Commercial Loans and Fun Blog

This is my 4th blog article on the subject of cap rates and commercial loans, and its a good one!  Today you will learn how appraisers and commercial brokers (commercial realtors) compute a cap rate.  Then you will learn how to appraise or value a commercial property using a cap rate.

A Pro Forma Operating Statement is a projected budget for a commercial property for the upcoming year.  A pro forma sets aside a reserve for vacancy and collection loss and a reserve for replacements (new roof, new HVAC unit, etc.).  It also budgets for outside management, even if the owner currently manages the property.  The bottom line of the pro forma is the commercial property's projected Net Operating Income (NOI).  We will use the NOI a lot in this article.

When an appraiser wants to figure out the cap rates at which nearby commercial properties are selling, he starts first by by gathering up the offering memorandums on recently sold commercial properties.  By the way, an Offering Memorandum is a sales brochure, prepared by the listing real estate broker, that describes the commercial property that is for sale, includes color pictures, and contains a pro forma operating statement on the property.  Please be sure to look at the sample offering memorandum.

From the offering memorandum, the appraiser gathers the Net Operating Income number.  Using the NOI and the actual sales price, the appraiser can quickly compute the cap rate.

How exactly does he do this?  Well, let's look at the definition of cap rate.

Cap Rate = (NOI / Purchase Price) x 100%

For this example, let's assume that the appraiser looked at the original offering memorandum of a recently-sold 8-unit apartment project and plucked off the number, $48,619, as the NOI.  The building eventually sold for $1,055,000.  Let's plug, chug, and then compute our cap rate:

Cap Rate = ($48,619 / $1,055,000) x 100%

Cap Rate = .046 x 100%

Cap Rate = 4.6%

In other words, if an investor purchased this 8-plex for $1,055,000 all-cash, and if he hired a professional management company to run the property, the investor would earn an annual return (think of it like "interest") of 4.6%.  This is a fairly low cap rate, but apartments are a very desirable form of income property, and this particular 8-plex was located in a densely-populated, high-demand area of Sacramento.

Okay, now let's look at a different property.  Suppose you're the appraiser or a commercial real estate broker.  You have looked at the numbers on a dozen nearby commercial properties that have sold recently and which are comparable to the retail building (lets say a dollar discount store) that you are trying to value today.  You have computed the cap rates on these dozen sales, and you have determined that small, free-standing retail buildings in this area sell for a cap rate of around 9.25%.

You have also looked at the lease and the historical operating expenses for this dollar discount store building, and using those numbers, you have prepared a pro forma operating statement.  You have computed the projected NOI to be $32,500 per year.

Now here comes your biggest nightmare.  Do you remember when your high school algebra teacher once said, "You're going to have to learn this stuff.  You will need to use algebra someday in business."  Well, folks, unfortunately today is that day; but I promise to go slow and to use baby language.  And please don't panic!  When I'm done, I am going to give you a simple formula that you can memorize to figure out the value of a commercial property.

Now let's first key our eyes on the target.  We are trying to value a little free-standing retail building that is currently leased to a dollar store.  We know the property's NOI, which we computed to be $32,500 per year.  We know at what cap rate comparable commercial properties are selling - 9.25%.  So how do we use what we know to compute the property's value?  Let's start with the definition of a cap rate.

Cap Rate = (NOI / Purchase Price) x 100%

In order to solve for Purchase Price (Value), we have to rearrange the equation to where we have "Purchase Price is equal to" on one side of the equation.  Therefore we are going to have to move some terms around to isolate Purchase Price on one side of the equal-to-sign.

Now, remember, in algebra we can do anything we want to one side of the equal-to-sign, as long as we do the same thing to the other side.  Let's start by multiplying each side of the equation by Purchase Price.

Purchase Price x Cap Rate = (NOI  / Purchase Price) x Purchase Price x 100%

What is seven divided by seven (7/7)?  One, right?  What is (9.2 / 9.2)?  One, right?  What is (Purchase Price / Purchase Price)?  One!  So now let's rewrite this equation:

Purchase Price x Cap Rate = NOI x 100% x (Purchase Price / Purchase Price)

Purchase Price x Cap Rate = NOI x 100% x 1

Purchase Price x Cap Rate = NOI x 100%

We are trying to isolate Purchase Price on one side of the equal-to-sign, so now let's divide both sides of the equation by Cap Rate.

Purchase Price x (Cap Rate / Cap Rate) = (NOI x100%) / Cap Rate

Purchase Price x 1 = (NOI / Cap Rate) x 100%

Purchase Price* = (NOI / Cap Rate) x 100%

*Another name for Value.

This formula in red is the one you can simply memorize.  You take the property's NOI and divide it by the Cap Rate (expressed as a decimal; i.e., 0.072 rather than 7.2%).  

Okay, we're now ready to plug and chug.  In this example we assumed that the proeprty's Net Operating Income (NOI) was $32,500 per year.  We also determined that comparable commercial properties nearby were selling at a 9.25% cap rate (0.0925 if expressed as a decimal).

Value = NOI / Cap Rate**

** Please note that we had substituted Value for Purchase Price and that in this formula we have to remember to express the Cap Rate as a decimal.

Value = NOI / Cap Rate

Value = $32,500 / 0.0925

Value = $351,351 or rounded to $351,000

Forget about the torturous algebra!  Just remember to divide the Net Operating Income by the Cap Rate (expressed as a decimal) to figure out the value of the property.

This is such an important tool that we are going to do one more example.  The subject property is an office tower in Indianapolis generating $2,324,000 per year in net operating income.  Similar office towers downtown are selling at 6.75% cap rates.

Value = NOI  / Cap Rate

Value = $2,324,000 / 0.0675*

Value = $34,429,629 rounded to, say, $34,430,000

* Would you have remembered to convert the cap rate to a decimal format? 

Congratulations!  You now know how to value a commercial property, even one that is located in Bum Flowers, Egypt.  :-)

By the way, if you enjoyed this article, and you are not already subscribed to my blog, please find my rump-ugly picture above and fill in your email address.  I am in the process of training my two sons, before I keel over and die, and you can therefore get trained in commercial real estate finance for free.

Also, some Facebook likes or Google-Plus +1's would make my old, weary heart a little happier.  I know, its disgusting when an old man begs.

Joke Du Jour:  So there I was, sitting at the bar staring at my drink when a large, trouble-making biker steps up next to me, grabs my drink and gulps it down in one swig.  "Well, whatcha' gonna do about it?" he says menacingly, as I burst into tears.  "Come on, man," the biker says, "I didn't think you'd CRY. I can't stand to see a man crying."

"This is the worst day of my life," I say. "I'm a complete failure. I was late to a meeting and my boss fired me. When I went to the parking lot, I found my car had been stolen, and I don't have any insurance. I left my wallet in the cab I took home, where I found my wife with another man.  Then my dog bit me."

"So I came to this bar to work up the courage to put an end to it all.  I buy a drink, I drop a capsule in it, and I sit here watching the poison dissolve. Then you show up and drink the whole thing! But hey, enough about me, how's your day going?"

This is the third article in my series on cap rates and commercial mortgage finance.  My eventual goal is to explain a line from an earlier blog article, where I pointed out:

"If the interest rate on a commercial loan is 13.9% and the commercial property is valued based on an 8% cap rate, it is mathematically impossible for the property to carry a new commercial loan larger than 57% loan-to-value."

Please stick with me here.  The math sounds hard, but its really not.  You are going to learn a TON today about cap rates, commercial loan constants, and commercial real estate valuation.  Let's start with a little review.

In prior articles, we said that a Cap Rate was merely the return on your money (think of it like the "interest rate" you would earn) if you bought a commercial property for all cash.  Cap rates can vary from 3.5% to 13%, but an average commercial property in an average area these days sells at a cap rate of between 8% and 9.75%.

For example, let's suppose you win the lottery, but its only a small one.  You net $1 million after taxes.  You're 63 years old, you've been brokering commercial loans for 25 years, and you're tired.  You're ready to retire and live off your investments.

Your local bank is only paying 1% on C.D.s, so if you left your $1 million in your local bank, you would only earn $10,000 per year in interest.  You can't retire on social security and a lousy $10,000 per year in interest.  You need a better return on your money.

You decide instead to buy a little 4-unit strip center, not far from your house, that houses a convenience store, a real estate office, a hair salon, and a chiropractor's office.  You pay $1 million for the strip center, and you buy it at an 8% cap rate.  This means that you would enjoy $80,000 per year in net rental income (8% of $1 million), which is enough, taken together with your social security, to retire.  Please note that the 8% return is a MUCH better deal than the 1% return offered by your bank.

Now let's talk about commercial loan constants.  When I first started in mortgage finance 36 years ago, the typical mainframe computer was the size of a small home.  It would take a mainframe computer a full two hours to compute the monthly payment on a $25,000 loan at a 4.25% interest rate, fully-amortized over 30 years.  Obviously a loan agent couldn't carry a ten-ton mainfame computer on his back when he went out to someone's home to take a loan application; but the borrowers still wanted to know what their monthly payments would be.  Therefore the commercial loan constant was created.

A loan constant is merely the monthly payment on a loan of exactly $1,000, fully-amortized over 30 years.

For example, the loan constant at 4.25% is $4.90 per month.  In other words, if you borrowed exactly $1,000 at 4.25% interest, and if you made $4.90 per month payments for 30 years, your $1,000 loan would be completely paid off.  See, that wasn't so hard, was it?

Now the year is 1977, and  I am on my way to take a loan application on a residential borrower at his home.  Instead of lugging a ten-ton computer on my back, I just bring my trusty loan constant ($4.90 per month).  When the borrower decides to borrow $25,000 and asks for his monthly payment, I simply multiply my trusty loan constant of $4.90 by the number of thousands that he wants to borrow, in this case 25.  The answer is $122.50 per month.  That's the monthly payment on a loan of $25,000, fully-amortized over 30 years at 4.25%.

"But gee, George, what if the interest rate changes? Won't the loan constant change?"

Yes it will.  Suppose the interest rate drops to 4.125%.  Home office will have to warm up old Ten-Ton-Betty (the company's mainframe computer) and have her devote two hours to computing the new loan constant.  In the morning, the office manager will inform us of the new loan constant.  We each received a stone tablet into which the new loan constant was chiseled.  (Just kidding!)

Now over time the term "loan constant" has evolved.  Nowadays the loan constant represents the interest rate you used when you computed the debt service coverage ratio.  

For example, you might call up your favorite bank commercial loan officer and say, "Bob, I have a great commercial loan for you.  The debt service coverage ratio is a whopping 1.55 based on a 3.75%, 30-year constant."

At which point Bob replies, "Gee, George, that all sounds great and everything, but because of the age of your commercial property, Loan Committee is going to want to amortize our loan over just 20 years.  And unfortunately our interest rate is not 3.75%.  It's 6.125%.  As I calaculate your deal, the debt service coverage ratio is just 1.07 based on a 6.125%, 20-year constant.  Your deal doesn't qualify.  Our minimum debt service coverage ratio is 1.25."

This is why veteran commercial mortgage brokers always disclose the loan constant they used when they computed the debt service coverage ratio.

This review having now been completed, in my next blog article I will show you why a property valued based on an 8.0% cap rate mathematically cannot carry any 13.9% loan higher than 57% loan-to-value.

Income property lending is an advocacy process, just like a criminal trial.  The matter before the tribunal is whether the income property loan should be approved by Loan Committee.

The Prosecuting Attorney, so to speak, is Loan Committee.  Loan Committee's job is to point out all of the flaws of the income property loan.  The Public Defender, in our drama, is the income property loan officer.  His job is to point out all of the good features of the commercial loan and argue why the income property loan should be approved.

I'm blogging on this subject today because one of our loan officers (we'll call him Sam) came to me last week, and he was very frustrated.  He had a $1.3 million commercial first mortgage loan request on a very nice, fully-leased strip center in a very desirable city in Texas.  The center was even partially occupied by the owner, a physician who had good credit.

Loan Committee cut the loan request to an unworkable number - just 57% LTV - because the loan would otherwise not cash flow.  From that number Loan Committee refused to budge.  Sam ended up losing the deal - his best deal in months - and his morale was devastated.

But it was Sam's own fault, and I told him so.  "Sam, you have to grow a pair and start pushing back with Loan Committee.  Loan Committee's job is to point out all of the flaws on the deal and to initially turn down the loan."

"Your job, as the borrower's income property loan officer, is not to roll over like a puppy and say, 'Yes, ma'am.'  Your job is to (respectfully and intellectually) fight for the deal."

Here's how the conversation should have gone.  Sam is the commercial loan officer.  Angelica is our wonderful Executive Vice President and the head of our Loan Committee.  She also effectively runs Blackburne & Sons.  I try to stay out of her way and focus on developing new products.

Angelica:  "Sam, this deal looks pretty good, but I am cutting the loan back from $1.3 million to $1.15 million (57% LTV).  The deal doesn't cash flow a penny more."

Sam:  "Angelica, this is a gorgeous shopping center in one of the most vibrant and fastest-growing cities in Texas.  This is great collateral."

Angelica:  "I'm sorry, Sam, but the reason the borrower is coming to us for the loan is because he is behind in his real estate taxes.  If we make any loan larger than $1.15 million, he won't be able to make both our payments and his real estate taxes.  He'll simply fall behind on his taxes again."

Sam:  "This guy is a physican who occupies part of the center with his medical practice.  He's not going to move out of this center and let the property go.  It would cost him $75,000 to $100,000 to move his office, and he would lose a bunch of his patients."

Angelica:  "I'm sorry, Sam, but this guy doesn't make enough money on paper to afford our payments.  What are the investors going to say when they look at his financials?"

Sam:  "What you can tell the investors is that we would suddenly own a beautiful strip center in a thriving and fast-growing city in Texas, the economically strongest state in the country.  We would own the strip center free-and-clear, and we would earn at least a 9.5% cash-on-cash return from the net rental income, even after management fees.  Where are you going to beat that investment?!"

Or -

Sam:  "The borrower is self-employed.  Everyone who is self-employed probably cheats a little bit on their taxes.  This guy is probably running $75,000 to $100,000 per year in family expenses through the company.  He's got the dough if he really needs it."

Or -

Sam:  "The borrower has a $3.5 million net worth.  He is not going to lose the strip center that houses his medical practice.  It would cost him $75,000 to $100,000 to move.  He would just have to sell off his rental house if the real estate taxes simply had to be paid."

Or - And this argument is the Winner-Winner-Chicken-Dinner!

Sam:  "Angelica, we're a hard money lender.  Few of our deals ever make sense on paper.  If this property is valued at an 8% cap rate, I can show you mathematically that if our interest rate is 13.9% - because the loan is large and we need a higher than usual interest rate to raise all of the dough to fund the loan - that no deal on earth will carry a loan larger than 57% loan-to-value.  Heck, Angelica, if the highest LTV we can go is a lousy 57%, Blackburne & Sons might as well close up shop.  We're not going to be able to close enough deals to keep the doors open."

This is a loan that should have been made at $1.3 million; but the fault wasn't that of Loan Committee.  The fault falls entirely on the shoulders of the ineffectual income property loan officer who merely rolled over and said, "Yes, ma'am," when he KNEW that Loan Committee was wrong.  

Okay, here are the practice lessons of this article:

1.  Loan Committee's job is to point out all of the flaws on your commercial loan and to initially turn it down.

2.  As an income property loan broker, don't just roll over and accept the first "No" that Loan Committee issues.  Respectfully and intellectually fight for your deal.

3.  Choose your income property loan officers carefully.  You don't want wimps or salaried, lazy old farts as your commercial loan officers.  You want fighters!

Bottom line:  No wimps!

Do you need an SBA loan to buy or refinance a commercial property?  If so, you may not be able to rely on your local SBA lender.  Perhaps an inexpensive bridge loan from Blackburne & Sons, one of the oldest private money commercial lenders in the country, would help.

Our friends at ValuExpress recently explained the problem to us:

"It’s October 1 and through failure of Congress to enact a fiscal budget or a continuing resolution to authorize federal spending, all parts of the federal government not deemed “essential” halted operations effective midnight last night."  This includes SBA loans and the SBA!

"According to Bloomberg BusinessWeek’s account regarding the first federal government shutdown in 17 years, about 800,000 government workers are being furloughed. In addition, funding is suspended for a wide array of services, including contracts that government agencies award to small business owners."

"This means that financing for small businesses will be significantly impaired. The Small Business Administration (SBA), which guarantees tens of billions in loans for tens of thousands of entrepreneurs annually, has furloughed about 62% of its 3,500 workers, according to its response to the threatened shutdown posted on the SBA website last week."

"SBA lenders have been here before, but this situation is not nearly as disruptive as the annual 7(a) subsidy fights that Congress went through prior to 2004, which shut down the entire loan program three times in 1995 alone."

“The SBA shutdown is definitely a bummer for us as we have a $5-million SBA 7(a) loan closing in process with our affiliate, Country Bank and we are not sure if we can close the loan because we need the SBA to sign off on the Environmental Site Assessment (ESA) for the project,” commented Jim Brett, the ValueXpress underwriter on the project."

Our thanks for this heads-up go out to ValuExpress, one of the few commercial loan conduits to survive the Great Recession.  They're good folks.

Where does this leave you if you have an SBA loan in process?  If your seller has a competing offer circling your target property, or if you need a commercial loan right away to keep your company doors open, you should apply immediately to a private money commercial lender. At Blackburne & Sons, We make bridge loans, commercial loans, and permanent loans, up to $2.5 million, on commercial properties nationwide, owner-occupied or not.

A private money commerecial lender can typically approve your commercial loan within just 24 to 48 hours.  At Blackburne & Sons we can even give you a commercial bridge loan with no prepayment penalty, so the moment the SBA re-opens its doors and starts guaranteeing SBA loans again, you can immediately close your SBA loan and pay us off.

Private money commercial lenders, like us, will often allow junior financing.  What this means is that a private commercial lender - unlike most commercial banks - will allow the seller to carry-back a second mortgage behind their first mortgage.  In a rush situation, this extra flexibilty from your commercial lender could save your deal ... or even your company.

Remember, the SBA does not actually make commercial loans.  Instead, it merely guarantees a portion of them.  Your bank may still legally be able to make you a commercial loan today, but they will probably insist on a written commitment from the SBA to partially-guarantee your commercial loan first.  As long as the SBA is shut down, such loan guarantees will not be forthcoming.  

Consider a private money commercial loan instead. 

If you need a commercial loan larger than $2.5 million, please apply by clicking the red button below:

Historically credit companies were a major source of commercial loans.  The big credit companies - commercial real estate lenders like GE Capital and CIT Financial - are fairly quiet right now, but mark my words.  If you believe in capitalism, these credit companies should be coming back in the market very aggressively before long.

What is a credit company?  A credit company is an old, well-capitalized lending company with an excellent reputation for borrowing, lending, and repaying its unsecured bond holders.  The following credit companies no longer exist in their most recognized form, but they were once household names:  Beneficial Finance, Ford Motor Credit, and Household Finance.

A credit company has a such a superb repuation for managing credit that it can walk up to the bond market and simply shout out, "Who wants to loan us money on an unsecured basis?  Okay, okay, just line up here please.  No pushing.  No shoving.  Okay, what interest rate do you want?  Three percent?  You're dreaming.  Step out of line please.  What interest rate do you want?  You'll loan us money at 1.50%?  Okay, that works.  Please give your dough to the clerk.  Who's next?  No pushing.  No shoving!"

So a credit company might be able to borrow money in a market like today at just 1.25% to 1.75% and then lend it out at a whopping 5% to 7%.

Many of the largest credit companies took a terrible beating during the Great Recession.  In September of 2008, during the darkest days of the slump, money market funds were facing massive withdrawals.  Even well-run companies, like GE Capital and CIT, were having trouble rolling over their commercial paper.  Commercial paper is defined as an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities.

Ben Bernanke, the Chairman of the Federal Reserve and my personal hero, saved the day by guaranteeing the deposits of money market funds.  Investors stopped withdrawing funds, the run on the money market funds ended, and the money market funds went back to buying commercial paper and short-term corporate bonds.

However, most credit companies were sorely wounded during near-collapse of the corporate bond market, and they have largely withdrawn from active participation in commercial real estate lending in recent years.  But I'm a betting man, and I am betting on capitalism.  They will soon be back.  Why?

Last year was the best year in the 33-year history of Blackburne & Sons.  My private money commercial mortgage company faced very little competition for commercial loans.  Bank-quality borrowers and near-bank-quality borrowers were forced to pay our soft-money rates if they wanted to take advantage of a discounted pay-off ("DPO") from their bank.  The same thing was true of commercial mortgage borrowers with balloon payments coming due.  Where else could they go?  As a result, Blackburne & Sons had a very good year.  We made good money, and we booked some terrific loans too.

However, it is a basic tenet of capitalism that "excess profits breeds competition."  You can absolutely bet that all across Wall Street and the board rooms of credit companies, capitalists are rubbing their hands together and saying, "There's gold in them 'thar hills!  It's time to get back into commercial real estate lending."

This is how a commercial mortgage market recovers.  There is a certain order to things.  First the private money lenders - who use the funds of very wealthy private investors with a large tolerance for risk - return to the market.  They make a big profit.  This attracts the credit companies and the finance companies.  A finance company is a company which borrows money from a commercial bank at a low rate then lends it out a higher rate.  The credit companies and the finance companies then make the big profits.

Eventually the regional banks and the community banks see the big profits being made by the credit companies and the finance companies, and then they return to the market.

Is this absolutely sure to happen?  As Mark Twain once said, “History doesn't repeat itself, but it does rhyme.”

Commercial loan brokers and commercial real estate lenders converged this week in Las Vegas for the California Mortgage Bankers Association's Western States Commercial Real Estate Finance Conference.  The Western States Conference is always the big Kahuna of trade shows in commercial real estate finance.  I have some interesting news for you from that conference.

My first observation was that the show was quite small, at least compared to 2005.  Fewer than 20 commercial banks and commercial lenders had exhibit booths.  In 2005, there were 150 to 200 commercial lenders exhibiting.  Clearly the number of hungry commercial real estate lenders is tiny compared to pre-crash times.

Nevertheless, I learned some things.  First of all, the money center banks (Wells Fargo, Bank of America, JP Morgan Chase) are crushing the life companies and conduits.  One speaker from HFF (formerly Holiday, Fenoglio, Fowler, the largerst independent commercial mortgage company in the country) described how his office was writing a 7-year permanent loan that was less than 3% interest for the first two years.  The rate floated with some annual rate increase caps thereafter.

There is no way that CMBS lenders and life companies can compete against such low, floating rate loans.  In fact, there was a lot of discussion about how the large, money center banks were buying up all of the independent commercial mortgage companies.  Could an independent commercial real estate lender even surivive in the face of competition from the money center banks?  As one panelist pointed out, "The commercial banks are essentially getting their deposits for free!"

I was amazed to hear that loan-to-deposit ratio of most commercial banks nationwide is just 52%!  In 2005 this same loan-to-deposit ratio was close to 90%.  Clearly the banks have an immense capacity to fund commercial loans.

That being said, the darth of banks exhibiting at the show was an unmistakable signal that, while the banks have the capacity to fund an immense number of commercial loans, they simply lack the courage and confidence to do so.

Even though few commercial banks seemed hungry for commercial loans, there appeared to be TONS of money from structured finance lenders - mezzanine lenders, preferred equity lenders, and equity providers.

One formerly traditional life insurance company has stopped making conventional permanent loans.  Now all this life company wants to do is high-yield mezzanine, preferred equity, and JV equity deals.  It's insane.  Their crystal ball must be VERY bullish on commercial real estate.  (At Blackburne & Sons, we are equally bullish on commercial real estate.)

An enormous volume of commercial real estate loans are multifamily loans being originated modernly for "the Agencies" (Fannie Mae and Freddie Mac) and FHA.   Note to self:  Get more Agency lenders added onto C-Loans!

As a commercial loan hard money lender, I was greatly disturbed to learn that the first sub-prime commercial loan ABS offering is currently being assembled.  Already this commercial sub-prime lender has booked $200 million in commercial loans at rates of less than 7%.  (Think of a lender like the old BayView Financial, but this time the lender has to carefully document their sub-prime loans.)

This lender is not a CMBS lender.  Instead they are an ABS lender.  ABS stands for Asset-Backed Securities.  ABS securitizations typically involve a multitude of different collateral, like scratch-and-dent residential loans, car loans, credit card loans, and sub-prime commercial loans.  Bonds issured by ABS securitizations typically offer much higher rates than CMBS offerings, in some cases as much as 150 bps. (1.5%) higher yields.

This new commercial loan sub-prime lender could really kill lenders like my own, Blackburne & Sons.   It's very disappointing because we just had our best year ever.  I don't welcome the competition.  The good news is that they have agreed to join C-Loans.com.  You will see them listed on our commercial mortgage portal shortly.

This is my second article for commercial loan brokers and commercial investors about cap rates.  In my last article we described how a Cap Rate is simply the return (think of it like "interest") that an investor would earn if he bought a commercial property for all cash.

Algebraically, the Cap Rate is the property's Net Operating Income (NOI) divided by the Purchase Price, multiplied by 100%.  Let's use a simple example to solidify this ratio in your mind.   Let's suppose an investor bought a small, average-quality, office building with a NOI of $50,000, and he paid $700,000 for the property.  Fifty thousand dollars divided by $700,000 is 0.071.  (Remember that Cap Rates are computed without regard to any commercial loan placed on the property.)

Multiplied by 100%, we have a Cap Rate of 7.1%.  Cap Rates are commonly expressed as percentages, to one digit.  Therefore Cap Rates look like this:  8.2% or 5.6% or 11.8%.

Not every investor will be satisfied with the same Cap Rate.  Let's go back to the above example, and now let's assume that a wealthy business owner is leasing one of the six office suites in the building.  In addition to partially-occupying the building, this wealthy business owner lives just five minutes away.  He likes the short commute, and he fears that he might someday be forced to move.  When he hears that the office building has been listed for sale and that an offer to buy the property has already been made, the wealthy business owner submits a competing offer for $740,000.

Just for practice, let's compute the wealthy business owner's new Cap Rate.  Fifty thousand dollars in Net Operating Income divided by the higher, $740,000 purchase price gives us 0.67.  Multiplied by 100% gives us a 6.7% Cap Rate.  Obviously the second guy's Cap Rate is lower because he paid $40,000 more for the same $50,000 worth of Net Operating Income.

So what are some common Cap Rates on average-quality buildings in middle-income areas?

Multi-family

6.0% to 8.0%

Office

7.5% to 9.5%

Retail

7.5% to 9.5%

Industrial

8.25% to 10.25%

Hospitality

9.5% to 11.5%

Here are some general rules about Cap Rates:

1. The nicer the area, the lower the Cap Rate.  Average-quality buildings in the wealthiest part of town commonly sell at Cap Rates of 6.5% or lower.
2. The more reliable the income stream, the lower the Cap Rate.  For example, an office building with a 20-year lease from Apple Computer might sell at just a 4.5% Cap Rate.
3. The more vacant land surrounding or close to the property, the higher the Cap Rate.  The reason why is because if rents ever increase too high, some developer will quickly throw up a competing building.
4. Buildings in successful downtown areas sell for absurdly low Cap Rates - sometimes as low as 3.5%.
5. The younger the building, the lower the Cap Rate.

We can therefore tell a lot about a building, just by its cap rate.  For example, if you tell me that I can buy an apartment building at a 14% Cap Rate, I would pretty much bet that the area suffers from pervasive drug use, a high crime rate, and gang violence.

If you tell me that an industrial building just sold for a 7.0% Cap Rate, I would bet that the property is less than seven years old, has tall ceilings (important to a modern warehouser, who stack pallets very high), and a stronger-than-average tenant.

If you tell me that an office building just sold at a 5.0% Cap Rate, my bet is that the office building is located in an upper-income downtown area with virtually no vacant land within a mile (prevents competing buildings from being built).

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This is the first in a new series of articles on cap rates.  If you are going to invest in commercial real estate, or if you are going to work as a commercial loan broker, you simply must be very comfortable with cap rates.  Watch me make this an easy subject:

Let's suppose you have just inherited $200,000 from your grandmother.  (Sorry for your imaginary loss.)  You could take this money down to your neighborhood commercial bank and buy a certificate of deposit.  Interest rates are low today, so the return on your investment might only be 1.0% annually; but at least your principal would be safe.

Alternatively, you could buy a junk bond through your securities broker and perhaps earn a return on your investment of 3.5% annually; however, this is a riskier investment.  The company issuing the junk bonds could go bankrupt, and you could possibly lose your entire investment.

Or, you could buy for $200,000 a little commercially-zoned house that is currently leased out to a chiropractor as his office.  (Important note:  There is no commercial loan involved here.)  He pays you $1,400 per month in rent, and he pays for his own utilities and landscaping.  You're responsible for real estate taxes, insurance, and repairs.  Because you hate late-night phone calls, you decide to also hire a property manager for $155 per month to manage the property for you.

Therefore, after real estate taxes, insurance, repairs, and management, you net $1,000 per month.  That's $12,000 in net rental income per year on an investment of $200,000.  In other words, the return on your investment is 6%.  (Once again, please note that there is no commercial loan here.)

A cap rate is simply the return on your investment if you buy a commercial property for all cash.  In other words, think of a cap rate as the "interest" you would earn if you bought a commercial building for all cash.

Every commercial property is different.  Some commercial buildings are so attractive and are so well-located that most investors would "lust" to own them.  Other commercial properties are more bread-and-butter properties, with no distinguishing appeal.  Finally, some commercial properties look terrible, are in need of repair, and are located in crumby neighborhoods.  Yuck.  Therefore when you go to sell commercial properties, the cap rate will be different for each one.

For example, let's suppose a commercial property - we'll call it Property 1 - generates $50,000 per year in net rental income.  If its an average-looking office building in a middle-income neighborhood, and the tenant is of average quality, most investors might need a cap rate (remember, think of a cap rate just like an interest rate) of around 8% before they would buy the property.  Fifty thousand dollars divided by an 8% cap rate produces a likely sales price of around $625,000.

Property 2 also generates $50,000 in net rental income.  Unfortunately Property 2 is a huge, old, rusting, steel-skinned industrial building located in the flatlands of Oakland, where drive-by shootings are an almost nightly occurance.  To get to the property to collect the rent, the property owner is literally taking his life in his own hands.  It might take a cap rate of 12% to sell this property.  Fifty thousand dollars divided by a 12% cap rate produces a likely sales price of just $417,000.

Property 3 is a cute, little five-plex in the Chinatown area of San Francisco.  Demand for apartments within walking distance of Chinatown (many Chinese immigrants do not own cars) is immense.  If there were ever a vacancy, a new tenant could be found in twenty minutes or less.  Such a commercial property is highly desirable, and an investor might be satisfied with a 3.5% cap rate (3.5% "interest") in order to own this building.  Fifty thousand dollars in net rental income divided by a 3.5% cap rate produces a likely selling price $1,428,000.

Therefore we have three different commercial properties, each producing exactly $50,000 per year in net rental income ("interest" on the buyer's investment), with three greatly different sales prices.  The yucky industrial building might only be worth $417,000.  The average office building was worth $625,000.   The nice, well-located apartment building was worth a whopping $1,428,000 - more than $1 million more than the ugly industrial building producing the same amount of net rental income!  

We'll explore cap rates further tomorrow.

Brick Building Photo Attribution: Joe Mabel

It can be very tricky for a commercial lender to foreclose on a blanket commercial loan.  If he doesn't bid exactly the right amount at each foreclosure sale, even an over-secured commercial lender can still take a painful loss.  An example will make this clearer.

Suppose a commercial lender has a $9 million blanket loan on an $11 million apartment building in Nevada and a $6 million office building in Pennsylvania.  Suppose further that this lender is based in Nevada, and he is not terribly familiar with the Pennsylvania commercial real estate market.

The borrower bitterly contests and delays the Nevada foreclosure, but he offers no resistance on the Pennsylvania foreclosure.  The commercial lender therefore completes his foreclosure on Pennsylvania building first.  Local Pennsylvania foreclosure law states that a foreclosing commercial lender must make a reasonable foreclosure bid, absent specific contractual language to the contrary.  At the foreclosure sale the commercial lender therefore bids $5 million.  No one outbids him at the sale.

Important note:  It is very rare, but not totally unheard of, for bidders to actively bid at commercial foreclosure sales.  The reason why is because any bidder must pay all-cash, and commercial properties are usually far more expensive than homes.  For example, five million dollars is a lot of cash (actually bidders use cashier's checks) to bring to a foreclosure sale.

Okay, so now the commercial lender owns the Pennsylvania office building for $5 million.  This leaves just $4 million remaining on the $11 million Nevada apartment building.  The commercial lender bids his $4 million at the foreclosure sale.  When an $11 million apartment building goes to sale for just $4 million, this is one of those rare times when the Big Boys whip out their cashier's checks and outbid the commercial lender.  Therefore the commercial lender only receives $4 million for his security interest on the nice, Nevada apartment building.

Now the trouble begins.  The commercial lender discovers friable aesbestos in the Pennsylvania office building that costs $600,000 to remediate.  Then the commercial lender's commercial broker drops a bomb.  A local chemical company - the city's largest emplyer - is moving its nearby national headquarters to another state.  Demand for office space in the area plummets, as the local economy tanks.  The lender is only able to sell the office building for $3 million, and this formerly over-secured commercial lender ends up taking a whooping $2.6 million loss!

Okay, so what went wrong?  The commercial lender foreclosed on the out-of-state property first, in a market that he did not know.  Had he been based in Pennsylvania, he might have read about Orkin Chemical Company moving out of town.  He would have known to have bid far less on the Pennsylvania office building.

The borrower also forced the commercial lender to foreclose on the Pennsylvania property first.  If only the commercial lender had a choice of where he wanted to foreclose first, he could have foreclosed on the Navada property first, a real estate market that he knows.  His foreclosure bid would have been far more precise.

The moral of the story is this:  If a commercial lender is going to make blanket commercial loans, he needs to add a clause to his deed of trust or mortgage that allows him to foreclose on any property, in any order he wants, and to bid any amount he wants.

I want to thank my old mentor and good friend, Bill Owens of Owens Financial Group for his help with this blog article.  Bill taught me the commercial mortgage business over thirty years ago.  Owens Financial Group just successfully converted its private mortgage fund into a commercial mortgage REIT listed on the New York Stock Exchange.  Wow!!!

Bill Owens reports that his REIT has plenty of dough with which to make new commercial mortgage bridge loans.  He is looking for commercial bridge loans requests from $1 million to $10 million in the western states.  You can reach Bill Owens at (925) 935 - 3840.

A long-time blog subscriber asked, "Why would the lender, who already put a $9M mortgage on the two properties, have to bid at the foreclosure sale?"

When a commercial lender forecloses, the commercial lender is required by each state's foreclosure law to bid an amount that he will accept in lieu of keeping the property.  The maximum amount the commercial lender can bid at the foreclosure sale is everything that is owed to him - principal, interest, late charges, past due interest, default interest (which is just like regular interest but at a higher rate - say, 20% per annun rather than 11% per annum), trustee's fees, legal fees, and legal costs.  A bid where a foreclosing commercial lender bids everything that he is owed is called a full credit bid.

Remember, its a foreclosure sale, not a foreclosure seizure.  This is easy to forget because almost no one ever bids at commercial property foreclosure sales.  If you are going to offer something for sale, there has to be some price that you will accept.  That price is the lender's bid at the foreclosure sale.

By the way, did you know that many states will allow the agent of the foreclosing commercial lender to increase his credit bid at the foreclosure sale?  For example, the commercial lender above could have started the bidding out at just $2 million.  The foreclosing commercial lender will normally instruct his foreclosure agent as to a starting bid and a maximum bid.  "Start the bidding at $2 million, Mr. Trustee, but if anyone is bidding against us, keep increasing your bid by an extra $10,000, up to a maximum of $5 million."

A legal, non-conforming property is a commercial property that was legally built years ago, but it could not be newly built today on the land, as the land is currently zoned.  A couple of examples will make this more clear.

Let's suppose that fifty years ago a developer built a 60-unit apartment building in downtown San Francisco with no on-site parking.  Since then the City of San Francisco enacted a municipal ordinance that says every two-bedroom apartment building must have at least one on-site parking space, and every three-bedroom unit must have at least two on-site parking spaces.

This apartment building - the old one with no on-site parking spaces - does not have to be torn down.  It's was legal when it was first constructed, and it is therefore still legal.  However, it no longer conforms to the current city ordinances.  It is non-conforming.

Here's another example of a legal, conforming building.  Suppose that Florida city planners observe that stick-built apartment building adjoining the Atlantic Ocean fared particularly poorly during hurricanes.  After seeing countless such apartment buildings destroyed along the coast, the city planners for most coastal Florida cities adopt an ordinance forbidding the construction of multi-family dwellings within a half-mile of the coast.  Does that mean that all of the apartment building buildings along the Florida coast have to be torn down?  No.  It just means that they are legal, conforming buildings.

Legal, non-conforming buildings can be repaired; but if such a building is substantially damaged - say, in an earthquake or a fire - it cannot legally be rebuild.

Okay, so what?  The lender will insist on a fire insurance policy, right?  If the building burns down, the lender simply gets paid off by the fire insurance proceeds.

Many times this is true; but sometimes a legal, non-conforming commercial building is worth far more than its replacement cost.  Absent a special endorsement to the fire insurance policy, the fire insurer will only pay for the replacement cost of the building!  What if your commercial loan is much larger than the replacement cost?  Yikes!

For example, this 60-unit apartment building might only cost $2.8 million to rebuild, but it might be worth $6 million (before the damage).  Based on the cash flow, a reasonable commercial lender might have placed a $3.9 million commercial loan on the property.  The building burns down.  The insurance company hands the commercial lender a check for just $2.8 million, the building's replacement cost, because the building cannot be rebuilt.  The lender has just eaten a $1.1 million loss.  Ouch!

Okay, so how does a commercial lender protect himself?  He obtains a special endorsment to the owner's fire insurance policy, called a ________________ (anyone know?), that pays more than the commercial property's replacement cost if the building burns down or is otherwise destroyed.  This special endorement to the fire insurance policy costs around 15% to 20% more than a guaranteed replacement cost policy.

My own private money commercial mortgage company, Blackburne & Sons, will gladly finance legal, non-conforming commercial properties.