Commercial Loans Blog

Commercial Loans That Cash Flow Too Well

Posted by George Blackburne on Thu, May 1, 2014

Bad CreditOne of our commercial loan officers said to me this week, "George, this commercial loan cash flows really-really well."  To which I replied, "I would much rather make a commercial loan that didn't cash flow worth a darn."  Why of EARTH would I say such a thing?

Poor folks with lousy credit pay far more for a 2-bedroom, 1 bath apartment than renters of nicer units with good credit.  The reason why is that in order for landlords to be willing to rent to folks with poor credit, they need to make a large premium in order to make up for the flakes who skip out in the middle of the night and the lowlifes who trash their property.

 

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Its much the same way for rent-to-own funiture and appliance stores.  Used car dealerships, which sell most of their cars to buyers with poor credit, do the same thing.  They charge a huge premium for their cars.

Therefore any time you see a multifamily or commercial property that cash flows unusually well, be alert to the possibility that the property may be in a rough area and/or may have low-class, dangerous tenants.

Another way to look at the same issue is to look at the cap rate.  Remember, a cap rate is just the return on your money that you would enjoy if you bought a commercial property for all cash.

For example, if you paid $1 million for a property that generated $80,000 in net operating income, you purchased the property at an 8% cap rate ($80,000 NOI / $1,000,000 purchase price times 100%).

What would you say if I told you that in order to collect your 8% return, you would have to drive through the ghetto every month to collect your rent?  Would you still pay $1 million for the property, when you would literally be risking your life every time you drove to see your own property?  If you got a flat tire, you might never see your sweet wife and kids again.  I can see the headline now, "Landlord Beaten to Death With Lead Pipe.  Local Toughs Suspected."

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Okay, so clearly you wouldn't pay $1 million for just $80,000 coming out of the ghetto.  How about $900,000?  Naw.  How about $750,000?  Tempting ... but no.  How about $600,000?  Well, every person has his price.  You could hire an armed guard to accompany you every month when you went to inspect the property and collect your rent.

Okay, so if you buy the property for just $600,000 - what is your cap rate?  C' mon, guys, this is just 7th grade math.  Chug a Red Bull and stay awake here.

Cap Rate = (Net Operating Income / Purchase Price) x 100%

Cap Rate = $80,000 NOI / $600,000 Purchase Price - all times 100%

Cap Rate = .133 times 100%

Cap Rate = 13.3%

The good news for you is that your new commercial loan from the bank is going to cash flow very well.  If the bank is financing 70% of the purchase price ($600,000 times 70% LTV = $420,000), and the bank is offering 5.5% commercial loan, with a 20-year amortization and a 5 year term, your debt service coverage ratio would be a whopping 2.31.  Wow.  This commercial loan has to be really-really safe, right?

Well ... until the tenant moves out, the two pit bull terriers are no longer manning the barbed-wire fence, local druggies quickly strip the building of all of its copper wire, and then the local gangsters vandalize the building, just for fun.

Okay, now let's compare this industrial building in the ghetto to a nice apartment building within walking distance of Chinatown.  That same $80,000 in Net Operating Income, because the property is in a such a wonderful location, might sell for $2,286,000 (a 3.5% cap rate).  The building would only carry a $858,000 new loan, if the commercial lender insisted on a 1.25 debt service coverage ratio.  Holy smack, the property will only carry a new commercial loan of 37.5% LTV because the property is selling at such a low cap rate.

But let's forget about cash flow for the moment and assume that the lender made new commercial loans of 60% LTV, based on the purchase price, on both properties.  Then let's assume that the borrowers defaulted and the lender has to foreclose both commercial loans.

After the foreclosure auction, which property do you think would be in better condition, the property in the ghetto or the property in the far nicer neighborhood with better quality tenants?

This brings me to the point of this article.  Any time a commercial property cash flows extraordinarily well, be on guard.  Perhaps the property is being valued at a very high cap rate because it is located in a very dangerous and very yucky area.

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Topics: High cap rate property