Commercial Loans and Fun Blog

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?

You'll find all sorts of free gifts and wonderful tools for commercial mortgage brokers here:

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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.  

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.