Commercial Loans and Fun Blog

This may be one of my most important commercial loans blog articles ever because I explain almost a dozen new commercial finance terms of art.  My history of commercial loans continues below.

In Part I, which took place during the late 1960's, we noted that there was no inflation yet; but every commercial loan had to be a portfolio loan because there was no organized secondary market for commercial loans.  A lender couldn't quickly sell off a commercial loan in a liquidity squeeze.

As a result, life companies, commercial banks, and savings and loan associations had only a limited appetite for commercial loans.  Money for commercial loans was available, but if you had a construction loan or a balloon payment coming due, there was never any guarantee that the nearby commercial lenders had any money left over in their commercial loan allocations (quotas).

Imagine the following scenario:  Your commercial loan balloons in November, but every life company, commercial bank, and savings and loan association in town has already used up all of their commercial loan allocation for the year!  You might have to pay the ballooning bank a two-point extension fee, just to extend the loan until the first quarter of the following year, when the nearby commercial lenders got a new allocation of commercial loan money!  Therefore construction lenders always demanded a forward takeout commitment.

Before we define a forward takeout commitment, we must first define a takeout loan.  A takeout loan is just a permanent loan that pays off a construction loan.  Because the property has just been constructed, a takeout loan is always a commercial property's very first permanent loan.

"Oh, great, George.  You've just defined a takeout loan using another term that I didn't know - a permanent loan.  So what on earth is a permanent loan?"

A permanent loan is a first mortgage loan on a commercial property, with a term of at least five years, that calls for some amortization.  In home loan lending, most first mortgage loans are amortized over 30 years.  In commercial real estate lending, most commercial loans are amortized over 25 years.  If a commercial property is older than 35-years-old, many commercial lenders will demand a 20-year amortization, or maybe even a 15-year amortization.

A permanent loan on a commercial property will typically have a term of 5, 7, or 10 years; although SBA loans and USDA Business and Industries loans (partially-guaranteed by the Federal government) will sometimes be fully-amortized loans over 25 years.  If a commercial first mortgage loan does not have any amortization; i.e., it's an interest-only loan, the first mortgage loan is usually considered a mini-perm.  Mini-perms typically have interest-only terms of two to three years.

Okay, so far we've said that a takeout loan is just a permanent loan that pays off a construction loan.  A permanent loan is just a first mortgage on a commercial property, with some amortization and a term of at least five years.  And because most takeout lenders had quotas on their commercial loans, commercial construction lenders almost always required forward takeout commitments.

A forward takeout commitment is nothing more than a letter promising to deliver a takeout loan at some time in the future, typically 12 months or 18 months out.  Forward takeout commitment letters typically cost the developer one or two points, just for the letter itself.  If the developer actually asked the lender to fund, there was typically a loan origination fee of another one or two points.

Did you know that if a developer paid for a forward commitment letter that he was NOT required to take down the lender's takeout loan?  For example, let's suppose a life insurance company issued a 12-month forward takeout commitment for $2 million at 5.0%.  Then let's suppose the developer completed the office building, and because Lockheed Aerospace opened a new plant in town, the developer filled the building at much higher rents than he was projecting.  Bank of America then offered the developer a $2.2 million takeout loan at 4.75% and a loan origination fee of just one point.  Most developers would jump all over the Bank of Amercia deal and would politely tell the life company that they were not taking its loan.  The life company might be ticked off (and might internally blacklist the developer), but there was nothing that the life company could do.

Commercial construction loans then, as well as now, were usually written by a local commercial bank.  The developer would start the construction loan process by first sitting down with a nearby banker.  Banks greatly prefer to make commercial construction loans close to one of their offices because construction loans require progress inspections, where a bank representative would visit the construction site and verify that the project was on-time and within budget, and that the project was being built according to plans and specifications.

The local banker knows the local commercial real estate market.  He might look at the developer's plans and financial projections and says, "I'm sorry, Bill, but you're projecting office rents of $36/sf here in podunk Midwest City, Oklahoma.  There is no way folks here can afford to pay that kind of rent.  This deal is a non-starter."

Or the local banker might say, "Okay, you're projecting $28/sf here in Arlington, Virginia (the fourth largest city in the state).  That looks very do-able.  Go get yourself a forward takeout commitment, and assuming you've contributed at least 20% of the total cost of the project, I'm sure our bank would be willing to make the construction loan."

So Bill, the developer, then went out and found a life insurance company to issue a fixed rate forward takeout commitment.  Back in the late 1960's, life insurance companies issued the vast majority of all forward takeout commitments, and these forward commitments were for fixed rate loans.  Life insurance companies like fixed rate loans because their businesses are based on actuarial projections (how many policy holders are going to die in any given year).  Life companies need to be virtually guaranteed of earning a certain interest rate on their investments.  Hence their preference for fixed rate loans.

The forward takeout commitment might read, "Bill, if you build this office building according to plans and specifications, and you get it 95% leased up at your projected rent of $28/sf, we'll fund a $2 million takeout loan to pay off your construction lender.  You must hand us two points before we give you this commitment letter, and there will be an additional 1.5 point loan origination fee if you ask us to actually fund the loan."

Bill, the developer, hands the life insurance company a check for $40,000 (two points on a $2 million commitment).  He then takes the forward takeout commitment letter to a bank, located close to the proposed property, and obtains what is known as a covered construction loan or a closed-end construction loan.  In other words the construction lender knows exactly who is going to pay it off.

This was the world of commercial real estate finance before President Richard Nixon took the United States off the gold standard and opened the bottle to the Inflation Genie.

This article is intended only for commercial loan brokers.  I have been marketing for commercial loans for over 33 years now, and one very successful technique that I use when marketing for commercial loans is to offer multiple products in every advertisement.

For example, I am designing this week a full page advertisement that will go out to about 100,000 commercial real estate brokers.  Rather than just advertising for commercial loans in general, my new advertisement will offer four different products:

ONE POINT COMMERCIAL BRIDGE LOANS
No Prepayment Penalty
Call Tom Blackburne at 574-210-6686

TRYING TO BUY AN INVESTMENT PROPERTY WITH JUST 20% DOWN?
We Can Provide the Extra 10% To 15% Your Bank is Demanding
Call Angela Vannucci at 916-338-3232

 EARN HUGE REFERRAL FEES IN YOUR SLEEP
We Once Paid a $21,250 Referral Fee
Simply Insert a Commercial Loans Hyperlink on Your Website

SUBMIT YOUR COMMERCIAL LOAN TO 750 DIFFERENT BANKS
C-Loans Has Closed 1,000+ Deals Totaling $1+ Billion
And C-Loans.com is Free!

My point is this:  If you have to pay for advertising, why not give yourself multiple chances to make a sale?  Always offer multiple products.

Have you ever seen one of my fax newsletters?  The Blackburne & Brown Letter is mainly designed to plug my commercial hard money lending company.  However, I alway also include a reminder about C-Loans.com, my commercial mortgage portal.  In addition, I always plug my basic 9-hour basic commercial mortgage finance training course, as well as my hard money training course.  Then I alternate plugging my commercial mortgage marketing course, my new course on the practice of commercial mortgage finance, or my program to buy commercial leads.

Just STOP for a moment.  Have you ever looked at my wonderful courses and wished you could afford to buy them?  You don't need cash.  You can buy them with Blackburne Bucks.  What is a Blackburne Buck?  Every time you enter a bona fide commercial loan request into C-Loans.com and submit it to six lenders, we'll give you $100 Blackburne Bucks.  You then redeem these Blackburne Bucks by buying my courses.

And these courses are wonderful!  I be dyin' if I be lyin'.  Every time I go to a major CREF trade show, at least three or four former students always come up to me and thank me profusely for this training.  You've read my blog articles.  I try hard to deliver solid, practical training in an easily understandable manner.

Okay, back to the subject of today's article.  My training lesson again is this:  Any time you have to pay for commercial loan advertising, be sure to offer multiple products.

"But George, I don't have training courses of my own to offer."  I'll address this issue shortly; but first please allow me to show you one more example.

Have you ever seen one of my email newsletters?  Please just scan the following two newsletters:

http://www.c-loans.com/mortgagestuff/mortgagestuff20131030.htm

http://www.c-loans.com/mortgagestuff/mortgagestuff20131024.html

You will note that I plug Blackburne & Sons, C-Loans.com, buying commercial mortgage leads, my nine-hour training course, my new commercial mortgage marbketning course, my finding investors course, and several other products.  Multiple products - get it?

Okay, now let's address your needs.  You don't have multiple products.  Yes, you do!  You have that one bank which will lend up to 80% LTV on apartments.  You have that other bank that will allow the seller to carry back a small second mortgage.  You have that life insurance company that is offering loans at 4.125%.  I'm making all of this stuff up, but you get the point.  You have several dozen niche lenders.  When you advertise for commercial loans, don't just say, "Commercial Loans".  Instead, plug the programs of at least four niche lenders.

If you're in the commercial loan business, the history of our industry is important to you.  Commercial real estate finance ("CREF") tends to repeat certain cycles.  Mark Twain said it best, "History doesn't repeat itself, but it does rhyme."  How commercial lenders reacted to periods of soaring interest rates, periods of declining interest rates, and periods when commercial real estate plummeted by 45% is a strong indicator of how they will structure their commercial loans in the future.

We will start our six-part journey in the 1960's, at a time when the United States was still on the gold standard, and inflation was close to zero.  Back then there was no organized secondary market for commercial loans.  If a bank or life insurance company ("life company") made a commercial loan, it was a portfolio loan.

A portfolio loan was a commercial loan that the lender intended to keep in its own portfolio for the entire term.  Portfolio lending was liberating.  When a commercial lender made a portfolio loan, it was lending its own dough.  The commercial lender didn't have to meet any rigid, outside underwriting criteria.  For example, if a bank felt comfortable making a third mortgage on a land lessor's interest in a shopping center site, the bank was free to make the commercial loan.

How could a third mortgage on land ever be prudent?  Suppose a former land owner leased his unsubordinated land (there were no mortgages in front of it) to a shopping center developer for a 99-year term at $10,000 per month.  The developer then built a $10 million shopping center on the land.  If the developer ever failed to make his $10,000 per month land lease payment, the land lessor could "foreclose" on his lease and own the $10 million shopping center free and clear!

The problem with commercial lending back in the 1960's was that commercial real estate lenders only had a limited appetite for commercial loans.  There were just three major types of commercial real estate lenders back in the 1960's - life companies, commercial banks, and savings and loan associations (known as "S&L's" or "thrifts").

A savings and loan association was a special type of bank that was only allowed to make real estate loans.  They did not offer checking accounts.  They could only offer savings accounts.  S&L's were not allowed to make business loans, car loans, personal loans, or credit card loans.  Instead, thrifts just made long-term real estate loans.  Interest rates on deposits were regulated back then (Regulation Q).  A giant bank like Bank of America could not offer higher CD rates than a local one-horse, small-town bank.  However, thrifts were allowed to offer certificates of deposit that were 25 basis points (one-quarter of a percent) higher than commercial banks.  The idea here was to encourage savers to keep their long-term savings in savings and loan associations, which would then use these deposits to make long-term real estate loans.

Back in the 1960's, there were several thousand S&L's, thousands of commercial banks, and about 300 life insurance companies.  Nevertheless, the appetite of these commercial lenders was extremely limited.  Why?  Because there was no way to sell off a commercial loan in the event of a liquidity crisis.  If depositors suddenly started lining up to withdraw their deposits (aka: bank run), a bank or thrift could quickly sell off its home loans to Fannie Mae or Freddie Mac to meet the run.  Their commercial loans, however, could NOT be easily sold off because there was no organized secondary market for commercial loans.

So in the beginning, every commercial loan was a portfolio loan, and commercial lenders could only risk having a handful of commercial real estate loans in their portfolios.

I have been originating commercial loans for over 33 years now, and it has been my observation that commercial mortgage borrowers are very sensitive to points.  Commercial mortgage borrowers will gladly pay a slightly higher interest rate, if by doing so they can reduce the size of the loan fee.

There is some logic in this position.  Many commercial property investors trade up to a more expensive commercial property, one with even more depreciation, every five to seven years.  Therefore it makes little sense to spend a lot money to obtain a long-term commercial loan, if that commercial loan is simply going to be paid off quickly.

Another example is when a commercial investor has a commercial property for sale.  He needs cash now, perhaps to buy another investment property, but his older commercial building simply hasn't sold yet. A commercial bridge loan is perfect for such circumstances, as long as the points aren't too high.

A bridge loan is a fast, short-term, somewhat expensive commercial loan used to cover short-term cash flow needs.  Most commercial bridge lenders will be very interested to hear the borrower's exit strategy. 

Blackburne & Sons, my private money commercial mortgage company, therefore introduced this week a new commercial loan product, our one-point bridge loan product for commercial properties:

1. Interest Rate:  14.9%
2. Loan Fee:  1 point + $950 (nothing up-front)
3. Term:  Six months
4. Prepayment Penalty:  None
5. Maximum Loan-to-Value Ratio:  65% (70% on purchases)
6. Properties:  Multifamily (5+ units), Commercial, and Industrial

One of my loan officers brought up an interesting issue today.  He was afraid to work a commercial loan lead on a California commercial property because the mortgage broker controlling the deal was licensed in another state (let's say New York).

The issue of licensing for commercial loan brokers is not as clear cut as one might think.  There may be some shades of gray.  Now be careful here.  I am not writing today as an attorney expressing a legal opinion.  I am just throwing some thoughts out there as a practicing commercial mortgage broker.  Do NOT rely on this article!

Let's suppose the borrower is located in New York, as well as the mortgage broker.  The property is commercial, rather than residential, and it is located in California.  Let's also assume the borrower is a repeat customer of the New York mortgage broker.  In other words, the New York mortgage broker is not actively soliciting commercial loan business in California.  It just so happened that one of his repeat commercial mortgage borrowers happened to own a commercial property in California.

Could the New York broker legally broker the commercial loan to a California bank?  Probably not.  The New York mortgage broker is not legally licensed to arrange commercial loans in California.  He does not have a California real estate broker's license.  To make or arrange a commercial loan in California requires either a California real estate broker's license (or a California Commercial Finance Lender's License?).  As a result, in the chain of players, borrower - mortgage broker - lender, there is no licensed California real estate broker protecting the borrower.

However, could the New York mortgage broker take this commercial loan to a licensed California real estate broker (Blackburne & Sons is a licensed California real estate broker) and co-broker the deal?

Very possibly so.  The New York mortgage broker arguably could "associate in" a California real estate broker.  Attorneys do this all of the time.  A New Jersey attorney, handling a one-off* legal case in Maryland, is legally permitted to "associate in" a Maryland attorney and do most of the work on the case himself, even though the New Jersey attorney is not licensed to practice law in Maryland.

Okay, so under what conditions might "associating-in" a California real estate broker possibly be legally permitted? 

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.

If you need a commercial mortgage loan, and your deal is probably "bankable", you can quickly submit your deal to hundreds of commercial banks using C-Loans.com.  Please click the maroon button below.

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):

Commercial Mortgage Brokers:  Did you know that every time you enter a legitimate commercial loan into C-Loans.com that you earn 100 Blackburne Bucks, which you can use to purchase some of our wonderful training courses?

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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. 

The following article was actually written by a hard money commercial loan competitor; but the article was so well-written that I simply had to memorialize it for my sons ... and my blog readers.  My sincere thanks go out to Clay Sparkman for allowing me to republish this wonderfully written article.

Clay's Wonderful Article on How to Read a Commercial Loan Appraisal:

The most important thing that you must understand about any commercial loan appraisal (or other real estate valuation instrument) is that it is only as good as its logic.  So that—in other words—you must never accept an appraisal’s conclusion regarding value without looking beyond the surface to understand the logic that leads to the conclusion and without making some reasonable determination as to the quality of the logical argumentation.

With that in mind, I offer you ten critical steps to follow when reading/analyzing (and thus attempting to assess the “goodness” of) a commercial loan appraisal.

(1)    The very first thing you must ask as you analyze a commercial loan appraisal is to what degree is the appraisal transparent?  In other words, how much of the logic leading to the value conclusion is on display for you the reader?  If the answer is none, the appraisal is useless.  Throw it away.  If the answer is some (in other words there are gaps in the logic) then you must either (a) once again, decide to toss the appraisal, (b) decide to accept some degree of uncertainty, (c) attempt to fill the gaps on your own, or (d) contact the appraiser and see if she can provide the missing logic.  (Sometimes the appraiser will have the information you need on file, but they just didn't include it in their final report.)  Ideally the answer is none or very little, and the commercial loan appraisal can be said to be highly transparent.  At any rate, you will need to be asking this question throughout your analysis.

(2)    The next thing you need to do is get a handle on what is being appraised.  Is it a home, a commercial building, a parcel of land?  What are the basic specifications?  Where is it located?  Is it urban or rural?  How desirable is the surrounding area?  Are there functional inadequacies?  If it is land, what horizontal infrastructure is in place or lacking and what does the current zoning allow?

(3)    I have never heard anyone else say this, but I stand by it (at least when valuing buildings and structures; for valuing land, not so much): one of the first things I do after getting a basic sense of the property is go straight to the photos.  (And by the way, make sure you have an original appraisal or color copies.  The photos can be quite useful, but not if they are blacked out by copying and faxing.)  I study the photos of the subject property and then I compare them to the photos of each of the various comps.  You will be surprised at how often you will begin to sniff some bad cheese at this point in the process (particularly when dealing with structures).  What you are looking for here is: (a) whether or not the comps are in the same general condition as the subject property, and (b) whether or not the comps are in the same general “class” as the subject property.  By class I am referring to the level of quality and distinction of the property.  If the answer to one or both of these is no, it is not necessarily game over, but you will now be looking even more closely at the adjustment matrix later on to see if the apparent differences are effectively accounted for to your satisfaction.

(4)    Next, you will want to check the effective date of the value given.  How current is the commercial loan appraisal?  In a steady up economy we used to be comfortable using appraisals that were as much as 1-2 years old.  We would adjust the value to be in-line with changes in the market.  With the chaos of the past 5+ years, this method is not as effective and must be utilized with great care.  Generally speaking (though this would depend to a certain extent on the region) you would want your appraisal to be less than 6 months old.

(5)    Check carefully to see if there are any “subject to” items associated with the value.  Generally this will initially be indicated by checking a box that indicates the appraised value is subject to certain additions, improvements, or modifications as indicated later in the appraisal.  This of course is a critical item, so make sure you have read through the entire body of the appraisal so as not to miss any such “subject to” items or conditions.

(6)    Look to see if any extraordinary assumptions are made by the appraiser.  Here again, you will be forced to read through the entire body of the appraisal to be sure.  On more than a few occasions I have seen what looked to be a perfectly reasonable appraisal completely neutralized (or actually nullified) at the discovery of one or more extraordinary assumptions.  The problem with most extraordinary assumptions is that they are indeed extraordinary.  If I am evaluating a parcel of bare land zoned rural agricultural, and an extraordinary assumption in my appraisal states that “The zoning will be changed to allow multi-unit residential at 8 units per acre.” … well chances are, the gig is up.  Even if some serious local zoning change is in the works, what is the chance that you can count on it to come through and thus turn this “straw” property into gold?

(7)    Take an accounting of the methods utilized for valuing the subject property.  In my opinion, a market sales comparison approach is ALWAYS essential and should be the primary method—and the one given most weight—in valuing a property.  The only true value in a  market economy is the amount that others are willing to pay for it, and thus the attempt to estimate market value by looking at recent sales—though still at best a process of estimation—is the only method we have that goes to the heart of the matter.  Beyond that, it would be nice to have a cost approach and an income approach (where relevant) but these are, in my opinion, at best a good way to cross-check the market value derived by the comparison approach.

(8)    Another thing you need to take a close look at is the aging of the comps.  If all the comps were sold quite recently, then you are good in this department.  But if one or more of the comps are more than 6 months old, this may be a problem.  The next step would be to look at the comp matrix to see how much the appraiser adjusts the target value to factor comp aging.  If one or more of the comps are listings … well then, these aren’t really comps at all.  I have seen comp workups using nothing but listings.  This is totally unacceptable. Anyone can list a property for any price they want.  It would perhaps be reasonable to have 1-2 listings along with at least as many “true” comps, but even this is getting into squishy territory.  So here again, you would have to look at how the appraiser adjusted the subject value based on the “listing” comps.

(9)    You should spend the majority of your effort fussing over the comp matrix.  This is the matrix which compares various characteristics of the subject property with various characteristics of the comps and makes specific adjustments for each of the comps to arrive at adjusted values for the comps (effectively attempting to monetarily “convert” each of the comps into the subject property).  If you have: (a) many adjustments, (b) large adjustments (relative to the price of the property), and/or many seemingly subjective adjustments, then you may want to seriously question the integrity of the appraisal.  You will want to walk through each and every adjustment, and here again, you must look for transparency.  Does the appraiser explain the logic behind his adjustment decisions?  If not, you have a transparency problem.  At the end of the day, you must be comfortable with the adjustments and you must feel that they are objective, transparent, well thought out, and seemingly reasonable.  If not, you must either (a) discard the appraisal, (b) contact the appraiser for further explanation, and/or (c) revise one or  more adjustments and revise the final subject value accordingly.

(10) And finally you will want to be sure and take a look at other methods of valuation utilized (generally income and cost on commercial loan appraisals).  And then you will want to determine how the appraiser has gone about reconciling the different values arrived at utilizing different methods.  Sometimes a weighted value approach is used.  If so, how much weight is being given to the comp value approach relative to other methods utilized.  As you may have guessed by now, I generally like to see all or at least the vast majority of weight given to the comp analysis.  If the appraisal doesn't explain the reconciliation, you have a transparency problem.  If the comp value approach is not given enough weight, you may want to fall back on the value arrived at by the comp value approach as your own final value.

And there you have it.  There is a great deal more that can be said about reading an appraisal, and certainly this list of ten items is far from exhaustive, but it does give you a few things that you will not want to overlook.  If anyone has their own favorite “crucial” steps, I would love to hear about them.  Please let me know and I will share them with the group.

Last word:  Don't think that you don't need to "read" a commercial loan appraisal just because you are the commercial loan broker or the borrower, thus relying on the work of the appraiser to be true and accurate given their credentials.  I often ask brokers and borrowers if they have read the appraisals they have submitted, and what their opinion was. If they haven't read the appraisal or clearly haven't put the effort in to attempt to understand and make sense of it ... well that wouldn't necessarily kill the deal, but to my mind it highlights a potentially serious credibility issue.  As a broker (and certainly as a professional investor borrower), you must read and understand the items that you are submitting.  Anything less will generally become apparent to the lender and will ultimately undermine your ability to do your job effectively.

Clay Sparkman
Vice President, Fairfield Financial Services, Inc.
clay@privatemoneysource.com
503-476-2909
www.privatemoneysource.com

This is George writing again.  I made my sons, George IV and Tom, study Clay's superb article.  My younger son, Tom, wrote back to me with the following wise comment:

These are essentially the exact same steps Angelica taught me to use when I didn't understand why she would accept one appraisal but not another.