Commercial Loans and Fun Blog

This New Financial Ratio Has Replaced the Debt Service Coverage Ratio

For over 50 years commercial real estate lenders determined the maximum size of their commercial mortgage loans using the debt service coverage ratio. For example, a commercial lender might insist that the Net Operating Income (NOI) of the property be at least 125% of the proposed annual debt service (loan payments).

But then, in the mid-2000's, a problem started to develop. Bonds investors were ravenous for commercial mortgage-backed securities, driving yields way down. As a result, commercial property owners could regularly obtain long-term, fixed rate conduit loans in the range of 6% to 6.75%.

At the same time, dozens of conduits were locked in a bitter battle to win conduit loan business. Each promised to advance more dollars than the other. Loan-to-value ratio's crept up from 70% to 75% and then to 80% and then up to 82%! Commercial property investors could achieve a historically huge amount of leverage, while locking in a long-term, fixed-rate loan at a very attractive rate.

Not surprisingly, the demand for standard commercial real estate (the four basic food groups - multifamily, office, retail, industrial) soared. Cap rates plummeted, and prices bubbled-up to sky-high levels.

When the bubble popped, conduit lenders found that many of their loans were significantly upside down. The borrowers owed far more than the properties were worth.The lenders swore to never let this happen again. The CMBS industry therefore adopted a new financial ratio - the Debt Yield Ratio - to determine the maximum size of their commercial real estate loans.

The Debt Yield Ratio is defined as the Net Operating Income (NOI) divided by the first mortgage debt (loan) amount, times 100%. For example, let's say that a commercial property has a NOI of $437,000 per year, and some conduit lender has been asked to make a new first mortgage loan in the amount of $6,000,000. Four-hundred thirty-seven thousand dollars divided by $6,000,000 is .073. Multiplied by 100% produces a Debt Yield Ratio of 7.3%. What this means is that the conduit lender would enjoy a 7.3% cash-on-cash return on its money if it foreclosed on the commercial property on Day One.

Please notice that this ratio does not even look at the cap rate used to value the property. It does not consider the interest rate on the commercial lender's loan, nor does it factor in the amortization of the lender's loan; e.g., 20 years versus 25 years. The only factor that the Debt Yield Ratio considers is how large of a loan the commercial lender is advancing compared to the property's NOI. This is intentional. Commercial lenders and CMBS investors want to make sure that low interest rates, low caps rates, and high leverage never again push real estate valuations to sky-high levels.

So what is an acceptable Debt Yield Ratio? Ten percent - this is the lowest number that most conduit lenders are using to determine the maximum size of their advances. In our example above, the subject commercial property generated a NOI of $437,000. Four-hundred thirty-seven dollars divided by 0.10 (10% expressed as a decimal) would suggest a maximum loan amount of $4,370,000.

Typically a Debt Yield Ratio of 10% produces a loan-to-value ratio between 63% and 70%, the maximum level of leverage that the current CMBS B-piece buyers are requiring.

It is the money center banks and investment banks originating fixed-rate, conduit-style commercial loans that are using the new Debt Yield Ratio. Commercial banks, lending for their own portfolio, and most other commercial lenders have not yet adopted the Debt Yield Ratio.

You will notice in my definition of the Debt Yield Ratio that I used as the "debt" just the first mortgage debt. The reason why I threw in the words first mortgage is because more and more new conduit deals involve a mezzanine loan at the time of origination. The existence of a sizable mezzanine loan behind the first mortgage does NOT affect the size of the conduit's new first mortgage, at least as far as this ratio is concerned.

Will conduit's ever accept a Debt Yield ratio of less than 10.0%? Yes, if the property is very attractive, and it is located in a primary market, like Washington, DC; New York; Boston; or Los Angeles - an area where cap rates are exceedingly low (4.5% to 5%) - a conduit lender might consider a Debt Yield as low as 9.0%.

Need a commercial mortgage loan right now? You can apply to 750 commercial lenders - including several dozen conduit lenders - in just four minutes using C-Loans.com And C-Loans is free!

Commercial Mortgages Are Being Paid Down or Written Off

The size of the commercial mortgage market in the United States continued shrinking in the first quarter, to $3.31 trillion from $3.34 trillion at the end of last year, according to the Mortgage Bankers Association's analysis of Federal Reserve Board flow-of-funds data. The universe of mortgages has now shrunk for five consecutive quarters and is now roughly the same size it was at the end of 2007.

Every major investor group, except the housing-finance agencies, private pensions, savings institutions and government entities, saw a reduction in the size of their mortgage portfolios. Commercial banking organizations saw an $18.9 billion, or 1.3 percent reduction in the size of their holdings, to $1.49 trillion. They are still the biggest holders of loans, accounting for 44.9 percent of the entire universe, down from 45.1 percent at the end of the fourth quarter.

CMBS and other securitization vehicles saw their portfolio of mortgages shrink by 1.6 percent over the last quarter to $679 billion. That accounts for 20.5 percent of the universe, down from 20.6 percent in the fourth quarter.

Life-insurance companies, which lately have become hungry to write loans but have faced tepid demand, saw their holdings fall by $4.4 billion, or 1.4 percent, to $301.9 billion. They now hold 9.1 percent of the total universe, down slightly from 9.2 percent at the end of last year.

The housing-finance agencies, meanwhile, saw their portfolios grow by $5.8 billion, or 1.9 percent, to $309 billion. That represents 9.3 percent of the commercial mortgage universe, up from 9.1 percent in the fourth quarter. If you look at only multifamily loans, the agencies - Fannie Mae, Freddie Mac and agency-backed mortgage pools - hold 36.3 percent of the $852.1 billion universe. That universe is up from $849 billion in the fourth quarter - testament that the agencies continue to actively write loans.

"Low levels of commercial mortgage borrowing mean that property investors are paying off and paying down more in mortgages than they are taking out," explained Jamie Woodwell, vice president of commercial real estate research at the MBA.  (Commercial Real Estate Direct)

Only Three Kinds of Commercial Lenders Are Left

Do you need to find some commercial lenders right now? You can submit your commercial mortgage mini-app to 750 different commercial lenders in just four minutes using C-Loans.com. And C-Loans is free!

Before the Great Recession, there were eight different kinds of commercial lenders - life companies, conduits, commercial banks, savings and loan associations (S&L's), mortgage REIT's, finance companies, thrift & loan associations, and hard money lenders. Today all but three of these classes of commercial lenders are kaput.

1. Life companies - The life companies were always the most conservative of the commercial lenders. They seldom made loans higher than 55% to 60% loan-to-value. As a result of their great caution, this class of commercial lenders is still standing. Life companies make about 10% of all commercial loans, but their loans are much larger ($5 million minimum) and much more conservative than the rest of the commercial lenders.
2. Conduits - Off all commercial lenders, the conduits were the most active. A conduit was a mortgage company that originated and inventoried fixed rate commercial loans for eventual sale to the commercial mortgage-backed securities market. At their zenith, they were originating over 50% of all commercial mortgage loans. Unfortunately in 2008 the secondary market for CMBS loans evaporated. Poof. It disappeared completely. No conduit loans are being originated today at all. This class of commercial lenders has disappeared off the face of the earth.
3. Commercial banks - The largest surviving class of commercial lenders are the commercial banks.  Banks will still make commercial loans, but at much lower loan-to-value ratio's and only to very strong borrowers.
4. Savings and loan associations (S&L's) - S&L's were once very active commercial lenders. Today very few S&L's even survive, and those that did survive are not active commercial lenders.
5. Mortgage REIT's - Even before the Great Recession, mortgage REIT's were not huge commercial lenders. I can think of only two surviving mortgage REIT's, and neither makes more than a handful of commercial loans annually. Essentially mortgage REIT's no longer exist as a class of commercial lenders.
6. Finance companies - Finance companies borrowed their money from the bank at prime plus 1% an relent that money on riskier, complicated loans at prime plus 7%. Virtually all of the finance companies making commercial loans are now bankrupt.
7. Thrift & Loans Associations - Not to be confused with S&L's, thrift and loan associations were a special kind of bank in California whose deposits were NOT insured by the FDIC. In the early 2000's, most of these commercial lenders failed. The rest converted to federally chartered savings banks.
8. Hard money lenders - Private lenders will always make commercial loans. It's just that when private investors get scared, the rates goes up. A great many mortgage funds are being wound down, but hard money lenders are still exist as a class of commercial lenders.

Do you need to find some commercial lenders right now? You can submit your commercial mortgage mini-app to 750 different commercial lenders in just four minutes using C-Loans.com. And C-Loans is free!

Neither Banks Nor Borrowers Want Commercial Loans

I have been in the commercial mortgage business for 30 years now, and these are the worst of times.

I used to think that 1982 was bad. In 1981 Fed Chairman Paul Volcker, determined to break the back of inflation, raised the prime rate to 21.5%. Surprisingly, borrowers still sought commercial loans. Real estate was still appreciating, and cash-hungry borrowers were still willing to accept a commercial loan at 16% to 23%. At the same time, the banks and thrifts (savings and loan associations) would still consider a commercial loan, if the commercial loan made sense.  Nevertheless, business was horrible.

But as bad as things were in 1981, the commercial loan market simply disappeared in 1982. By then the Fed had broken the back of inflation. The inflation rate tumbled from 16% to less than 6%. At the same time, the Fed started to quickly ease. The prime rate began to fall at the rate of 1/2% to a full 1% per month.

I hate it when interest rates fall! No one wants to borrow. Why borrower at 15% today when the rate will be 14% or maybe even 13% in six more months. So borrowers procrastinated. Our commercial loan office became a tomb. I called my old buddy, Bill Owens of Owens Financial Group, and begged him to tell me what I should do. "George," Bill commented with his wry humor, "sometimes all you can do is go fishing." For the rest of the year commercial lending activity was almost non-existent.

But at least in 1982 the problem was just on one side.  Borrowers were procrastinating.

What about today? "It's deja vu all over again."  Except this time, neither lenders nor borrowers want commercial loans.

The banks don't want any more commercial real estate loans for obvious reasons. They've lost tens of billions of dollars as thousands of commercial loans nationwide have gone bad. In addition, commercial real estate has already fallen 35% to 40% in many areas. Many experts expect the declines to get worse.

Borrowers don't want commercial loans because they are not investing. Why buy commercial real estate today when prices will only be cheaper tomorrow? Business owners aren't pulling cash out of their buildings because they are already cutting back on their existing manufacturing capacity. Why invest more in plant and equipment?

"But George, what about the hundreds of billions of dollars in ballooning commercial loans that we keep reading about?" The banks and conduit loan servicing agents are simply extending these loans for a few years.  Why foreclose on an otherwise performing loan? Commercial lenders don't need any more commercial properties to manage.

So where does this leave us? The commercial loan market is now frozen to a standstill. Very few new commercial permanent loans are being written, and commercial construction lending is essentially non-existent.

If you do happen to need a commercial loan:

1. If it's a bankable deal, you can submit your deal in just four minutes to hundreds of commercial lenders by using C-Loans.com.

2. If you need a commercial permanent loan of less than $1.5 million, please call me, George Blackburne III, on my cell at 574-360-2486 or email me a package at george@blackburne.com

Commercial Mortgage Lenders Are Requiring Larger Down Payments

Since the start of the Great Recession, commercial real estate lenders have become more cautious. Before the economic downturn, commercial lenders would regularly make commercial loans to 75% loan-to-value on office buildings, retail centers, and industrial buildings. In fact, in 2006 and early 2007 some conduit commercial lenders were even making commercial mortgage loans as high as 80% loan-to-value.

Today few commercial lenders will make new permanent loans much higher than 60% to 65% loan-to-value. In addition, they will not allow sellers to carry back a second mortgage behind their new first mortgage loans.

This means that real estate investors wishing to purchase commercial buildings must now put down 35% to 40% of the purchase price in cash. No surprisingly, far fewer commercial properties are changing hands.

There is a technique, however, that commercial real estate investors can use to reduce the size of their required down payments.  Instead of carrying back a second mortgage on the commercial property being purchased, the seller can carry back a second mortgage on a different piece of commercial property owned by the buyer.

For example, let's suppose that an investor wants to buy a commercial center owned by a seller. The parties agree on a price of $2 million. Without using this technique, the investor would probably be required by the bank to put 40% down - or $800,000 in this example. That's a lot of dough.

However, the parties might make the following agreement. The investor (buyer) will put down $500,000 in cash, which is still a significant amount. We, in the business, might say that the investor (buyer) has more than enough "skin in the game" to assure that he is motivated to make his new commercial loan payments and maintain the property. The seller - and this is the key - could carry back a second mortgage on an apartment building, a property different from the one being purchased, owned by the investor (buyer). This arrangement would probably pass muster with the vast majority of commercial lenders today.

Need a commercial loan right now? You can apply to hundreds of commercial lenders with a single, four-minute, mini-app using C-Loans.com, the nation's most popular commercial lender portal. And C-Loans is free!

It Has Never Has It Been Harder to Close a Commercial Loan

A buddy of mine recently sent me an interesting email that says it all about placing commercial loans today.

George,

... The markets have been turned upside down. There is a real disconnect today with what the borrowers want and think they can get and what they can realistically can get from the lending community.

We just funded a $6.5 million loan for a self-storage project at a 6.95% rate for ten years. The borrower wanted a NON-recourse loan. While there were several hundred lenders in that market for that product 18 months ago, today there are none. The exception, the life companies, are at 55% LTV. Our deal was 61% LTV without 12 months of stabilized income. The life companies would not even take a hard look at the deal. The borrower was VERY well qualified, with lots of cash and a great financial statement.

We went to over 120 lenders who would make a loan on this property type in So Cal and found only ONE who would do the deal. The deal closed, and the lender has now eliminated self-storage as a product they will lend on.

Borrowers in most cases are still not realistic about what they will accept vs. the market. There is no 100% financing. The borrower must have 25% to 35% equity in the deals today. For refi's the borrower must have a DSCR of at least !.25:1, and even Fannie Mae wants 1.20:1 for apartments. And FNMA has a new requirement that they want you to own at least four multi-family projects, or have owned that total (in the past), if they are to consider you for a loan ...

R. H. Adams

This mortgage broker had to submit his commercial loan to 120 different commercial lenders before finding the one commercial lender who would do the deal. He didn't quit. To his credit, he pushed on and on until he found a home for the deal. You will probably have to do the same with your own commercial loans.

I have often said, "Sometimes placing a commercial loan is as difficult as finding a wife for your best friend. You can set him up with a lovely girl that is the right age, the right size, the right level of beauty, and the right religion ... and still there is just no chemistry or fireworks. All you can do is keep setting your friend up with new ladies. It becomes a numbers game."

So if you are trying to place a commercial loan with a bank or a life insurance company today, you may have to submit your commercial loan to 50 to 100 commercial lenders ... until you find just the right chemistry.

Comments at a Recent Banking Conference

“Last week, I hosted a meeting of mortgage lenders,” continued last night’s emcee. “They got together all the mortgage lenders in Britain who are still in business. I felt sorry for the guy. All alone…

“Today, a guy goes into a bank and he says… ‘I’d like to talk to you about a loan…’ and the banker says to him, ‘Great…how much can you lend us?’

Just Learned an Interesting New Term of Art - Lien Clearing

As a hard money commercial lender, Blackburne & Brown has to foreclose on about ten to fifteen commercial properties every year. Contrary to what you may think, we never make money when we foreclose on property - never. I wish we didn't have to do it, but it's a necessary evil in this industry.

After foreclosing on ten to fifteen properties every year for the past twenty-five years, I have noticed an interesting fact. Hardly no one ever bids at commercial foreclosure sales. We have sold a commercial property at a foreclosure sale just once in twenty-five years.

Therefore, if you are the holder of a junior lien on a commercial property that goes to a foreclosure sale by the first mortgage ... well, you're toast. No one is going to over-bid the amount of the first mortgage. You will almost surely be wiped out by the foreclosure.

This week we foreclosed on an office in the foothills of the Sierras. It's a beautiful building. There was a $2 million second mortgage behind our $3.3 million first mortgage, and this second mortgage loan was completely wiped out.

We also wiped out a $350,000 mechanics lien that was junior to our loan.

As we prepared for the foreclosure, one of our attorneys used an interesting term: lien-clearing. Our successful foreclosure cleared off the title to the property and left us owning the property free and clear of any competing claims for the property.

The junior lienholders, in my opinion, made a fatal error when they failed to cure our senior loan. The second mortgage holder and the mechanics lien holder should have banded together and each chipped in enough dough to payoff our first mortgage.

Instead, they went to the foreclosure sale hoping that someone would over-bid our first mortgage. In real life, this never happens.

It's Getting More Difficult for Hard Money Lenders to Raise Lending Capital

If you are commercial mortgage broker, you should not be trying to place large, hard money, commercial loans. Large commercial loans just aren't closing these days.

One of the reasons why is because hard money commercial lenders are having a difficult time raising money. Before the real estate crash of 2007, most hard money commercial loan brokers raised their money using mortgage funds. When the markets crashed, all of their depositors try to pull their money out of these funds. The situation has not improved since October of 2007.

Therefore very few hard money commercial lenders still have mortgage funds with which to make large commercial loans. Instead, if a hard money commercial lender wants to fund a commercial loan today, he has to syndicate a fresh group of private mortgage investors. This is a whole lot of work.

Therefore very few hard money commercial lenders are making commercial loans larger than $3 million today.

Need a commercial loan? You can apply to 750 different banks and hard money commercial lenders in just four minutes using C-Loans.

Cap Rate is Short for Capitalization Rate

You have probably heard the term cap rate many times, but what does it mean? Here's an easy way to understand the concept as it applies to commercial real estate. A cap rate is simply the return on your investment if you bought a commercial property for all cash.

For example, let's suppose that you buy for $1 million an office building that is leased out to an insurance broker. The insurance broker pays you $9,000 per month in rent, but there are also expenses, like real estate taxes, insurance, property management and a small reserve where you set aside money every year to eventually replace the roof and the HVAC system. Let's assume your net operating income (NOI) is $77,000 per year.

To compute the cap rate at which you bought the building, you merely divide your anticipated NOI by your purchase price.  In this case, $77,000 divided by $1,000,000 is 0.077. To express this cap rate as a percentage, we merely multiply 0.077 by 100% to produce a cap rate of 7.70%.

In plain English, a 7.70% cap rate means that you - as a passive commercial real estate investor - will earn a 7.7% annual return on your $1 million investment in this commercial property. Please also remember that for the purposes of computing a cap rate that you should assume that the buyer did not use a commercial real estate loan to finance the property.

You can't use the same cap for every commercial property. Some commercial properties are far more desirable than others. For example, let's suppose that Microsoft Corporation was the tenant on this property, and they signed a lease for 20 years. Arguably Microsoft is one the strongest credit tenants in America. If you - as the owner of the commercial property - had a lease with a strong, credit tenant, other investors would be very envious of you. In fact, they would offer you a lot of money for this property, perhaps as much as $1,800,000.

Now remember, the net operating income is still just $77,000 per year. If you sold the commercial building to another commercial real estate investor, who wanted a very reliable income stream, for a whopping $1,800,000 - he would be buying this same commercial property for just a 4.3% cap rate. Would someone really buy a piece of commercial real estate with a cap rate of just 4.3%? Maybe ... if indeed the property was leased to a major credit tenant for twenty years. By the way, a credit tenant is usually publicly traded or a large private entity with a strong S&P rating.

On the other hand, suppose you owned an old industrial building in a seedy part of town that was leased to an auto parts manufacturer. Suppose this auto parts manufacturer sold its parts mainly to General Motors, and the auto parts company wasn't making a lot of money. Let's further suppose that the neighborhood immediately surrounding your property was filled with prostitutes and drug dealers.

Even if this property was generating the same $77,000 in net operating income, you might not be able to sell the property for very much money. Any potential buyer might think to himself, "Geesh, if I drive over to collect the rents or to check on the condition of my property, I'm putting my life in danger. Yuck." This investor might not be willing to buy the property for less than a 12% cap rate.  Seventy-seven thousand dollars divided by 12% is just $641,000.

Remember, the more desirable the commercial property, the lower the cap rate a buyer will require before he buys it.