Financing Commercial Real Estate Property Investments: It Is Easier Than Most Investors Think
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq.,
InvestingInLand.com
Financing commercial real estate is actually much easier than most new
investors think, especially those who are accustomed to financing single family
home, condominium, or other types of personal use residential property
investments. The key is understanding lender procedures and playing by THEIR
rules, not attempting to rewrite the rules to suit yourself.
Getting Started With The Commercial Lender
After signing the purchase contract on a commercial property such as an
apartment building, strip mall, office complex, shopping center, or whatever,
each lender before considering issuing a mortgage to complete this purchase will
want to examine the following paperwork. It pays to have all the
documents prepared long in advance, even before the actual purchase contract is
signed. Most of these documents should be assembled during the due
diligence part of the real estate process before making a formal offer on any
property.
Borrower's History
Lenders will want to see a complete biography of the borrower, their
experience managing and owning commercial real estate, their financial
statements especially indicating the source of down payment funds, the
borrower's credit history, and everything else to indicate why this lender
should trust this borrower with the property to be purchased. Obviously a great
credit report and a long history of successfully managing commercial properties
makes a lender more comfortable than a first time buyer with average credit. It
goes to say that you should check your own credit report before applying for any
loan, this is common sense, but surprisingly many investors do not and receive
unexpected bad news during the mortgage application process that was
unnecessary.
Property Income Analysis
Any lender will require a detailed study of the income potential of any
property to measure how much free cash flow will be available to support debt
service and pay equity investors, if any. This is basic spreadsheet analysis of
gross and net income and expenses but all numbers must be supported by current
official documents. Lenders will want copies of all current leases, insurance
policies, utility statements, tax bills, and proof of all operating costs such
as maintenance and repairs. Here it is better to provide too much information
than not enough. Be prepared to answer any question on the income statement with
a supporting document and have that evidence ready at all times. Do not attempt
to mislead lenders by providing current information you know is already
outdated. An excellent example is property tax liabilities. Taxes may be X this
year but if you know the county has just raised rates to X+5 next year you need
to disclose the higher rate even though it does negatively impact your cash flow
analysis. Getting caught in a lie or a deliberate or even accidental falsehood
can be the kiss of death for a loan application.
Physical Description Of The Property
It is very hard for a lender, especially one located far away from the
property itself in another city or state, to judge what they are going to be
lending against. A description like "a sixteen-unit apartment building at 234
Main Street, Akron, Ohio" does not inspire confidence in their minds. So a
comprehensive physical description should be provided. This starts with a
property survey conducted by a licensed surveyor to measure the legal and
physical constraints of their potential collateral but it should not end there.
It pays to have a professional photographer take a series of flattering
photographs of the property from every angle, inside and out, and of adjoining
properties to give lenders an idea of what the neighborhood looks like if that
helps sell the loan. I say professional photographer because most amateur
photographs make a property look darker and more dingy than it really is. Also
include past advertisements featuring the property, a list of tenants and former
tenants, recommendations from neighbors, tenants and others who know the
property and whatever other information you can think of so a loan officer in
Houston can accurately picture in their mind and judge a property in Boston.
Physical Inspection Of The Property
For most properties this will be a Phase I environmental inspection and a
report issued from a licensed firm stating that the property is free of such
contaminants as asbestos, lead, dangerous chemicals, underground storage tanks,
explosives, and other environmental dangers and a physical inspection of the
condition of the property again by a reputable or licensed inspector to check
the property's physical structure such as electrical wiring, plumbing, HVAC,
drainage systems, and the like. Both reports make sure the lender's collateral
is in good shape and does not subject the mortgagee to harsh environmental
liabilities.
Lenders may require all sorts of other documents and they will let you know
precisely what they need to see. But all will need to see the above so it pays
to start working on them as soon as possible.
Some Ideas For Borrowers
There are two important aspects from an lender's underwriting perspective,
the property and the property's management. As a borrower you need to reassure
the lender on both points. First, that the property is in good shape physically.
Second, that the property can earn the free cash flow that is projected. And
most importantly third, that the borrower will be a dedicated manager of that
property and keep it in good repair, avoid legal liabilities that may entangle
the lender, and profitably manage the property for maximum cash flow. Anything
that can be done to assure the lender on these points helps sell the
application.
Critically assess your strengths and weaknesses as a borrower. If you have
strong financials but a weak management history, bring a partner or skilled
manager aboard your team before applying for the loan. If the property is weak
on initial cash flow, develop a detailed step-by-step plan on how you will boost
cash flow in the early months of property ownership. If your credit history is
weak, raise more equity so the principal borrowed will be less. Any commercial
mortgage application can be improved if the borrower will just put ego aside and
look at their request for funds from the lender's perspective.
All the above described costs, inspections, reports, photographs, and more
are the borrower's responsibility so there is an inherent tendency to cut costs
and be cheap here. Avoid it. A poorly prepared financing application is worse
than none at all. Even simple matters like having the document proofread to
avoid typos and factual errors is crucial. Most lenders will not know you
personally so your report is a physical manifestation and representation of who
you are. Put on the glitz here and realistically spare no expense. Lenders will
deny it but they are impressed with four color photographs, glossy paper, and
detailed charts and appendices all bound together in fancy hardcover books. Any
given lender can only make so many loans so you want to make your application as
impressive as possible so it stands out from the crowd.
Do not try to overborrow or overbuy. If you have never owned rental
properties before, a 54-unit apartment building is not the place to start. You
are also not going to get an LTV of 98% on a half abandoned shopping mall. Many
financing applications are just plain absurd from the start. A building with a
net cash flow of $15,000 per month cannot support a $15,500 mortgage payment. To
the inexperienced borrower it seems like common sense it does but most lenders
know with cash flow that thin on a property, one disaster or unexpected vacancy
and they have a delinquency on their hands. Be realistic when you apply for
financing. Again, it sounds like simple advice but so many borrowers fail to
think about this from the lender's perspective.
Choose your lender well. Many lenders specialize in a particular type of
property or a given geographic area. Since they have this unique knowledge it
makes the application process much easier. Do not go to a lender that has never
loaned on retail space if you are buying a strip mall. Develop a list of
possible lenders with both expertise and capital available in your particular
area of interest before you start making offers. Know what their lending
criteria are so you can tailor your purchase offers towards meeting them instead
of trying to put a square peg into a round hole afterwards.
The Bottom Line
Financing commercial real estate is much easier than most investors think.
Lenders are looking to property cash flow more than the income history of the
borrower as is the case with normal residential property underwriting. They know
their debt service comes from the property itself and not from the job or other
income of the borrower. This makes it easier for borrowers to get loans if they
can show the property's potential and their ability to successfully manage it.
The toughest part of getting commercial financing is raising the equity
component of the purchase either through direct investment or with partners.
Once that is done, some lender will write a loan although interest rate and
terms will always be issues for the marginal borrower. The best policy is
usually to leave the commercial financing applications to the well-capitalized
investor or developer and profit through joint ventures whenever possible. This
means that even the inexperienced or capital deprived investor can participate
in large commercial projects even when normal lender criteria would
automatically exclude them from such profits.
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