Commercial Real Estate Lending – Know Your Business
It is very important as a Commercial Mortgage Broker that you are knowledgeable and come across as a professional expert in your trade. You need to know and understand commercial real estate terms, the different type of loan programs available across all property types, conforming vs. non-conforming loans, and how to present the best financing solutions for your client based upon their situation. We are going to show you everything you will need to know. Commercial real estate (CRE) is income-producing real estate that is used solely for business purposes, such as retail centers, office complexes, hotels, and apartments. Financing – including the acquisition, development, and construction of these properties – is typically accomplished through commercial real estate loans: mortgage loans secured by liens on commercial, rather than residential, property. Just as with residential loans, banks and independent lenders are actively involved in making loans on commercial real estate. Also, insurance companies, pension funds, private investors and other capital sources, including the U.S. Small Business Administration’s 504 Loan program, make loans for commercial real estate.
INDIVIDUALS VS. ENTITIES
While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities (e.g., corporations, developers, partnerships, funds, and trusts). These entities are often formed for the specific purpose of owning commercial real estate. An entity may not have a financial track record or any credit history, in which case the lender may require the principals or owners of the entity to guarantee the loan. This provides the lender with an individual (or group of individuals) with a credit history and/or financial track record – and from whom they can recover in the event of loan default. If this type of guaranty is not required by the lender, and the property is the only means of recovery in the event of loan default, the loan is called a non-recourse loan, meaning that the lender has no recourse against anyone or anything other than the property.
LOAN REPAYMENT SCHEDULES
A residential mortgage is a type of amortized loan in which the debt is repaid in regular installments over a period of time. The most popular residential mortgage product is the 30-year fixed-rate mortgage.
Residential buyers have other options, as well, including 25-year and 15-year mortgages. Longer amortization periods typically involve smaller monthly payments and higher total interest costs over the life of the loan, while shorter amortization periods generally entail larger monthly payments and lower total interest costs. Residential loans are amortized over the life of the loan so that the loan is fully repaid at the end of the loan term. A borrower with a $200,000 30-year fixed-rate mortgage at 5%, for example, would make 360 monthly payments of $1,073.64, after which the loan would be fully repaid.
Unlike residential loans, the terms of commercial loans typically range from five years (or less) to 20 years, and the amortization period is often longer than the term of the loan. A lender, for example, might make a commercial loan for a term of seven years with an amortization period of 30 years. In this situation, the investor would make payments for seven years of an amount based on the loan being paid off over 30 years, followed by one final “balloon” payment of the entire remaining balance on the loan. For example, an investor with a $1 million commercial loan at 7% would make monthly payments of $6,653.02 for seven years, followed by a final balloon payment of $918,127.64 that would pay off the loan in full.
The length of the loan term and the amortization period will affect the rate the lender charges. Depending on the investor’s credit strength, these terms may be negotiable. In general, the longer the loan repayment schedule, the higher the interest rate.
Another way that commercial and residential loans differ is in the loan-to-value ratio (LTV): a figure that measures the value of a loan against the value of the property. A lender calculates LTV by dividing the amount of the loan by the lesser of the property’s appraised value or purchase price. For example, the LTV for a $90,000 loan on a $100,000 property would be 90% ($90,000 ÷ $100,000 = 0.9, or 90%).
For both commercial and residential loans, borrowers with lower LTVs will qualify for more favorable financing rates than those with higher LTVs. The reason: They have more equity (or stake) in the property, which equals less risk in the eyes of the lender.
High LTVs are allowed for certain residential mortgages: Up to 100% LTV is allowed for VA and USDA loans; up to 96.5% for FHA loans (loans that are insured by the Federal Housing Administration); and up to 95% for conventional loans (those guaranteed by Fannie Mae or Freddie Mac).
Commercial loan LTVs, in contrast, generally fall into the 65% to 80% range. While some loans may be made at higher LTVs, they are less common. The specific LTV often depends on the loan category. For example, a maximum LTV of 65% may be allowed for raw land, while an LTV of up to 80% might be acceptable for a multifamily construction. There are no VA or FHA programs in commercial lending, and no private mortgage insurance. Therefore, lenders have no insurance to cover borrower default and must rely on the real property pledged as security.
DEBT-SERVICE COVERAGE RATIO
Commercial lenders also look at the debt-service coverage ratio (DSCR), which compares a property’s annual net operating income (NOI) to its annual mortgage debt service (including principal and interest), measuring the property’s ability to service its debt. It is calculated by dividing the NOI by the annual debt service. For example, a property with $140,000 in NOI and $100,000 in annual mortgage debt service would have a DSCR of 1.40 ($140,000 ÷ $100,000 = 1.4). The ratio helps lenders determine the maximum loan size based on the cash flow generated by the property.
A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service. In general, commercial lenders look for DSCRs of at least 1.25 to ensure adequate cash flow. A lower DSCR may be acceptable for loans with shorter amortization periods and/or properties with stable cash flows. Higher ratios may be required for properties with volatile cash flows – for example, hotels, which lack the long-term (and therefore, more predictable) tenant leases common to other types of commercial real estate.
INTEREST RATES AND FEES
Interest rates on commercial loans are generally higher than on residential loans. Also, commercial real estate loans usually involve fees that add to the overall cost of the loan, including appraisal, legal, loan application, loan origination and/or survey fees. Some costs must be paid up front before the loan is approved (or rejected), while others apply annually. For example, a loan may have a one-time loan origination fee of 1%, due at the time of closing, and an annual fee of one-quarter of one percent (0.25%) until the loan is fully paid. A $1 million loan, for example, might require a 1% loan origination fee equal to $10,000 to be paid up front, with a 0.25% fee of $2,500 paid annually (in addition to interest).
A commercial real estate loan may have restrictions on prepayment, designed to preserve the lender’s anticipated yield on a loan. If the investors settle a debt before the loan’s maturity date, they will likely have to pay prepayment penalties. There are four primary types of “exit” penalties for paying off a loan early:
- Prepayment Penalty. This is the most basic prepayment penalty, calculated by multiplying the current outstanding balance by a specified prepayment penalty.
- Interest Guarantee. The lender is entitled to a specified amount of interest, even if the loan is paid off early. For example, a loan may have a 10% interest rate guaranteed for 60 months, with a 5% exit feeafter that.
- Lockout. The borrower cannot pay off the loan before a specified period, such as a 5-year lockout.
- Defeasance. A substitution of collateral. Instead of paying cash to the lender, the borrower exchanges new collateral (usually Treasury securities) for the original loan collateral. High penalties can be attached to this method of paying off a loan.
Prepayment terms are identified in the loan documents and can be negotiated along with other loan terms in commercial real estate loans. Options should be understood ahead of time and evaluated before paying off a loan early.
THE BOTTOM LINE
With commercial real estate, it is usually an investor (often a business entity) that purchases the property, leases out space and collects rent from the businesses that operate within the property: The investment is intended to be an income-producing property.
When evaluating commercial real estate loans, lenders consider the loan’s collateral; the creditworthiness of the entity (or principals/owners), including three to five years of financial statements and income tax returns; and financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio. For more information, read 7 Steps To A Hot Commercial Real Estate Deal and Find Fortune In Commercial Real Estate.
- Apartments – Multifamily
- Self Storage Facilities
- Single-Family Flip Projects
- Office Buildings
- Land Development
- Retail Centers
- Mobile Home Parks
- Raw Land
- Mixed Use
- Convenience Stores
- Gas Stations
- Car Wash
- New Residential Development
- Pawn Shops
- Golf Courses
- Auto Body Repair
- Owner Occupied Business
- Special Purpose Properties
- Gold Mines
Conforming vs. Non-Conforming
There are two primary loan categories all property financing transactions will fall under, conforming (best rate), and non-conforming (higher rate). Best rate conforming loans usually take 45 – 90 days or longer to close. Non-conforming are considered either Alt-A or Hard money / Bridge loans. Non-conforming Alt-A loans offer rates slightly higher than conforming, with more flexible credit and property requirements. Closing periods are the same as conforming loans. Hard money / bridge loans are used for short-term purposes, usually 3-24 months. These loans can be closed in 5-7 days, and usually always close in less than 30 days. Hard money / bridge loans require less documents, but rates are much higher, usually between 9% and 12% with loan fees between 3 and 10%
We offer conforming loan programs with initial fixed rate periods of 3, 5, 7 and 10 years as well as 15, 20, 25 and 30 year fixed loans. Our most popular conforming loans are our 3, 5, 7, 10, and 15 year fixed loans. sThese loans are what we call “full doc” loans, offering the best rates available on the market, and are usually sold, transferred or brokered to major banks, hedge funds, and insurance companies. Underwriting approval requirements will usually include the following documents from the borrower for best rate conforming loans:
1.) Property Rent Roll
2.) Property Operating History / Profit & Loss – Last two years and Year-to-date
3.) Borrowers Financial Statement w/Schedule of Real Estate
4.) Personal & Property Tax Returns 3 years
It usually takes 45 to 90 days to close a conforming loan.
Conforming – 3, 5, 7 & 10 Year ARM’s
Loans with a fixed rates for the first 3, 5, 7 and 10 years. After that the initial fixed rate period, these loans have an adjustable rate that changes semi-annually for the remaining life of the 30 year loan.
Since the rate is lower with this type of ARM product, a borrower can save money on their commercial real estate mortgage payment for the first three to ten years. After the initial fixed rate period, the loan will be subject to an adjustable interest rate. The interest rate on the loan can change every six months to one year. The interest rate is going to be tied to a financial index and will move up and down, based on that index. Usually, there will be an interest rate cap on the loan. This means that if the financial index moves substantially, the interest rate on the loan will be capped at a specified amount.
The primary benefit of this type of loan is that a borrower will be able to get a lower interest rate initially. This makes the 3, 5, 7 or 10 year ARM ideal for properties that have a lower rental income and expects their rental income to increase over the next three to ten years. This type of loan is also usually used if the property owner is planning on selling or refinancing the property within the fixed rate period.
Even though this loan can be beneficial,it also has some drawbacks. When this type of loan is used, the borrower subjects themselves to market interest rates after the initial fixed rate period. If the interest rate in the market increases substantially after the fixed rate period, the loan payment may go up substantially if the property is not sold or refinanced.
Hard Money / Bridge Financing
ICS Hard money/ bridge loans can be closed in 5-7 days, and usually always close in less than 30 days. Hard money / bridge loans require far less documents, are not borrower credit based, with rates usually between 9% and 12%. We offer hard money / bridge financing for projects where short-term capital is needed for 3 – 24 months, usually bridging the time gap between attaining long-term financing or a future property sale. Underwriting and approval requirements are extremely flexible.
1.) Approval based off equity and LTV
2.) Max LTV 75%
3.) Underwriting deposit usually required
4.) Poor borrower credit ok
5.) 1st and 2nd lien positions
6.) Loan amounts $25,000 to $200,000,000
7.) Rates between 9% and 12%
8.) 3-10 Lender points depending on property type and loan size
There is so much construction money available today that very few commercial construction lenders require forward takeout commitments anymore. And when the project is completed, there are hundreds of hungry lenders who will give a developer a takeout loan to pay off his construction loan
Commercial Loans in Detail
Below is a list containing many of the various types of commercial real estate loans. To learn even more about a particular type of commercial loan, simply click on the associated hyperlink.
Permanent Loans– A permanent loan is a garden variety first mortgage on a commercial property. To qualify as a permanent loan, the loan must have some amortization and a term of at least five years.
Bridge Loans– A bridge loan is a short-term, first mortgage loan on commercial property. The term could be from 6 months to three years. The interest rate on bridge loans is typically much higher than on permanent loans.
Commercial Construction Loans– A loan of one to two years used to build a commercial property. The loan proceeds are controlled by the lender in order to make sure they are only used in the construction of the new building.
Takeout Loans– A takeout loan is a garden variety permanent loan where the proceeds of the loan are used to pay off a construction loan.
Conduit Loans– A conduit loan is a large permanent loan on a fairly standard type of commercial property, which is written underwritten to secondary market guidelines and which has an enormous prepayment penalty. Such loans enjoy very low interest rates. Conduit loans are later assigned to pools and securitized to become commercial mortgage-backed securities.
SBA Loans– Loans to users of commercial real estate which are written by private companies, such as banks and specialty finance companies, but which are largely guaranteed by the Small Business Administration. SBA loan guarantees were created by Congress to encourage the formation and growth of small businesses.
SBA 7(a) Loans– The SBA 7(a) program is a 25-year, fully-amortized, first mortgage loan program with a floating rate, tied to the Prime Rate.
SBA 504 Loans – The SBA 504 loan program starts with a conventional, fixed-rate, first mortgage and then adds a 20-year fully-amortized, SBA-guaranteed, second mortgage behind it. It is the most common way to get a fixed rate SBA loan.
SBA Construction Loans– Many SBA lenders will write conventional construction loans that convert automatically to 25-year SBA loans upon completion.
USDA B&I Loans– The Department of Agriculture’s Business and Industry loan program is very similar to the SBA loan program, where a conventional lender makes the loan but the USDA guarantees most of it. USDA Business and Industry loans were created to help create jobs in rural areas.
Hypothecations– A hypothecation is actually a personal property loan secured by a note and mortgage owned by the borrower. The borrower’s note and mortgage are often created when the borrower sells a piece of real estate and carries back the financing. Later the borrower might need cash and pledges his mortgage receivable as collateral.
Fix and Flip Loans– Fix and flip loans are renovation loans that are similar to construction loans. Typically the loan is used to acquire property with enough additional proceeds to renovate the property for a quick sale.
Permanent Commercial Loans
A permanent loan is defined as a first mortgage on a piece of commercial property that has some amortization and a term of at least five years. Most commercial permanent loans are amortized over 25 years. If the property is older than 30-years-old and/or showing signs of wear and tear, many banks will insist on amortizing their commercial permanent loans over just 20 years.
Permanent loans usually enjoy the lowest interest rates among the various type of commercial real estate loans. In large part this is because permanent loans are usually garden variety loans, with no special risks in the deal. The property has already been constructed and almost completely leased out.
Permanent loans are usually made by either life insurance companies, conduits, banks, or credit unions. In terms of the number of commercial loans written, banks are by far the most active makers of permanent loans. I listed the types of permanent lenders in the order of their typical rates. In other words, life insurance companies offer the lowest interest rates on permanent loans, followed next by conduits, banks, and credit unions. Therefore, if you have the most gorgeous commercial property in town, you may want to start your search for a new permanent loan by applying to some life insurance companies.
Life insurance companies – known in the industry as just life companies – typically have a minimum loan size of $5 million. The same is true with conduits, although some conduits will make permanent loans as small as $3 million. Banks are far more flexible about commercial loans sizes. They will make commercial permanent loans from $100,000 to $100 million, although you should choose your bank according to the size of your loan request. In other words, you should take small commercial loans to small banks and large commercial loans to large banks. Credit unions usually have a maximum commercial loan size of $1 million to $2 million.
A takeout loan is a type of permanent loan, but it is a special type of permanent loan. A takeout loan always pays off a construction loan.
There are other types of commercial first mortgages that are not permanent loans:
A bridge loan is defined as a first mortgage loan on a commercial property with a term of just six months to two years. Bridge loans give the owner some time to effect some change to his property, such as renovating the property or finding a tenant. Once the troubling issue with the commercial property is fixed, the owner will usually either sell the property or come back and secure a permanent loan to pay off the bridge loan. Bridge loans are typically more expensive than permanent loans.
A mini-permor interim loan is defined as a first mortgage on a commercial property with a term of two to three years. A mini-perm can either be an interest-only loan or amortized over 25 years. Most mini-perms are made by banks, and they are used to give the property owner time to solve some problem, most often leasing out the property. Many mini-perms are written by banks, in connection with their own construction loans, to serve as standby takeout loans, just in case the developer cannot qualify for a normal takeout loan, perhaps because the building is not yet sufficiently leased. These are known as construction-mini-perm combo’s. The banks typically charge an extra point for the mini-perm commitment letter and another one point if the mini-perm actually funds.
A construction loanis defined as a first mortgage loan on a commercial property that is used to build the property. The loan proceeds are controlled by the construction lender to ensure that the building is actually built. Most commercial construction loans are made by banks. The typical loan term is one year, but often a six-month extension for one additional point can be negotiated.
A forward takeout commitmentis a letter from a bankable lender promising to deliver a takeout loan in the future. Most, but not all, forward takeout commitments are issued by life insurance companies on large construction projects. The letters usually cost between one and two points, plus many lenders often charge an additional fee of 1/2 point to one point if the loan actually funds.
A standby takeout commitment is defined as a letter from a bankable lender promising to deliver an undesirable takeout loan in the future. No one ever expects a standby loan to fund. The reason why is because the actual loan terms of most standby takeout loans are pretty ghastly – a very high interest rate and an additional one to two points if the loan actually funds. The purpose of a standby takeout commitment is merely to satisfy some construction lender that he has a guaranteed way to get paid off. Standby takeout commitments cost two to three points, just for the letter. The standby takeout commitment business is really out of favor right now because too many standby lenders over the years have used legal loopholes to weasel out of their commitments to pay off the construction lenders.
An Open-Ended Construction Loanor an Uncovered Construction Loan is defined as one with no forward takeout commitment in place. This has become quite common today as banks develop confidence in the constant availability of commercial takeout loans.
A Close-Ended Construction Loan or a Covered Construction Loan is defined as one with a forward takeout commitment firmly in place. For the past 20 years commercial mortgage money has been abundantly available. As a result, most construction lenders are quite comfortable making Uncovered Construction Loans. Those commercial construction lenders demanding a forward takeout commitment are finding that they are not closing many deals.
A bridge loan is defined as a short-term real estate loan that gives the property owner time to complete some task – such as improving the property, finding a new tenant and/or selling the property.
The typical commercial property bridge loan has a term of six months to one year, although many commercial bridge loan lenders will grant the owner the option to extend for six months to one year for a fee of between a half-point point to two points.
Bridge loans are more expensive than permanent loans. In a market where a commercial property borrower might be able to obtain a 6% permanent loan, he might have to pay LIBOR plus 3% to 4% (8.25% to 9.25%), plus a point or two, for a bridge loan from a commercial real estate opportunity fund. Commercial property bridge loans are typically paid off when the owner places permanent financing on the property, after the improvements are completed and the new tenant(s) move into the property. Because of their short term nature, most bridge loans have no prepayment penalty. Example: Suppose Bob inherits an older, rundown office building from his father. Because the property has been allowed to deteriorate by his ailing father, the property is half-vacant and commands very low rents. If Bob tried to refinance the building today, he might only qualify for a $400,000 new loan based on today’s cash flow. Bob might therefore apply for a $700,000 new bridge loan to pay off the existing $250,000 first mortgage and to pay for $450,000 in improvements. After Bob has replaced the roof, repainted the building, retextured the walls, upgraded the electrical and HVAC systems, and recarpeted the property, he might be able to fill the entire building with new tenants paying twice as much in rent. When the new tenants move in, Bob might be able to refinance his bridge loan for $1,300,000, put $500,000 in cash in his pocket, and still have a $3,000 per month positive cash flow. This would be a great use for a bridge loan. There are all kinds of bridge lenders. Many banks will make bridge loans if the borrower has excellent credit and a large financial statement. Some renovation and releasing projects are a bit more speculative and need to be made by opportunity funds specializing in bridge loans. An opportunity fund is defined as a special fund set up to make high-yield commercial real estate loans requiring special expertise and understanding. Opportunity deals are what we in the industry call “brainer deals”, as opposed to “no-brainer deals”, which as are deals so simple and straight-forward that even a child could understand them. The kinds of investors who invest in commercial real estate loan opportunity funds are pension plans, endowment trusts, wealthy private trusts and some REIT’s. If the borrower has less-than-average credit, a modest financial statement, and/or little commercial real estate experience, he may have to go to a hard money bridge lender. Hard money bridge lenders are lenders who loan primarily on the equity in the property.
Commercial Construction Loans
Need a multifamily construction loan or a commercial construction loan? Are you building an office building, retail center, industrial building, or any other type of income-producing property?
A related test is the Loan-to-Value Ratio. After the project is completed and, say, your strip center is occupied, will the construction loan be less than, say, 75% loan-to-value.
Some of our construction lenders are so hungry for deals that they might even allow 80% loan-to-value. But if you still need more equity, it may be possible for you to obtain a mezzanine loan.
Apartment construction lenders and commercial construction lenders often will not trust the appraisal. Instead, they will look to the Loan-to-Cost Ratio. What percentage of the total cost is the construction lender being asked to cover? Historically developers were asked to cover at least 20% of the total cost of the project, usually in the form of free and clear land. After all, the construction lender wants the developer to have some skin in the game. Modernly, however, apartment construction loans or commercial construction loans up to 90% of cost, or more, are possible. And if the developer needs even more leverage, a mezzanine loan is sometimes possible.
Will the apartment construction lender or commercial construction lender be able to get out of the deal? If you build your strip center, will the center make enough money to qualify for a takeout loan large enough to pay off the construction loan?
To determine if the takeout loan is large enough to pay off the apartment construction loan or the commercial construction loan, the construction lender will compute the Debt Service Coverage Ratio. The ratio must usually be larger than 1.25. In other words, the net income from the project must be 25% larger than the proposed payments.
Finally the apartment construction lender or commercial construction lender will look to the developer’s Net-Worth-to-Loan-Size Ratio. Generally the developer’s net worth should be at least as large the loan amount.
Commercial and Apartment Construction Loans “Takeout Loans”
Takeout Loan: A Permanent Loan That Pays Off a Commercial Construction Loan
Commercial construction lenders – over 500 of them – await your application for a multifamily or apartment construction loan, a commercial construction loan, a condo or residential subdivision construction loan, or a land development loan.
A permanent loan is simply a long term first mortgage on a multi-family or commercial property. You own an office building. Your existing first mortgage is ballooning. You simply need a new permanent loan.
Any first mortgage loan on a commercial property with a term of at least 5 years is considered to be a permanent loan, even though it has a balloon payment. A 10 year term is about as long of a term as most commercial mortgage lenders will go. Permanent loans are usually amortized over 25 – 30 years, unless the property is older. A lender might amortize a permanent loan on a 35 year old building over just 20 years, with a balloon payment after 5 or 10 years.
A takeout loan is simply a permanent loan that pays off a construction loan.
It’s that simple. You build an office building with an uncovered construction loan; i.e., the lender does not require a forward takeout commitment. The building is completed. You shop around, now that the property is completed (standing) and leased, and you find a conduit that will give you a takeout loan to pay off your commercial construction lender.
Do not confuse a takeout loan with a forward takeout commitment. A forward takeout commitment is just a very expensive letter that promises to deliver a takeout loan in the future if the property is built
Conduit lenders – several hundred of them with fantastic commercial loan rates – await your commercial mortgage mini-app.
WHAT IS A CONDUIT LOAN?
Commercial real estate first mortgage debt is generally broken down into two basic categories: (1) loans to be securitized (“CMBS loans”) and (2) portfolio loans. Portfolio loans are originated by a leader and held on its balance sheet through maturity. In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled and transferred to a trust. The trust issues a series of bonds that may vary in yield, duration and payment priority. Nationally recognized rating agencies then assign credit ratings to the various bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is subordinate to the lowest rated bond class.
Investors choose which CMBS bonds to purchase based on the level of credit risk/yield/duration that they seek. Each month the interest received from all of the pooled loans is paid to the investors, starting with those investors holding the highest rated bonds, until all accrued interest on those bonds is paid. Then interest is paid to the holders of the next highest rated bonds and so on. The same thing occurs with principal as payments are received. This sequential payment structure is generally referred to as the “waterfall.” If there is a shortfall in contractual loan payments from the Borrowers or if the loan collateral is liquidated and does not generate sufficient proceeds to meet payments in all bond classes, the investors in the most subordinate bond class will incur a loss with further losses impacting more senior classes in reverse order of priority.
The typical structure for the securitization of commercial real estate loans is a real estate mortgage investment conduit (REMIC). A REMIC is a creation of the tax law that allows the trust to be a pass-through entity which is not subject to tax at the trust level. The CMBS transaction is structured and priced based on the assumption that it will not be subject to tax with respect to activities; therefore, compliance with REMIC regulations is essential.
CMBS has become an attractive capital source for commercial mortgage lending because the bonds backed by a pool of loans are generally worth more than the sum of the value if the whole loans. The enhanced liquidity and structure of CMBS attracts a broader range of investors to the commercial mortgage market. This value creation effect allows loans intended for securitization to be aggressively priced, benefiting Borrowers.
THINGS TO BE CONSIDERED BEFORE CLOSING A CONDUIT LOAN:
Many misconceptions about the CMBS lending still exist among Borrowers , mortgage bankers and brokers. Especially with respect to how loans are serviced once they have been securitized. While basic loan administration for CMBS loans is substantially the same as for portfolio loans, some key differences exist between servicing for CMBS versus portfolio loans. Borrowers should be informed of the rules governing CMBS servicing as well as the mechanics for processing servicing requests. Borrowers need to carefully consider what types of servicing requests they many have over the life of the loan and try to address how these requests will be handled in their loan documentation before the loan closes.
THE POOLING AND SERVICING AGREEMENT:
Once the loan is transferred to a trust and securitized, the loan is serviced in accordance with the applicable loan documents and the Pooling and Servicing Agreement (PSA) for the trust. The PSA governs the allocation and distribution of loan proceeds and losses to the bondholders. It also describes in detail how the loans are to be serviced and includes guidance to ensure that the trust continues to comply with the REMIC provisions of the tax code in order for the trust to maintain favorable tax treatment. A key difference between traditional portfolio loans and CMBS loans is that, while each portfolio lender will apply his own individualized standards, CMBS services administer loans in accordance with PSAs which generally standardize practices and procedures to meet REMIC requirements and to protect the bondholders. Examples of REMIC restrictions relative to CMBS loan servicing requests are provided in more detail later. All CMBS servicers (primary, master and special) are required to act in accordance with the “servicing standard” as defined in the applicable PSA. Although the definitions may vary slightly from deal to deal, the same standard usually requires the servicer to use the same care, skill and diligence as it uses to service and administer comparable mortgage loans on behalf of third parties or on behalf of itself, whichever is the higher standard. Due consideration is given to customary and usual standards of practice utilized by institutional commercial mortgage lenders or servicers under comparable circumstances.
CMBS INDUSTRY PARTICPANTS:
The following parties are typically involved with a loan once it has been securitized:
- Primary or Sub-Servicer
- Master Servicer
- Special Servicer
- Directing Certificateholder/ Controlling Class/ B-Piece Buyer
- Rating Agency(ies)
PRIMARY OR SUB-SERVICER:
In some cases the Borrower may deal with a Primary Servicer that may also be the loan originator or Mortgage Banker who sourced the loan. The Primary Servicer maintains the direct Borrower contact, and the Master Servicer may sub-contract certain loan administration duties to the Primary or Sub-Servicer. The Master Servicer remains responsible to the trust for the Primary Servicer’s performance and actions. While Master Servicers maintains all of the responsibilities and duties to the trust under the PSA, a sub-servicing agreement between Master Servicer and Primary Servicer typically mirrors the servicing provisions under the PSA so that the Primary Servicer’s discretion is fairly limited and subject to the same servicing standard as the Master Servicer. Given their role in the origination of the loan, the originator or Mortgage Banker’s involvement as a Sub-Servicer allows for Borrower relationships to be maintained while adding to the collective servicing knowledge about the loan.
The Master Servicer’s responsibility is to service the loans in the pool through maturity unless the Borrower defaults. The Master Servicer manages the flow of payment and the information and is responsible for the ongoing interaction with the performing Borrower. The Master Servicer is responsible for collecting the payments from the Borrower, holding and making any disbursements from escrows and performing most routine loan administration functions. The Master Servicer is also responsible for collection and analyzing rent rolls, operating statements and other financial and property information from the Borrower, as well as conducting periodic physical inspections. A Primary Servicer may perform many of these responsibilities to the extent a sub-servicing arrangement is in place.
The Master Servicer is generally required to process all Borrower requests related to consents, waivers, and modifications related to performing loans. The Master Servicer’s ability to waive, consent or modify terms of any mortgage loan is governed by the PSA. Many material servicing requests or modifications will also require the consent or approval of the Special Servicer. In some cases those decisions are further subject to approval by the Directing Certificateholder or review by Rating Agencies as described later.
Upon the occurrence of certain specified events, primarily a default, the administration of the loan is transferred to the Special Servicer. A Borrower will receive notification from the Master or Special Servicer if its loan has been transferred to Special Servicing. Besides handling defaulted loans, the Special Servicer also has approval authority over material servicing actions, such as loan assumptions.
The Special Servicer is a specialist in dealing with defaulted mortgage loans and is usually selected by the Directing Certificate holder. In many cases the Special Servicer is a related entity to the Directing Certificate holder. Like Master Servicer, the Special Servicer has a duty to the trust and is subject to the serving standard. The standard usually mandates that the Special Server must act to maximize the recovery on the mortgage loan to the bondholders (as a collective whole) based on an analysis of collection alternatives using a net present value methodology. The Special Servicer will consider multiple alternatives as part of its analysis including loan modification, foreclosure, deed-in-lieu, negotiated payoff or sale of the defaulted loan. Frequently the Directing Certificate holder also has the ability to direct the Special Servicer’s actions with respect to defaulted loans. Provided the servicing standard is maintained.
DIRECTING CERTIFICATEHOLDER / CONTROLLING CLASS / B-PIECE BUYER:
The investor in the most subordinate bond classes is commonly referred to as the “B-Piece Buyer.” B-Piece Buyers generally purchase the B-Rated and BB/Ba-rated bond classes along with the unrated class. The most subordinate bond class outstanding at any given point is considered to be the Directing Certificate holder, also referred to as the Controlling Class. Given that losses come out of the lowest rated bonds, the PSA provides the Directing Certificate holder the opportunity to play an active role in monitoring the performance of each loan, make decisions on key asset issues and appoint and/or terminate the Special Servicer.
The Trustee’s primary role is to hold all the loan documents and distribute payments received from the Master Servicer to the bondholders. Although the Trustee is typically given broad authority with respect to certain aspects of the loan under the PSA, the Trustee typically delegates its authority to either the Special Servicer or the Master Servicer. As holder of the loans, the Trustee will be named in enforcement actions related to the loans (such as lawsuits or non-judicial foreclosure actions) yet in most instances the Trustee is acting by and through either the Master Servicer of the Special Servicer. All Borrower interaction rarely, if ever, interacts with the Trustee.
There will be as few as one and as many as four Rating Agencies involved in rating a securitization. Rating agencies establish bond ratings for each bond class at the time the securitization is closed. They also monitor the pool’s performance and update ratings for investors based on performance, delinquency and potential loss events affecting the loans within the trust.
The bond ratings assigned at the time the securitization closes assume that the credit quality of the loan pool will not change significantly over time. As such, some decisions cannot be made without respect to the loans in a securitized pool without rating agency confirmation that such actions will not cause a downgrade of any of the bond class ratings. Rating Agency confirmation is frequently required with respect to actions on the largest loan in the trust, but certain items such as approval of subordinate financing may also require Rating Agency confirmation regardless if the size of the loan. The Rating Agencies will work directly with a servicer in processing these types of requests and will not interact directly with the Borrower.
Who to Contact:
Borrowers should always initiate their requests with the Primary or Master Servicer, as they know who the players are in the securitization, what the process is, what information is needed for the specific request and whose consent is required. Even if the request must ultimately be approved by the Special Servicer or Directing Certificateholder, there parties will still generally look to the Primary or Master Servicer for a recommendation. It is common practice for servicers to send an introductory letter to the Borrower at the time a loan is closed or securitized, which typically includes a contact address. In the event such correspondence is not available, Borrowers should review their monthly billing statement to locate the identity of the Primary or Master Servicer for their loans and obtain contact information.
COMMON BORROWER REQUESTS:
Just as portfolio lenders service loans to protect their interests, CMBS servicers will act to protect the interests of the certificateholders as a whole. Unlike portfolio loans, where serving decisions are guided by the leaders’ own internal policies, CMBS servicers’ discretion in servicing loans is governed by the PSA and, in some instances, restricted by the REMIC regime.
Complying with REMIC regulations is central to most CMBS transactions to maintain the trust’s favorable tax treatment. One of the primary restrictions imposed upon the trust by the REMIC regime is the requirement that the loan constitute a “static pool.” This means that substitution of collateral cannot occur nor can the loan be materially modified unless specifically provided for in the loan documents or unless the loan has defaulted or default is deemed imminent. Many Borrowers offer good solutions to problems that are, however, not permissible under REMIC regulations and are frustrated when the CMBS servicer must reject their request. Even so, the requirements the REMIC tax regime has on CMBS servicing are limited and, in large measure, can be ameliorated by advanced planning. It is, consequently, extremely important at the loan origination stage to think through, in advance, the needs of the property over the life of the loan and what features and flexibility should be specifically spelled out in the loan documents at origination. This will help avoid a possible REMIC restriction and provide the servicer with clear direction as to how requests are to be handled.
The list below sets forth examples of activities that are prohibited or permissible under REMIC rules.
REMIC Prohibition *
- Change interest and amortization payments
REMIC Permissible ** (with advanced planning only)
- Release a material portion of or expand the collateral
- Substitute collateral
- Uncross loans
- Change escrow payments
- Release lease termination payments to the Borrower
REMIC Permissible *** (but loan or servicing documents may still restrict)
- Prepay the loan during a lockout period
- Waive or reduce a prepayment premium
- Allow secondary financing
- Release a guarantor of non-recourse carveouts
- Modify existing casualty/condemnation proceeds distributions
- Allow an assumption of the loan pursuant to the loan documents
- Allow an assumption of the loan not pursuant to the loan documents
- Modify Borrower reporting requirements
- Release escrows
- Release casualty or condemnation proceeds pursuant to docs
PREPAYMENT AND DEFEASANCE:
CMBS bonds are generally called protected. Call protection is an attractive feature of CMBS to many bond investors and implies that the underlying CMBS loans cannot be prepaid without some form of compensating payment being made to enable investors to maintain their expected yield. Bond investors are willing to accept tighter yields on CMBS because of the call protection. This results in more aggressive pricing to Borrowers. Call protection in CMBS is achieved through either defeasance of some form of prepayment calculation.
The form of call protection unique to CMBS loans is defeasance. Defeasance is the substitution of government securities for the property of collateral. A Borrower desiring to obtain a release of its property from the trust may purchase and pledge to the trust a collection of government securities that are specifically selected to generate sufficient cash to make all monthly payments due on the loan through and including any balloon payment due on the maturity date. Defeasance is not prepayment. Technically the note remains outstanding, but is repaid from cash flow from the government securities purchased rather than through cash flow generated by a property. The property is released to the Borrower free from the mortgage lien. In an interest rate environment higher than the loan coupon, a Borrower may even be able to defease for legal, accounting and rating agency fees. Defeasance is prohibited for at least the first two years following securitization due to REMIC prohibitions on substitution of collateral.
Prepayments differ from defeasance in that the note is actually paid off and removed from the trust. Prepayments are frequently accompanied by the payment of a sum of money designed to compensate investors for the loss of yield. This is often referred to as yield maintenance. Yield maintenance is a present value calculation that enables investors to reinvest the loan payoff proceeds at then current treasury yields through the original loan maturity and maintain the same yield as if the loan had not paid off early. Yield maintenance should not be viewed as a “windfall” to the trust as it only allows investors to maintain their expected yield bond classes. The amount of yield maintenance at any point in time depends on the level of current treasury yields relative to the loan coupon. The lower treasury rates are relative to the loan coupon, the greater yield maintenance amount. Prepayments at par are frequently allowed in many CMBS loans near the end of the loan term, commonly the last 3-6 months. More flexible prepayment terms are, however, available on floating rate CMBS than on fixed rate CMBS.
Each Borrower should carefully consider whether prepayment of defeasance is its right course of action, especially considering the potential fees involved. In certain higher interest rate environments, defeasance may provide a less expensive option for the Borrower to release the property from the trust. The out-of-pocket costs associated with defeasance, however, may make defeasance a more costly alternative for smaller loans or in a stable to lower interest rate environment.
Small Business Loans
Start a New Business (Real Estate Involved)
Maybe you want to buy a motel or a restaurant. Or let’s suppose you want to start a small machine shop. You want to buy the building because moving and installing your equipment is really expensive. You will also need some serious cash to buy and install your machinery. If this sounds like your kind of deal, an SBA loan may be your best bet. An SBA loan is a loan made typically by a bank which is guaranteed in part by the Small Business Administration, a department of the Federal government. If there is real estate involved, you can apply to scores of SBA lenders for a small business loan in just four minutes using
Buy a Franchise (Real Estate Involved)
Let’s suppose you are buying a fast food chain franchise, and there is real estate involved. SBA lenders finance a ton of of franchise purchases. An SBA loan is a loan made typically by a bank which is guaranteed in part by the Small Business Administration, a department of the Federal government.
Expand Your Existing Business (No Real Estate Involved)
You can definitely apply for an SBA loan from your bank … but before you do, you should consider a conventional small business loan from your local bank – a loan that is not guaranteed by the government. The problem with SBA loans is that the process takes several extra months and the SBA lender often wants to blanket your house with a second mortgage.
If you are making good money, your bank should be willing to make a conventional small business loan for you. If you’re making money and your existing bank won’t help you, consider applying to a competing small bank down the street. They will want you to move your bank accounts to their bank, but that’s no big deal. Your accounts have to be somewhere.
If you’re making money, but not enough to wow the bank, go ahead and apply for an SBA loan from your local bank. An SBA loan is a loan made typically by a bank which is guaranteed in part by the Small Business Administration, a department of the Federal government.
SBA 7(a) Loan
The SBA 7a loan program is a government-sponsored commercial real estate loan program that helps small businesses acquire the commercial real estate that their companies need to grow. As a result of the sub-prime crisis and the resulting credit crunch, banks across the United States have greatly reduced their commercial real estate lending. The Federal government is desperate to pump money back out into the economy. One of the vehicles that they are aggressively using is the SBA loan program.
The Small Business Administration (SBA) does not actually make small business loans. Instead, the SBA merely guarantees up to 90% of the principal of certain business loans made by banks and other specialized SBA lenders. Two of the most popular SBA loan programs are the CDC/504 program and the SBA 7(a) program.
Under the SBA 7(a) program, an SBA lender will make a commercial real estate loan that is fully-amortized over 20 or 25 years. Right off the bat, this is a very attractive program because most commercial real estate loans have a loan term of only five to ten years.
The SBA will then guarantee up to 90% of this small business loan for the bank, and the bank will typically be able to sell the loan off in the secondary market at a handsome premium – often five to seven percent of the loan amount. A loan or a bond sells for a premium when it fetches more than the face amount of the debt, usually because the interest rate is higher than the market.
SBA 7(a) loans are written as adjustable mortgage loans tied to prime. The spreads will vary from a low of 1.5% over prime to a maximum of 2.75% over prime. The loan fee depends on the size of the loan and the type of collateral (equipment versus commercial real estate), but the fees usually run between 2 and 3 points.
Small business owners can borrow between $50,000 and $2 million using the SBA 7(a) program.
The really big advantage of the SBA 7(a) program is that the owners of existing small businesses can often get loans up to 90% of the purchase price in order to buy commercial real estate for their businesses. Commercial real estate loans up to 90% loan-to-value are pretty terrific today, especially when you consider that many conventional commercial real estate lenders have cut their loan-to-value ratios down from 75% to just 58% to 63% LTV.
In order to qualify for an SBA 7(a) loan, the business owner must occupy, or intend to occupy, at least 51% of the commercial real estate being purchased. The commercial real estate cannot have a residential component. For example, if the target property consisted of an old home and a large warehouse, it probably could NOT be financed using SBA financing.
SBA 7(a) loans must be fully-collateralized. In other words, the SBA lender is likely to blanket all of the borrower’s inventory, receivables and equipment. This makes it difficult for the business to obtain a business line of credit from a bank. In addition, the SBA lender will usually blanket the personal residence of the borrower.
Borrowers can also obtain SBA 7(a) loans for working capital, to purchase equipment or to acquire businesses or franchises. The required down payments, however, are larger. Start-up borrowers will usually be required to put at least 20% down. More often they will be required to put 30% down.
SBA 504 Loans
The SBA 504 loan program is the best way to get a fixed rate SBA loan. The SBA 7a loan program is a floating rate commercial loan, tied to prime with no floor or ceiling. Yikes. SBA 504 loans are a little complicated to understand, but they are super-easy to get. The program consists of a conventional first mortgage, with an SBA-guaranteed second mortgage riding piggyback on top. The conventional first mortgage will typically come from a bank. It will have a fixed rate for the first five to ten years. If the loan is only fixed for the first five years, it will typically readjust once at the end of five years and then be fixed for the remaining five years. The conventional first mortgage loan will usually be amortized over 25 years, and it will balloon after ten years. The piggyback second mortgage will come from a local Community Development Corporation (CDC), and it will be guaranteed by the Small Business Administration. By the way, the word “piggyback” is redundant. A second mortgage is always subordinate to a first mortgage, but my point here is that the first mortgage and the second mortgage are recorded on the same day, just minutes apart.
A Community Development Corporation (CDC) is a non-profit organization consisting of a small group of people trying to bring businesses and jobs into a city. It frequently includes the Mayor, the City Treasurer, and the head of the local Chamber of Commerce. They often hand out tax breaks to companies that move plants to their city. Now you, as a borrower or broker, never have to worry about the CDC. Your SBA 504 lender will find them and bring them to the table. This piggyback second mortgage is fully-amortized over 20 years, and it enjoys a low-low fixed rate for the entire twenty year term! Why is the interest rate so low? Because it is guaranteed by the SBA, a department of the Federal government. You will often see that the fixed interest rate on the conventional first mortgage is pretty low, say 5.5%, but the rate on second mortgage, say 5.25%, is even lower, and that low interest rate is fixed for the entire 20-year term. The borrower’s blended rate in this example is around 5.4%, a wonderful rate. The SBA 504 loan program is terrific. The conventional first mortgage cannot exceed 5/9th’s of the approved financing. The SBA-guaranteed second mortgage makes up the remaining 4/9th’s of the approved financing. The example below will help you to understand. Example: Bob’s Trucking Company, a seven-year-old company, wants to buy a depot to house and repair its trucks. The purchase price of the depot building is $1,000,000. Since the company is older than three-years-old, the company qualifies for 90% LTV financing. In other words, they only have to put down 10% of the purchase price. By the way, if the company was younger than three-years-old, it would only qualify for 70% LTV financing. Bob’s Trucking applies just once to 504 Loans Are Us, Inc., a private finance company that specializes in SBA 504 loans. The specialty finance company arranges for First Neighborhood Bank to make a conventional first mortgage loan of $500,000 that is fixed at 5.875% for the first five years. The loan is amortized over 25 years, and it has a balloon payment after 10 years. The specialty finance company also arranges for Neighborhood Community Development Corporation, the business development arm of the City of Neighborhood, to make a 20-year, fully-amortized, fixed rate loan of $400,000 at just 5.75%. The specialty finance company gets the second mortgage guaranteed by the SBA and arranges to sell the second mortgage in the secondary market to an investor who loves the fact that the loan is guaranteed by the Federal government. Bob’s Trucking Company doesn’t care about all of these behind-the-scenes machinations. They just applied once to the specialty finance company, and the 504 loan company took care of everything. Now they are moving into their $1 million new facility, and they only had to put down $100,000 (10%). Wow. Best of all, they will now enjoy a low-low fixed rate loan. You can find scores of SBA 504 lenders by submitting your commercial loan application through C-Loans. Just click the Apply Now button above, and be sure to click the “I want an SBA loan” checkbox on your application.
The USDA Business and Industries (B&I) Loan for Commercial Property in Small Towns.
The USDA Business and Industries Loan (B & I Loan) Program is a Federal loan guarantee program that is designed to encourage the commercial financing of rural businesses. The reason why the Federal government is involved is because it wants to create and save rural jobs and improve the economic and environmental climate of rural communities.
Here’s what makes a B&I loan different: The Business & Industry Loan program is lender-driven. The USDA guarantees the loan rather than lending directly. A commercial lender requests the B & I guarantee, and, if it is approved, the commercial lender makes and services the loan.
The benefits of the B & I Guaranteed Loans Program for businesses is that the borrower gets a higher loan amount. The reason why is because the guarantee strengthens the loan application, allowing the bank to feel comfortable with a smaller equity injection.
B&I loans also offer lower interest rates and longer repayment terms. This greatly assists businesses that may not qualify for conventional commercial real estate financing, which provides the rural business greater stability and leads to greater growth, expansion and rural employment.
Below is a list of the authorized uses of the loan funds. A borrower must be engaged in, or proposing to engage in, a business that will (1) Provide employment; (2) Improve the economic or environmental climate; (3) Promote the conservation, development, and use of water for aquaculture; or (4) Reduce reliance on nonrenewable energy resources by encouraging the development and construction of solar energy systems, and other renewable energy resources.
Authorized Loan Purposes:
- Business and industrial acquisitions, construction, conversion, expansion, repair, modernization or development costs
- Purchase of equipment, machinery or supplies.
- Start-up costs and working capital.
- Processing and marketing facilities.
- Pollution control and abatement.
- Refinancing for viable projects, under certain conditions.
- Purchase of start-up cooperative stock for family sized farms where commodities are produced to be processed by the cooperative.
Bottom line, the USDA Building and Industry Loan (B&I Loan) program is a terrific program if the commercial property is located in a town of less than 50,000 residents. A great many small motels are financed using the B&I loan program.
Hypothecations: Loans Against Mortgages Receivable
Suppose a wealthy commercial real estate investor owns a commercial building free and clear. A potential buyer makes a good offer on the commercial building, subject to his obtaining a new commercial mortgage loan at 7% from his bank for 75% of the purchase price. The wealthy commercial property owner accepts the offer.
Unfortunately, the commercial lending world is in turmoil right now. Banks are afraid to make new commercial loans for more than around 62% loan-to-value. The bank turns down our borrower’s 75% LTV commercial loan application, and the deal looks like it is going to fall apart.
Then the commercial real estate broker has an idea. He convinces the wealthy owner to carry back a commercial loan for 75% of the purchase price at 7% interest. After all, the wealthy investor owns the commercial building free and clear. The buyer puts down 25% of the purchase price in cash, and the deal closes.
Now let’s scroll forward four years. The stock market has tanked, and the wealthy investor is not so wealthy anymore. He has lost 70% of his stock investments, and now he desperately needs cash to fix up an empty office building that he owns.
He takes his $750,000 first mortgage note that he owns to a number of commercial mortgage companies that specialize in discounting commercial notes.
Because his commercial loan has a 27-year remaining term and the note rate is only 7%, he learns that he will have to discount it by close to 28 points in order to sell it. He would have to give up over $200,000 if he tried to sell his note at a discount; and he really only needs the money for about 18 months. He is going to use the money to pay for the tenant improvements on his vacant office building. Once the new tenants move in, he’ll be able to easily refinance the building and pull out lots of dough.
The investor therefore calls his clever commercial real estate broker, and the broker tells him to just hypothecate his first mortgage note. A hypothecation is a loan secured by a mortgage receivable. It’s a loan secured by a loan. In this case, the investor will be pledging his $750,000 first mortgage note as security for a new hypothecation loan of $500,000.
The advantage of hypothecation loan, compared to selling a mortgage receivable at a discount, is that the investor won’t have to discount his perfectly performing first mortgage note by over $200,000. He’ll just pay a modest 3 point loan fee on the new, smaller $500,000 loan. The interest rate on the hypothecation, typically around 12%, is admittedly higher than what a bank would charge for a new commercial loan, but banks are not really lending right now. In addition, our investor really only needs to borrow the money for about 18 months, until his new tenants move into his vacant office building and he refinances the building. It’s far better to pay 12% on $500,000 for 18 months than to suffer a $200,000+ discount if he tries to sell his commercial loan.
Fix & Flip Loans
Fix and Flip Commercial Loans A fix and flip commercial loan is typically used by a speculator to buy a foreclosed commercial property, also known as an REO, from a bank. REO’s can frequently be purchased for just 60% of their fair market value. The speculator then fixes up the commercial property, leases it, and flips it (sells it) for a profit. Banks are very reluctant to make fix and flip commercial loans today. They are trying to reduce, rather than increase, the number of commercial loans in their portfolio. Now if you are a very wealthy investor, and you keep large deposits in your bank, you can probably twist the arm of your banker until the bank makes you a fix and flip commercial loan. Absent this kind of economic power, it is unlikely that you will be able to convince a strange bank to make you a commercial fix and flip loan. The lenders who are actually closing commercial fix and flip loans today are the private money lenders (hard money lenders). Most hard money lenders will loan you around 60% of the purchase price of the REO. It is then up to you to fix up and the property and then sell it (flip it). This means you might be required to put down 40% of the purchase price, pay all of the renovation costs (fix up costs), and cover the loan payments out of your pocket until you finally lease the property. Ouch! A better way to approach a commercial fix and flip loan is to view it as a form of construction loan. The total cost of the project will include the purchase price of the REO plus the cost to fix up the property plus the leasing commission plus the loan payments for nine to twelve months. The fix and flip lender will then loan you a certain percentage of the total project cost; say, 60% to 65%. The proceeds will then be controlled by the lender, similar to a construction loan, in order to be sure the proceeds are actually used to fix up the property. Using such a structure, the speculator will be able to borrow far more.
Calculating Interest Only Mortgage Payments – To calculate an interest only payment, take the loan amount multiplied by the interest rate, divided by 12.
For Example: $1,000,000 loan amount at 9%. $1,000,000 x .09 divided by 12 = $7,500 per month.
Return on investment (ROI)- is an accounting term that indicates the percentage of invested money returned to an investor after the deduction of associated costs. The formula may be simply stated as follows:
But while the above equation seems easy enough to calculate, a number of variables including repair and maintenance expenses and methods of figuring leverage – the amount of money with interest borrowed to make the initial investment – come into play, which can affect ROI numbers.
There are two methods by which ROI calculations are made:
The Cost Method The cost method calculates ROI by dividing the equity by all costs.
As an example, assume a real estate property was bought for $100,000. After repairs and rehab of the property, which costs investors an additional $50,000, the property is then valued at $200,000.
Equity Position: Total New Value – (Cost of Investment + Costs of Repairs etc) -> 200,000 – (100,000 + 50,000) = $50,000.
ROI, in this instance, is Equity Position / All Costs Related to Purchase & Repairs ->$50,000 / $150,000=.33 or 33%
- Out of pocket method-is preferred by real estate investors because of higher ROI results.
Using the numbers from the example above, assume the same property was purchased for the same price, but this time the purchase was financed with a loan and a down payment of $20,000. Out of pocket expense is therefore only $20,000, plus $50,000 for repairs and rehab, for a total out of pocket expense of $70,000. With the value of the property at $200,000, the equity position is $130,000.
Equity Position: Total New Value – (Out of Pocket Expenses + Costs of Repairs) -> 200,000 – (20,000 + 50,000) = $130,000.
ROI, in this case, Equity Position / Total New Value à $130,000 / $200,000= .65 or 65%. The result is just one percent less than double the first example. The difference, of course, is attributable to the loan – leverage as a means of increasing ROI.
Equity Is Not Cash Before the ROI, cited above, may be realized in actual cash profits, the properties must be sold. Often, a property will not sell at its market value. Frequently, a real estate deal will be consummated at below the initial asking price, reducing the final ROI calculation for that property. Keep in mind, also, that there are costs associated with selling a real estate property – again, there may be expenses needed for repairs, painting or landscaping. The costs of advertising the property should also be added up, along with appraisal costs and the commission to the real estate broker.
Both advertising and commission expenses may be negotiated with the service provider. Real estate developers, with more than one property to advertise and sell, are in a better position to negotiate favorable rates with media outlets and brokers. ROI on multiple sales, however, with varying costs for advertising, commission, financing and construction present complex accounting issues that are best handled by an accountant.
Property Cash Flow- An investor may have $30,000 in equity in a commercial rental property for which he paid $10,000 for an ROI of 300%. The property also yields $500 a month in rentals, for a total of $6,000 annually. That’s a 60% ROI on the property’s cash flow – $6000 divided by the $10,000 cost of investment.
Complications in Calculating ROI- Complications in calculating ROI can occur when a real estate property is refinanced, or a second mortgage is taken out. Interest on a second, or refinanced, loan may increase, and loan fees may be charged, both of which can reduce the ROI, when the new numbers are used in the ROI equation. There may also be an increase in maintenance costs and property taxes, and an increase in utility rates if the owner of a residential rental or commercial property pays these expenses.
Complex calculations may also be required for property bought with an adjustable rate mortgage (ARM) with a variable escalating rate charged annually through the duration of the loan. (To know more about ARM, check out:
The Bottom Line- Calculating ROI on real estate can be simple or complex, depending on all the variables mentioned above. In a robust economy, real estate investments, both residential and commercial, have proven to be very profitable. Even in a recessionary economy, when prices fall and cash is scarce, many bargains in real estate are available for investors with the money to invest. When the economy recovers, as it invariably does, many investors will reap a handsome profit.
For income tax or capital gains tax purposes, however, real estate property owners are urged to get professional tax advice from a reliable source before filing. Property tax is another factor in the equation when calculating return – if a property owner believes a property tax assessment is too high, in most cases, the assessment may be challenged and often a judgment is made in favor of the challenger.
Net Operating Income (NOI)- Net operating income (NOI) is simply the annual income generated by an income-producing property after taking into account all income collected from operations, and deducting all expenses incurred from operations. The net operating income is as follows:
Calculating net operating income is relatively straightforward once you break out each of the individual components. The components of net operating income consist of potential rental income, vacancy and credit losses, other income, and operating expenses.
Potential Rental Income – Potential Rental Income, or just PRI, is the sum of all rents under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market based rent is used based on lease rates and terms of comparable properties.
Vacancy and Credit Losses – Vacancy and credit losses consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. For the purposes of calculating NOI, the vacancy factor can be calculated based on current lease expirations as well as market driven figures using comparable property vacancies.
Effective Rental Income – Effective rental income in the net operating income formula above is simply potential rental income less vacancy and credit losses. This is the amount of rental income that the owner can reasonably expect to collect.
Other Income – A property may also collect income other than rent derived from the space tenants occupy. This is classified as Other Income, and could include billboard/signage, parking, laundry, vending, etc.
Gross Operating Income – This is simply the total of all income generated from the property, after considering a reasonable vacancy and credit loss factor, as well as all other additional income generated by the property.
Operating Expenses – Operating expenses include all cash expenditures required to operate the property and command market rents. Common commercial real estate operating expenses include real estate and personal property taxes, property insurance, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.).
Net Operating Income – As shown in the net operating income formula above, net operating income is the final result, which is simply gross operating income less operating expenses.
Capitalization Rate- A rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor’s potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. If you want to get technical, it is basically the discount rate of perpetuity. Please note that the higher the cap rate the better for the buyer and the lower the cap rate the better for the seller.
Capitalization Rate = NOI / PRICE
- Get the recent sold price of an income property, such as an apartment complex.
Example: Six unit apartment project sold for $300,000
- For that same apartment project, determine the net operating income, or the net rentals realized by the owners.
Example: The rental income after expenses (net) is $24,000
- Divide the net operating income by the sale price to get cap rate.
Example: $24,000 / $300,000 = .08 or 8% (The Capitalization Rate)
***Please NOTE: The CAP Rate Formula can be rearranged to produce one of three variables if you know the other two.
For example: Price= NOI / CAP RATE
NOI= CAP Rate x Price
CAP RATE = NOI / PRICE