Commercial Loans and Fun Blog

Our friends at George Smith Partners publish every week an excellent commercial real estate finance newsletter called FinFacts.  I try to send a copy to my staff every week to enhance their understanding of the language and terminology of commercial mortgage finance.

This weeks the folks at George Smith Partners used a number of big, fancy, finance-ese terms that my staff asked me to clarify.

Coupon:

You've probably heard the term, "clipping coupons".  In the old days, corporations would issue bonds to investors with little coupons attached that could be cut off.  Every month little widows would go down to the bank and clip off one of the coupons and redeem it for one month's interest, with which the widow would buy her groceries and pay her rent.

The coupon rate is therefore the interest rate on the note that the borrower actually pays every month.  In most cases, the coupon rate is the same as the note rate, but not always.  You could have a note with an interest rate of 17% and a coupon rate of 10%.  The borrower would pay interest to the lender every month at the annual rate of 10%, and the difference between 10% and 17% would simply accrue and defer.

Carve-Outs:

A non-recourse commercial loan is one where the borrower does NOT have to personally guarantee the commercial loan.  There are some exceptions, however, to the general rule that the borrower is not personally responsible to the commercial lender for any losses on a non-recourse commercial loan.  These exceptions are known as carve-outs.

If the borrower commits certain Bad Boy Acts, the borrower is suddenly subject to a springing personal guaranty.  Here is a partial list of those Bad Boy Acts:

1. Fraud
2. Toxic Contamination
3. Intentional Waste (Taking a sledgehammer to the building)
4. Placing a Second Mortgage on the Property
5. Converting (Stealing) Insurance Proceeds

Mini-Perm:

A permanent loan is a first mortgage on a commercial property with some amortization, usually 25 years, and a term of at least five years.

A mini-perm is a commercial first mortgage loan with a term of just two or three years.  While mini-perms may have a 25-year amortization, many are written on an interest-only basis.

What's the difference between a mini-perm and a bridge loan?  Bridge loans are usually fast, expensive, short-term loans.  In contrast, mini-perms come from commercial banks, and the interest rate is usually deliciously low.

Balance Sheet Lender:

You will recall that a balance sheet is just a list of a company's assets and liabilities, plus the values of each.  The difference between the company's assets and liabilities is the company's net worth.

A balance sheet lender is a commercial lender that is lending its own dough, and who does not have to meet any other lender's criteria.  The commercial loan is destined to just stay on the commercial lender's books - as an asset on the company's balance sheet.  Hence the expression, "balance sheet lender".  The commercial loan is not being originated to be resold to anyone else at a later date.

Balance sheet lenders have tremendous freedom to make exceptions.  A balance sheet lender could make a third trust deed, behind a $15 million first and second mortgage, on a land lessor's interest in land.  A balance sheet lender has the freedom to say, "I don't give a snot whether you think this is a good commercial loan or not.  We like this commercial loan.  We're funding this commercial loan and keeping it in our own portfolio."

50 Basis Point Treasury Movement:

A basis point is 1/100th of 1%.  Therefore a 50 basis point move is 50/100 of 1% or one-half of one percent.

Many commercial lenders tie their interest rates to comparable U.S. Treasury securities.  For example, if a commercial bank is making a 10-year, fixed rate loan, with one rate renogotiation at the end of year five, the bank may designate that the rate for the second five years will be 250 basis points (2.5%) over 5-year Treasuries.  A 50 basis point Treasury movement could mean that the fixed interest rate for the second five years will be 50 basis points (0.5%) higher than the first five years.

Difference Between Accounts Receivable Financing and Factoring:

Banks and specialized commercial finance companies are the commercial lenders who finance accounts receivable.  These commercial lenders make loans, secured by the accounts receivable (maybe at 50% of face value).  If the borrower doesn't pay, the commercial lender "forecloses" on the accounts receivable.

Factoring is a far more desperate act.  Factoring is the outright sale of accounts receivable to a factor at, say, 35 cents on the dollar.  A "factor" is a company or wealthy investor who buys accounts receivable.  Legally a factor is not a loan shark, but if a factor won't help you, your next stop may be the neighborhood loan shark.

Advanced commercial real estate finance is all about the structured finance.  Structured finance involves the placement of mezzanine loans, preferred equity, and venture equity on commercial real estate.  Today I am going to cover more about preferred equity.

First of all, why do we even care about preferred equity?  Preferred equity is just a subject for the Big Boys working for the investment banks in New York, right?  Well, that's been true up until now, but I predict that this form of commercial financing will become far more common in the next few years.

First of all, most commercial mortgage lenders today forbid the placement of second mortgage loans behind their first mortgages.  An owner with a ton of equity in his commercial property would now have to refinance the entire project in order to tap that equity.

But there're a problem with refinancing many commercial properties.  Many commercial first mortgage loans have enormous defeasance prepayment penalties.  Some commercial loans even have a lock-out clause that simply prohibits a prepayment.

A lock-out clause is an absolute prohibition against an early prepayment.  Let's suppose you have a $7 million commercial loan from a conduit, and you win a $50 million lottery.  You trot down to your mortgage company and hand them $7 million in cash to pay off your loan.  Three days later you're likely to receive a certified letter, along with a cashiers check for $7 million, saying, "Sorry, sir, but prepayments are prohibited."

Typically commercial real estate loans from life insurance companies and conduits have a lock-out clause for the first half of the term (the first five years of a ten-year loan), followed by an enormous, gargantuan defeasance prepayment penalty.

Okay, let's get back on track.  I said that preferred equity financing is likely to become more common in the future because most commercial first mortgages now prohibit commercial second mortgages.  The owner often cannot simply refinance his property because of lock-out clauses and defeasance prepayment penalties.

I also predict that commercial real estate is poised to appreciate substantially.  The economy is stronger than the unemployment rate suggests.  Many of the unemployed are too poorly educated to be hired by today's computerized businesses.  Others are too old and frustrated to even try.  The balance of our workforce, however, is rockin'.  The average American worker - because of automation and computers - is four times more productive than the average Chinese worker.

Commercial real estate is poised to appreciate sharply because the vast majority of American businesses are thriving, and there has been virtually no construction of new commercial space since 2008.  That's over five years of stunted commercial real estate development.  I own the commercial mortgage portal, C-Loans.com, and we have not seen a commercial bank close a commercial construction loan since 2008.  They are simply too scared to make commercial construction loans, and while their terror seems to be subsiding, commercial banks are FAR from having an appetite for such loans.

Commercial real estate values all come back to supply and demand.  Older commercial buildings have been abandoned and/or bulldozed.  Very few new commercial buildings are being constructed.  In the meantime the U.S. economy continues to grow.  The vacancy rate for office space in the San Francisco Bay Area is the lowest in the country.  Office rents in San Francisco have increased more than 60% since the trough in 2010.

As commercial real estate rents start to inch up across the country, commercial real estate values will follow.  As values increase, commercial real estate investors will see their equity increase - and they will want to get at this equity.

A new commercial loan may be impossible or economically infeasible; but a preferred equity investment from a liquid financial partner may be just the trick.

This is my 5th article on commercial loan underwriting and cap rates.  Cap rates are an extremely important concept in commercial real estate finance, so if you first want to catch up by reading my first four articles, here they are:

1. Cap Rates and Commercial Loans I
2. Cap Rates and Commercial Loans II
3. Commercial Loans, Cap Rates, and Commercial Loan Constants
4. Commercial Loans and Valuing a Commercial Property Using a Cap Rate 

But don't panic.  You don't need to read the prior articles to understand's today's lesson.  The odd lesson that I hope you will learn from today's article is that commercial loans on butt-ugly properties in gang warfare zones actually cash flow better than commercial loans made on gorgeous properties in prime areas.

Real estate investors buy commercial properties because such properties generate cash flow (net rental income).  You will recall that we said that a Cap Rate is simply the return on your purchase price that you would earn if you bought an income property for all cash.

For example, if you paid $1 million in cash for an average office building in an average area and enjoyed $80,000 per year in net rental income from the investment, you have bought the property at an 8% cap rate.

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

Cap Rate = ($80,000 / $1,000,000) x 100%

Cap Rate = .08 x 100%

Cap Rate = 8.0%

Suppose I told you that you could buy a competing building and earn $85,000 per year in net rental income (net operating income).  Would you do it?  Of course!  That's an extra $5,000 per year.  You could buy season tickets to the San Francisco Giants.

But wait a minute.  What if I told you that, in order to collect your rent, you would have to drive every month into some gang-infested, war zone with contaminated heroin needles lying everywhere.  Yuck.  No thank you!

Hold on a second.  What if I made it $90,000 per year in net operating income (a 9% cap rate)?  That's an extra $10,000 per year in income.  No?  How about if the property generated a net operating income of $100,000 (a 10% cap rate)?  You're still shaking your head.  Apparently you don't like risking your life twelve times a year to collect your rent.

Okay, here's my final offer:  You can buy this competing income-generating building in the ghetto at a whooping 12% cap rate.  In other words, if you invest $1 million in this building, it will throw off $120,000 in cash flow (net operating income).  That's an extra $40,000 per year.

Hmmmm.  You could be careful to only visit the ghetto property on sunny days in the morning.  You could hide a gun in your car.  You could run in, collect the rents, run out, and drive quickly away, like a bank robber.  Okay, you'll buy this building at a 12% cap rate.

So lesson number one:  When you are underwriting a commercial loan, the higher the cap rate, the yuckier the property and/or its location.

Now let's suppose that you decided not use all of your available cash to buy this new income property.  Instead, you decide to put just 25% down ($250,000) and finance the rest with the bank.

Will your commercial loan qualify?  Just for fun, let's look at both buildings, the average office building in an average area selling at an 8% cap rate and the ugly industrial building in the ghetto selling at a 12% cap rate.  Let's also assume that the bank is making conventional commercial loans today (let's assume the year is 2016 and interest rates are higher) at 7.25%, amortized over 25 years.

The Debt Service Coverage Ratio (DSCR) is defined as Net Operating Income (NOI) divided by the Annual Debt Service (just a fancy word for annual loan payments). 

DSCR = NOI / Annual Debt Service

 This number usually must equal or exceed 1.25.

Let's look at the average office building first.  The Annual Debt Service on a $750,000 loan at 7.25%, amortized over 25 years (the typical amortization period for a conventional commercial loan from a bank) is $65,052.  Therefore -

DSCR = $80,000* / $65,052

DSCR = 1.23 (The property doesn't qualify!)

* Remember, a cap rate of 8% means that if you buy the $1,000,000 commercial property for all cash, you will enjoy a Net Operating Income (think of it as the "interest" on your investment) of $80,000.

Please note that because the Debt Service Coverage is only 1.23 - less than the required 1.25 DSCR - this average-quality office building in an average area does not qualify for the full $750,000 loan.  Hmmm ...

Now let's look at the industrial property in the ghetto.  We said you could buy this $1 million property at a 12% cap rate.  A 12% cap rate means that you would enjoy a whopping $120,000 in Net Operating Income (net rental income).  Once again, think of this 12% return as if it was the "interest" on your investment.

Now before we compute the debt service coverage ratio of a $750,000 loan on this ugly industrial building in the ghetto, there is one more little twist to consider.

When making commercial loans on ugly commercial properties or commercial loans in rough areas, commercial banks will usually cut the Amortization Term from 25 years to just 20 years. Therefore, for the purposes of computing the Debt Service Coverage Ratio (DSCR) on this ugly industrial building in the ghetto, we will use a 7.25%, TWENTY-year loan constant.

Okay, we are now ready to compute the Debt Service Coverage Ratio (DSCR) on a $750,000 commercial loan - using a 7.25%, 20-year loan constant - on our ugly industrial building in the ghetto.

DSCR = NOI / Annual Debt Service

DSCR = $120,000 / $71,134

DSCR = 1.69 (The deal qualifies and really cash flows nicely!)

Hmmm ... this is interesting.  The commercial loan on the butt-ugly industrial building in the ghetto actually cash flows much better than the commercial loan on the average-quality office building in the average area.  Who would have 'thunk it?

So this is the lesson for today.  While commercial properties that sell at higher cap rates are usually uglier and/or have inferior locations to those that sell at lower cap rates, they actually cash flow much better.

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If you don't have time to work with a bank, if your commercial loan involves the seller carrying back a second mortgage, or if your commercial loan is slightly flawed, you should apply to Blackburne & Sons, my hard money commercial mortgage company (est. 1980):

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Apartment investors and multifamily loan officers sometimes need to quickly value apartment buildings to see if an asking price or an apartment loan request is reasonable.  The gross rent multiplier is not a perfectly accurate tool, but it's a quick, easy, and helpful one.

The Gross Rent Multiplier (GRM) is define as follows:

Gross Rent Multiplier = Sales Price / Annual Gross Scheduled Rents

For example, let's suppose a 12-unit apartment building sold for $1,350,000.  All 12 apartment units were 2-bedroom, 1-bath units rented for $1,000 per month.  Twelve-thousand dollars per month times twelve months equals $144,000 in annual gross scheduled rents.  Therefore we have:

Gross Rent Multiplier = $1,350,000 / $144,000

GRM = 9.4

Let's look at another example, but this time let's use the gross rent multiplier to compute the likely sales price or value of an apartment building.  Suppose we're now looking at a 10-unit apartment building located just a few blocks away from the 12-plex (the above example) that sold last week for $1,350,000.  We calculated the gross rent multiplier on the 12-plex to be 9.4, and let's assume the two buildings are roughly comparable (same neighborhood, similar condition, similar appeal).

So what is the 10-plex worth if its annual gross scheduled rents are $118,600?  This one is pretty simple.  What do you do with a gross rent multiplier?  Er .... multiply the gross rents by it?  Correcto-mundo!

Sales Price* = Annual Gross Scheduled Rents x Gross Rent Multiplier

*or Value

Value = $118,600 x 9.4

Value of the 10-Plex = $1,115,000

The nice thing about the gross rent multiplier is that the comparable apartment buildings don't have to be all that similar.  If one apartment building is nicer than another, its really not a problem.  The adjustment is automatically built in because the nicer building will command a higher rent.  In other words, Building A is nicer and rents for $0.76 per square foot per month, while Building B is more run down and rents for only $0.63 per month per square foot.  The same gross rent multiplier can be used to value both apartment buildings.  Investors buy apartment buildings to generate income.  The valuation of Building A - the nicer building - will come in appropriately higher than Building B because Building A commands a higher rent.

So how do apartment investors and multifamily loan officers arrive at the proper gross rent multiplier for an apartment building?  They look at the sales of other apartments in the neighborhood.  Then they divide the sales price by the property's annual gross scheduled rents to arrive at the gross rent multiplier.  After computing the GRM for a dozen or so apartment sales in a town or large city neighborhood, apartment investors and apartment loan officers start to get a good feel for the value of a multifamily property.

Marcus and Millichap is nationally known brokerage firm that is particularly good at selling apartment buildings. An easy way to get an approximate gross rent multiplier would be to simply call a local Marcus & Millichap broker and ask him.  He'll know. 

Let's suppose you're a commercial loan officer for a bank, working in the multifamily lending department.  A newby real estate broker brings you an apartment loan request for a $2,700,000 refinance on a 20-unit apartment building.  The borrower is refinancing his building to pull out equity to buy a second building.  The whole deal only makes sense if the borrower can borrow the full $2,700,000.  An apartment loan of $2,500,000 simply won't suffice.

"So how much is his current apartment building worth?" you ask the newby.  "I dunno.  I just started in the business," he replies.  "Okay, then what is the apartment building's annual gross scheduled rents?" you ask.  The newbie replies, $257,000."

From working on other apartment deals, you know that apartments in Fishers, Indiana sell for a gross rent multiplier of around 11.0.  You therefore multiply $257,000 by 11.0 (the GRM) to arrive at a value of just $2,820,000.  Uh-oh, the deal doesn't make sense.  There is no way that your commercial bank is going to make a loan of $2,700,000 on an apartment building worth only $2,820,000.  That would be an insane loan-to-value ratio of 95.7%!  (Seventy-five percent LTV would be more reasonable on an "A" deal.)  So you quickly kill the deal and move on to the do-able deals on your desk.

So what is the proper gross rent multiplier for apartments in Fishers, Indiana or Sacramento, California.  The answer is that each area has its own number.  Gross rent multipliers can range as low as 4.5 in the flatlands of Oakland or the South side of Chicago (gang territory) to as high as 12 to 13 in the ritzy neighborhoods of Palo Alto or San Francisco.

A lot depends on the availabilty of nearby land for development.  If you are looking to make an apartment loan in Indianapolis or suburban Dallas, where there are still plenty of in-fill lots available, where developers could build competing apartment buildings, rents are unlikely to soar.  Why?  Because if rents did soar, some developer would quickly rush in and throw up a competing apartment building.

On the other hand, if the subject apartment building is located in downtown San Francisco, where hardly one square inch is undeveloped, you could envision apartment rents soaring further, if, say, Twitter relocated its headquarters to downtown San Francisco.  (This is true, by the way.)  The more likely that apartment rents will increase in the future, the higher the gross rent multiplier that investors will pay.

Earlier I mentioned that the comparable apartment buildings do NOT have to be terribly similar.  For example, its perfectly acceptable to use the gross rent multiplier, derived from the sale of an apartment building with all one-bedroom units, to value an apartment building with all two-bedroom units.  How can this be?  The building with two-bedroom units will command higher rents, and those higher rents will produce a higher valuation.

However, when computing and using a gross rent multiplier, be sure to use apartment buildings with similar operating expenses.

Here's why:  In the downtown area of many big cities, there are many older apartment buildings that are not individually-metered for utilities.  There the landlord pays all of the utilities.  The rents for these apartments will be $350 per month, or so, more expensive than individually-metered apartment units because the landlord needs the extra dough to pay the utilities.  You cannot compare apples to oranges.

The gross rent multiplier is far from a perfect valuation tool for other reasons as well.  The gross rent multiplier does not take into consideration any vacancies that the area may be suffering.  Instead, it uses gross scheduled rents, as if every unit were occupied.  Therefore, in areas of high apartment vacancies (think of the lower-income areas of St. Louis), the gross rent multiplier will be significantly lower.

Collection loss is another issue.  If a large percentage of tenants fail to pay their rents (think of the outlying areas of Houston), the gross rent multiplier will be pitifully low.

Gross rent multipliers are the opposite of cap rates.  Very desirable apartment buildings in nice, very dense areas sell for high GRM's; while low-income apartment buildings in war zones sell at shockingly low GRM's.