"Property Play - A Primer for Investors who are considering commercial real estate to build up their nest eggs" by Kemba J. Dunham

In case you missed yesterday's Wall Street Journal article "Property Play - A primer for investors who are considering commercial real estate to build up their nest eggs", here is a review of this great introduction into real estate investing.

In this article, Kemba J. Dunham puts forth a basic outline to consider when looking at commercial real estate. Commercial real estate investments can range between retail strip malls, office buildings to real estate investment trusts (REITS), apartment buildings, and even five family residences. Unlike twenty years ago, financing is readily available for the purchase of commercial properites - making commerical real estate investing an option for the average American. However, as the article states commerical real estate investing is not for everyone and there are key considerations to follow.

First, Ms. Dunham states that every fledgling investor GET HELP. In every market there are commercial real estate brokers that can assist investors in selecting properties. They can add insight into local market rents, comparables, and even lenders. Other key advisors include a real estate attorney, and an accountant.

Second, the article points out several forms of ownership the investor should take title to the property. Direct Ownership or a third party vehicle, such as a Limited Liability Company or General Partnerships are the basic title considerations. Each form has its pluses and minuses. Direct Ownership is means that you take title to the property in your name. Some benefits include favorable tax consequences (consult a expereicned tax consultant), the ability to later conduct a 1031 exchange, and you're your own boss and don't have to share profits. The big downside to direct ownership is the liability - which is squarly on your shoulders.

Ms. Dunham provides a smart consideration to those investors that want to invest in commercial real estate but don't want the headaches of managing the property. In every market, there are capable property management companies that will manage the day to day on the property for a fee - usually 5% to 10% of the gross rent. The article suggest that "when hiring a management company, check out its references and see how well it is regarded locally".

Third, going alone scares many would-be investors, so partnering up with other investors makes sense. Partnering spreads the risk and lowers the personal contribution to get things going. However, an obvious drawback is the fact that you have to share the profits. The article suggests that those who don't want to go it alone find sponsors who buy commercial properties on behalf of small investors for a fee.

It goes on to suggests alternative forms of third party or sponsored ownership methods such as general partnerships, limited liability companies, or tenant-in-common arrangements (TIC). In a TIC arrangement each tenant owns a fractional share in the property. Limited liability companies offer the tax consequences involved in direct ownership while offering a direct liability shield against claims. There is a cost to set up a limited liability company or general partnership and a good commercial lawyer can assist in that process.

The last bit of advice in this great article focused on Triple Net-Lease Properties, which are properties that the tenant covers the utilities, taxes, and insurance in the rent. While the advantge to the owner is just collecting a check every month, the tenant would most likley require a long term lease as incentive to agree to those terms. As Ms. Dunham states in the article, "Because of the long leases, net lease properties can be very illiquid".

Overall, the article is a solid start for anyone looking to enter the commercial real estate market. The best piece of advice is get professional help - a commercial realtor, a real estate attorney, and an accountant.

How do I know I'm getting a good rate? Secrets your Banker doesn't want you to know.

The most obvious way to know if your getting a good deal on your interest rate is to obtain at least three offers from Banks. The second way is not so obvious and is something that your Banker probably would prefer you not know. Here is the quick test.

1) Find out what index or source of funds your loan is based on. Most proposal letters will (should) tell your that your ten-year loan is based on the Ten-Year Treasury, the Ten-Year Federal Home Loan Bank, the Bank's own Cost of Funds, or LIBOR. You can check these base rates on the Internet or in newspapers such as the Wall Street Journal.

2) Take the stated interest rate found in your proposal letter and subtract the base rate determined in Step 1 above. For example, your proposal letter might state a 12% interest rate based on the Ten Year Treasury, which is at 9% (for example only). So 12% minus 9% equals 3% and that represents the Bank's revenue on the loan - revenue not profit. The spread between your stated rate and the base rate tells you a couple of things. First, the greater the spread the greater perceived risk by the Bank on your loan. Second, if you have an existing relationship with a bank, the spread can tell you if they are taking advantage of your company's business.

A fair spread between the index and the stated rate in the proposal letter is usually 2.00% -2.25%. This would represent a normal risk profile and most likely equates to a decent profit for the Bank. Remember, your Bank needs to make money as well and a bank that's not making money on your account will not be that helpful if things go bad.

Spreads in-excess of 2.25% could represent increased risk in the transaction or aggressive profit taking by your Bank. Risky transactions might include acquisition financing, shareholder buy-out that will affect the balance sheet, or a loan to fund net losses in the business. If any of those factors are involved then the Bank is just trying to risk adjust the rate they are charging for the new risk involved.

If your loan request is a normal term loan to buy a new machine, a line of credit to fund growth and your leverage isn't that high (below 3.5x), and your making money, then a spread above 2.5% means that your Bank is trying increase the profit on your relationship. I would speak to your lender and remind him or her of your relationship and that the pricing of the loan doesn't reflect that relationship. The banker might be so embarrassed that he or she might lower the spread to 2.00% or better.

So remember, an interest rate spread above 2.50% requires you to ask questions and either gain an understanding and respect for how your bank is looking at your loan, or come to the realization that your bank is gauging your cash flow through higher than necessary interest rates.

The Connecticut Development Authority ("CDA") Is Your Friend!!!

The CDA is chalk full of good loan programs for Connecticut Companies. The CDA plays a very important role in the Connecticut banking landscape. Not only does it promote job growth or job retention in the State, it also provides a buffer with the wide swings in credit availability supplied by the Banks.

Now, you might think that with any quasi-government program comes with a mountain of red-tape - not with the CDA. The CDA has provided a streamlined, well publicised application process that reduces the time and frustrations felt by borrowers in the State. The application can be downloaded from its web site: CDA Application. But wait, there are very helpful CDA loan professionals ready to assist you with your situation. The CDA suggests calling the CDA loan offices prior to filling out the application (CDA Contact Info).

Before we go into some of the specific loan programs, here are some do's and don'ts with the CDA.

1. Which came first the chicken or the egg, or in this case the CDA or the Bank. Well, its a bit confusing with the CDA as well. The CDA's customers are the participating banks and lenders in the State, and not necessarily or directly the borrower. If you've been turned down by a bank or your astute enough to know that your loan request might cause your lender stress, then study the CDA programs and speak with a CDA loan officer. Get a green light (not a commitment, but an indication from the CDA that your request is in the realm of possibilities) from the CDA loan officer. Then start speaking with your existing lender or any prospective lenders about your loan request and the CDA. Having this knowledge would also so your bank that you mean business.
2. Have an understanding of the timing of the CDA and your lender. The CDA's Board of Directors meet once a month, usually on the 15th if that falls on a weekday. Applications usually have to be approved by the CDA management the last week of the prior month (at the latest). So if you have a tight time frame associated with your loan, then missing a key date might mean waiting another month before your get the funds.
3. Be confident on your projections in particular your employment projections. Remember, the CDA bases its support on your current and projected employment - among other things such as cash flow and collateral. Historically, the CDA has lent or guaranteed $10,000 to $20,000 per employee. The CDA will conduct annual audits on your employment levels, and any shortfalls that aren't easily explainable or extraordinary may result in penalties.
4. Provide the CDA the same information package that you provided your lender and remember your Lender has to fill out an application and provide certain information to the CDA as well. The lender has to fill out an application supporting its request for the CDA support and also has to provide the CDA its loan approval memo prior to the CDA going to its Board for final approval. So keeping tabs on your lender is important. Ask your loan officer if the CDA has the Bank's loan approval document. If he or she doesn't then you might be waiting another month.

The CDA is a great organization and its loan officers are experienced former bank lenders. So communication is important, and they are a good source of information and help. I'd like to now highlight one of the many lending programs offered by the CDA: The Participating Loan Program.

The Participating Loan Program essentially allows the CDA to participate with your lender in the loan structure provided to you - usually on the term or mortgage structure of your loan request. You continue to work with the lender and make your payments. The lender then distributes the CDA's piece of the payments to them. You are still working with one entity - your lender. There are no outside fees required as the CDA will participate with the lender's fees which you signed up for when you signed the commitment letter.

So its a marriage made in heaven - hopefully. The lender receives support to provide the needed loan to the customer (you), while not compromising its loan standards. The customer gets the money required to complete his or her business plan. The CDA provides support to the lender and thereby supports employment growth by the borrower. How does the CDA participation help the lender? The CDA participation is junior to the lender, which means that the CDA essentially has a second lien and the lender a first lien on the assets of the company.

If you find yourself looking for help to get the required money to grow your business and employee base, then the CDA is a great option to consider. If your banker doesn't mention it, then mention it to your banker. For more CDA programs, click here. Good Luck!!

How do I buy my competitor? Will my bank help me?

Acquisition financing has always been challenging for banks. Why? Typically, the multiple being paid exceeds the tangible assets found on the acquired company's balance sheet. This collateral shortfall - as perceived by the bank - is a hurdle that most banks require an equity contribution to cover. The bank would also want you to have "skin" in the game by requiring an equity contributions. Equity contributions have hovered between 20% to 40% since 1996.

To figuire out how much your bank would lend on an acquistions, you must calculate the lendable value of the tangible assets, determine the debt service capability of the acquired company, and calculate the overall balance sheet and cash flow leverage at closing. Let's review each one seperately.

Lendable Value of the Tangible Assets:
Create a simple spreadsheet and put the assets in the first column, and the values found on the balance sheet of the acquired company. Typical assets include: Account receivable, Inventory (excluding Work-in-Process Inventory), Machinery and Equipment, and the Real Estate. Other assets such as customer lists, trade names are all assets, but not lendable assets from the bank's point of view.

In the next column put the following advance rate percentages next to each asset class: Account Receivable at 80%, Inventory at 50%, Machinery and Equipment at 50% of net book value, 70% of the orderly liquidation value, 90% of the forced liquidation value, and 80% on the value of any real estate. Total the net lendable value to determine the total lendable value of the acquired assets. Subtract 15% from the lendable value of the accounts recievable and inventory to account for working capital availibility that all banks will require.

Determine the Debt Service Capability of the Acquired Company's Cash Flow:
Start with the acquired company's EBITDA (Earnings before interest, taxes, depreciation, and amortization). Then adjust the cash flow from any expenses that are eliminated by the fact you are acquiring the company. These expenses might include: Prior owner's excess compensation and benefits, Miscellaneous professional fees, and rent. Once you've calculated the adjusted EBITDA, take the total lendable value of the tangible assets calculated above (minus the 15% working capital adjustment), and amortize that amount over seven year period to determine your annual principal payment. Most banks will set loan amortizations and maturities on acquisition debt to be between 5 to 7 years. In some cases, I've seen 10 years - when supported with an SBA guarantee or other credit enhancement. Apply a conservative interest rate on the debt to determine the total annual interest exepense. Add the total interest expense and principal payment to determine your total debt service.

Then take your total adjusted EBITDA and project your future capital expenditures. Subtract the capital expenditures from the EBTIDA to determine your free cash flow to service debt. Take that cash flow and divide into it the total annual principal and interest payments. This ratio cannot be lower than 1.20x. If it comes in below that figure, then more equity needs to go into the transaction. Siginificant cushion over the ratio might be a way to justify a lower equity contribution!

The last step is to determine the Day One balance sheet and cash flow leverage. Balance sheet leverage is determined by dividing your total liabilities by your total shareholders' equity. This ratio should be below 4.0x, although some bank's might be fine with 5.0x. Total calculate your cash flow leverage, divide your adjusted EBITDA by your total liabilities. This ratio should be below 5.0x and again some bank's might accept 6.0x.

Your banker will help you if you present to information calcluated above in the form of a formal presentation which would include projections. The quality of the presentation is a signal to the bank as to wether you are on the ball with this significant transaction. Listen to suggestions from your banker. Your banker might even suprise you and lend you 90% of the acquisition price, or he might say that this transaction would push your total debt over the risk tolerance of the bank. In that case you've got to go find a bank to help you complete the transaction.