrial gross basis; i.e., you show in the body of the Pro Forma 100% of the expenses for real estate taxes, fire insurance, management, and reserves.  If the building is younger than 35-years-old, I like to use 2% of Effective Gross Income for the Reserves for Replacement (roof, HVAC, parking lot, exterior walls, etc.).  If the building is older than 35-years-old, you should use 3% of Effective Gross Income for the reserves.

Okay, back to this sophisticated question about preparing a Pro Forma Operating Statement on a building that is leased partially on an industrial gross basis and partially on a triple net basis.  So we will show 100% of the expenses for which the landlord might be responsible; but then we recapture, say, 47% of the real estate taxes and fire insurance as CAM reimbursements from the NNN tenants who occupy 47% of the space.

Totally lost?  Don't worry about it.  This is pretty advanced stuff for a deal that we are actually working on this week in our office.

If you are new to this blog - perhaps because one of my readers kindly re-Tweeted this article or shared it on Facebook - I encourage you to sign up for this free training blog about commercial real estate finance.  Simply find my rump-ugly picture on our actual blog site and register by merely typing in your email address.

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The next three years are likely to be the most three profitable years in the history of the commercial mortgage business.  (See my earlier blog article about the tidal wave of ballooning commercial mortgage loans coming due.)  Don't you think its finally time to learn this business?  Remember, the same practical and understandable guy who writes this down-to-earth and fun blog will be the same guy teaching the course.

 

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Topics: Creating Pro Formas