Financing your first commercial property

This post might be helpful to an investor looking to finance its first multifamily residential property or any type of commercial income producing property that might be confused with commercial lending.

I can understand why most investors are a bit confused with commercial lending. The problem is that it lacks the uniformity of residential lending. Blame the lack of a well developed secondary market for the loans. After all, most residential loans are packaged and sold to investors while most commercial loans are kept on the books of the banks that originate them.

There are some basics that you cannot get away from in commercial income producing loans from banks.

 1)      Your loan-to-value needs to be at 75% or better. This means you will need to come out of pocket with $125,000 if you are looking to purchase an apartment building for $500,000

 2)      The fees associated with the closing of a commercial loan facility are usually higher than for a residential loan. Appraisals for apartment buildings can be anywhere from $2,000 to $4,000, and some banks require environmental reports, which cost about $1,000.

 3)      Underwriting procedures require that the debt service coverage {DSC} is at least 1.25X., which means the NOI {Net Operating Income} of the property can cover the loan payments at least 1.25 times. This is usually the one requirement that kills most deals because even if the property appraises at the right amount, the vacancies might create a shortage in the debt service coverage.

 4)      Lenders will most likely request your personal guarantee for small loans. Even if the property is being purchased under a Corporation or an LLC.

 Here is a hypothetical for you. Lets assume that you have been looking for a building, and found a nice 10 unit apartment building that you are interested in buying. Each unit rents for $600, and operating expenses are about $30,000 a year. You see it advertised for $450,000., and you are able to negotiate the purchase price down to $400,000., You remembered what you read about having to put at least 25% of your own money so you get $100,000 of your savings and walk to the bank to talk to you lender. The twist here is that of the 10 units only 5 are rented and your building has 5 units vacant or 50% vacancy.

The lender tells you that they do apartment loans all of the time, and he will be glad to talk to you about them. He also tells you that his rates are very competitive and that he does apartment loans at 5% with a 25 year amortization. The problem is that when he starts looking at the numbers, he will do a quick calculation like this.

 

CASH FLOW PROJECTIONS  
 

Actual

Occupancy

50%

 

 

Gross Rental Income

72,000

Less: Vacancy

36,000

Effective Gross Income

$36,000

   
Operating Expenses

30,000

  NET OPERATING INCOME

6,000

Debt Service – Assumption

$21,191

  DEBT SERVICE COVERAGE RATIO

0.28X

The problem that the lender has is that if he were to give you a loan under those circumstances, the bank would have a criticized asset on day one. The reason is that the primary source of repayment is insufficient to service the debt.

This does not mean that the loan cannot be done, there are at least two ways that the loan can be structured so that it gets approved.

I, Assuming that you are gainfully employed, the bank could make you a co-borrower and add your personal cash flow to the NOI of the property to calculate debt service. There are different ways to do the math on this. I have seen some lenders use the “excess cash flow after personal debt service”, and add that number to the NOI. In other places, I have seen the lenders put together a global cash flow. Either way, we are talking about the bank relying on your income.

Some investors might be concerned about being directly liable for the debt instead of just having a contingent liability as a guarantor. I agree to a certain extent with that train of thought as being a co-borrower might make the bank quicker on going after your assets in case of default. However, chances are that if you are a wealthy investor, the bank will try to come after you anyway if something does go wrong.

II, Another way I have seen shortages in the debt service being dealt with is that the bank requests that the borrower puts up the difference in a restricted account. The money is kept there until the property stabilizes {i.e.: fills up the vacant units}, and is able to provide the required DSC on its own. The math is simple and goes something like this

 

Debt Service – Assumption

$21,191

NOI needs to be for 1.25X

$26,489

NET OPERATING INCOME is

6,000

Shortage to be put in a CD

 $20,489

The problem with this method is that the investor needs to come up with another $20,489 for the purchase. The good part about this is that you can include a clause in the loan agreement that will call for the release of the CD once the building achieves stabilization, but the lender is probably going to want to wait a year until they allow the release.

 Conclusion: There are many reasons why one might want to buy a building with high vacancies. For example, you might think that under your management, you will be able to rent most of the vacant space out. High vacancies are not a deal killer, you just need to find a lender that is able to work with you to come up with creative structures.

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