Remember This: There are a 1,000 of THEM and only ONE of YOU!!

It can be down right scary. What if I say the wrong thing? What if my credit score isn't high enough? What if he shoots holes in my business plan? What if she doesn't believe that I can increase the occupancy rate to 90%? Oh, I need to get this loan closed in 30 days or I'll lose this great opportunity. My lender won't call me back. Have you felt these emotions when you last dealt with your bank? In short, do you look or feel like the picture below when dealing with the commercial loan process?

Let me tell you a secret. A secret that your banker doesn't want you to know. You can now obtain your loan to buy that business or buy that property from ANYWHERE on terms Better than what your loan officer can give you. You can buy that property with the help of a private lender in California. A hedge fund in Texas will help you acquire your competitor. Why or how did this happen? Well I'll get to that later, but it's important to know more about this nasty little secret.

Why doesn't your banker want you to know this devastating secret? Because, if you knew this secret (and now you do!) then he or she would have to return your phone calls or worse they would have to close your loan on your time table, versus, the banks. Better yet, they wouldn't be able to make you jump through hoops with questions and documents only to say NO leaving you with no options, and no time to find another lender. Well, thanks to the globalization of finance, Main Street USA now has access to capital from Asia, Europe, and all over the United States.

See, despite what you see on television regarding the residential mortgage crisis or the collapse of Bear Stearns, the United States has one of the most efficient capital markets system. Even with all of its warts (savings and loans debacle of the 80's, the collapse of the hedge fund Long Term Capital Management as examples of our warts), the United States' financial system attracts capital from all over the globe.

What this means for you- the Main Street investor or business owner? Well, the massive amounts of capital invested in the United States continues to chase fewer and fewer larger transactions. This puts pressure on putting the money to work, prompting these capital providers to lower their loan size requirements.

So now, that real estate owner in Newington looking for $50,000 cash out on his properties can obtain his loan from a private lender in Pennsylvania who's largest investors are private banking clients from Europe.

So the next time you call your banker, I bet he or she will take your call. Suddenly, they're hoping you take their loan; hoping that they don't say something that will make you go elsewhere. Remember, there are 1,000 of them and only One of You. You're driving the bus.

Storm Clouds - First Bolt of Lightning

From time to time, I like to jump in and comment on the current lending environment facing commercial businesses and real estate investors. Today's entry, hopefully isn't a harbinger of things to come.

I know that several other large private lenders have closed up shop however, most of those closures stemmed from these lender's exposure to the residential market and not due to commercial. Well, we have our first potential casualty from a pure play commercial lender.

CIT Group yesterday drew down 100% on its $7.3 billion back up credit facility to meet current cash flow needs, and cash to service debt in the near term. CIT has to refinance approximately $3.0 billion in short term debt in 2008.

The reason for CIT's troubles stem from the disruption in the commercial paper market - which is almost non existent for lenders. Without access to the commercial paper market, CIT has to rely on other sources of funds, such as commercial deposits and other deposits. CIT's lack of a substantial deposit base created a liquidity crisis.

CIT management stated that the Company has the liquidity to fund its operations in 2008, but commented that it has to reduce its lending to new customers to preserve capital. This might be a sign of relief for CIT's current business customers, but it reduces the total amount of capital available to all commercial business and real estate investors.

The issue with the commercial paper market are intertwined with the general lack of investor confidence in the assets (loans) supporting these obligations. It started in the residential mortgage market, and know has swept into the commercial debt market.

The Fed and Wall Street hope that the recent liquidity added to the market will prime the pump to allow investors and lenders to create a floor in the value of these assets supporting the obligations. A floor, created by good old buying and selling (trading) that is the foundation of our market system, will signal to all parties that we reached the bottom of the residential and now commercial debt market leaving only upward pressure on asset values. Upward movement in asset values with increase the acceptance and ability of investors to buy lender ogligations. Let's hope they are right. If not, the storm could turn into a hurricane.

Real Small Business Loans for Real Small Businesses

If you were looking for a $300,000 business loan, would you pay and additional $67,000 over three years in order to get a two percentage point reduction in the interest rate?

Unlikely.

But that's what plenty of small business owners do because they seek bank financing with seemingly low rates of interest, versus a so-called stated income/asset loan that carries an apparently higher interest rate.

How can this be?

Simple. The low rate loan is a full documentation, conventional loan. The seemingly higher rate loan, the stated income/asset loan, requires limited documentation and no income verification. For small business owners, there is a world of difference. The reason is because the owner of a small and or cash based business may have a very low salary, but quite legitimately derive economic value from the business in excess of $100,000. But stating this to satisfy a bank can at the same time provoke tax authorities, and generate significantly more taxes well into the future.

Thus the savings from the apparently lower rate of interest are illusory. Worse, because of potential tax liabilities, low rate loans may result in an effective interest rate that is much, much higher.

We are all brought up to believe that banks finance businesses. And there is a myth that small banks and small businesses fit hand and glove with one another. But the truth is that banks and small businesses are actually a tough fit.

The bankers aren't bad guys. It's simply that banks - even regional and community banks that have a vested interested in funding businesses where they operate - are structurally incapable of serving the needs of small and or cash based businesses. Banks need plenty of hard assets to collateralize loans. In addition, they are subject to scrutiny by federal regulators on their underwriting policies and practices, and have an expensive monitoring process that favor larger borrowers - those that need to borrow $500,000 to $1 million or more.

By contrast, smaller, cash based businesses typically do not possess a lot of hard assets, may have uneven financial performance that make regulators wince, and typically require loans of less than $1 million. The reality of this "structural mismatch" can be vexing and frustrating for small business owners who often diligently visit every bank in town only to get turned down by each one.

For these reasons, non bank lenders and stated income/asset programs can be a viable alternative for cash businesses, 'mom and pop' shops, self employed individuals, businesses with environmentally sensitive properties (i.e. auto repair shops, dry cleaners) as well as property owners that want to cash out, or leverage up to purchase additional properties. In the highly regulated environment of a conventional bank, these borrowers present insurmountable obstacles. In the more entrepreneurially driven non bank lender environment, these borrowers present a myriad of opportunities for which creative solutions can be developed.

What is the secret of non bank lenders that offer stated income/asset loans? First, they operate in an underserved market: small businesses seeking loans of less than $1 million. By virtue of this, non bank lenders can identify promising businesses that traditional banks would not even see. Second, non bank lenders are not regulated. This means they can adopt policies that while sound, would nonetheless go against the grain of federal regulators provoking questions and inquiries that bank executives would like to avoid altogether. Finally, non bank lenders believe in the value of real property as collateral. By lending prudently against the value of real property, non bank lenders need go no further in assuring the safety of their capital. Putting all these factors together means that non bank lenders offering stated income/asset programs can provide small businesses with solutions that are more consistent with the challenges they face.

For example, many traditional lenders require cross collateral agreements. These are agreements in which the borrower, after pledging all of the businesses' assets and real property as collateral, pledge their personal property as well. This arrangement can complicate loans, especially when there are multiple business owners whose active participation in the business may vary. Because stated income lenders focus on the underlying value of the businesses' real estate, in addition to its cashflow, they generally do not require cross collateral agreements.

Stated income/asset lenders are also more comfortable with so called cash out loans. For example, suppose you own a property that houses your business, and you want to leverage the value of your equity, and take cash out. Perhaps this cash will be used to expand the business. Or perhaps you might view this cash as a just reward for years of carefully managing the business and the property.

Traditional bank lenders are uncomfortable with cash out loans. They often feel that such arrangements leave them vulnerable. By contrast, stated income/asset lenders, which again place an emphasis not only on the business's cash flow but the underlying property as well, actively seek such loans. Their appetite for these loans is a valuable source of liquidity for small business owners.

As one more example of how stated income/asset lenders are more geared to the needs of small businesses, consider typical loan covenants. Traditional lenders often seek the right to audit the books of the borrower and have the borrower issue a covenant pledging that the business will perform at its current level or better. A breach of this covenant, over which the small business owner may not have complete control, can result in the borrower being in default, and the lender initiating foreclosure proceedings.

Again, there is nothing wrong with this per se. After all because banks are the stewards of consumer deposits that are insured by federal funds, i.e. taxpayer dollars, they must avoid risk at all costs. This is why banks operate in what is often characterized as 'an abundance of caution mode,' and adds bulk to the explanation of why banks are not built for the kinds of risks that small businesses typically present.

It also explains why there is such a void in the market for loan and credit services to small businesses. However, stated income/asset lenders have stepped into this void and are actively seeking out companies to provide loan solutions to help businesses maintain their track record of success, or take a giant step forward to the next level.

How Real Estate Affects the Bottom Line for Small Businesses

Perhaps the most striking feature about the money made by homeowners from their house was how little of it was intentional. For many, a mortgage payment was simply a substitute for the monthly rent payment. But over time, loan balances went down, values went up, and suddenly there's a half a million in equity sitting on the table.

Although a similar opportunity exists for small businesses, fewer entrepreneurs take the leap. Running a business is challenging enough, why add the headache of owning additional property? This may be true, but buying real estate to house your business - as opposed to renting - can have a material impact on your return from the business and your overall wealth.

To see this concept in action, consider the performance our hypothetical retailer, The Speed Shop, which sells automotive products, before and after the purchase of real estate.

For years, The Speed Shop, provided a nice living for its owner. Located in the suburb of a major metropolitan area, the business, a subchapter S corporation, consistently generated $750,000 in sales and distributed net profits of 5% or about $37,500 after the payment of a $60,000 salary to the owner. Since the business was stable, the owner typically took the net profits out of the business in the form of a cash payment.

Suddenly, the owner receives a call one day. The building owner has died. The executor of the estate would like to know if he would be interested in buying the building for $750,000? Because the owner had invested his bonuses wisely over the past 10 years, there was no question he had the cash to make a 40% down payment of $300,000.

But the question became would the purchase of the building have a positive or negative effect on the Speed Shop's owner? Let's assume the owner buys the building personally, and rents it to the business to see how far out ahead he might come after 10 years, versus continuing to rent.

If the $450,000 balance was financed with a 6.25% adjustable rate mortgage, the monthly principal and interest payment would be $2,770, if amortized on a 30 year basis. Including the annual taxes of $7,200 increases the monthly payment to $3,370. This is less than the current monthly rent of $6,500 that the company pays, so the transaction is off to a good start.

But let's be conservative and assume that the Speed Shop's owner spends $37,500 annually on maintenance and operating expenses for the building. This $37,500 is annual difference between the old rental payments and the new mortgage and tax payments.

Now we need to make two adjustments to account for depreciation and principal contributions.

Let's take principal first. The mortgage payments of $2,770 per month which total $33,240 annually contain about $5,300 in principal payments in the first year. These principal payments cannot be expensed.

On the other side, there's depreciation to consider. Net of land, which cannot be depreciated, the value of the building is $675,000 which is $750,000 less an assignment to the value of the land at about $75,000 or 10% of the total value of the property. The useful life prescribed by the IRS for non residential commercial real estate is 39 years. Therefore the annual depreciation expense for the property is $17,308 which is the $675,000 basis divided by the 39 year useful life.

The income statement for the first year will look like this:

Income: $78,000
Expenses
Mortgage Payments
Net of Principal $27,940
Taxes $7,200
Operating Expenses $37,500
Depreciation $17,308
Total Expenses $89,948
Net Loss $11,948

The landlord feels none of this net loss because it's delivered in large measure by the non cash depreciation expense. On the down side however, he also doesn't really feel the increase in equity of $5,300, because, despite the lower mortgage balance, the mortgage payment does not change.

Regardless, what's important is the ability of the landlord to take this loss and net it against the profits he receives from his retail business that will ultimately have a material impact on his wealth.

Remember the 5%, or $37,500 in profits? Thanks to the loss on the building the owner will pay taxes on just $25,553 ($37,500 profits - $11,948 loss from real estate). In a 35% bracket, this means avoided taxes of $4,181.

Said differently, the Speed Shop's net margin would have to increase to 5.86%, to leave its owner with the same amount of cash after taxes. This represents an astounding 17.2% (0.86% / 5.00%) increase in net realized profits to the owner.

It's important to keep in mind however that the feds, as a general rule do not like to see passive income (i.e., such as income from a real estate investment) offsetting active income, (i.e., such as income from running a retail operation). There are rules that govern limits to the offsets over certain amounts. And if you get into a discussion with the Internal Revenue Service that your ownership and management of the building is active, you might very well be unable to get them to see your point of view.

Now project 10 years into the future, and assume that rather than selling the business, the owner simply shuts it down and sells the building. Also assume that after the first year he replaced the 6.25% adjustable rate mortgage with 9.87% permanent financing. How did he do? At the end of 10 years, he owed the bank $410,000. However because real state values went up by an average of 7% per year, he sold the building for $1.47 million. After paying off the mortgage, the Speed Shop's owner has $1.06 million.

True, he doesn't get to pocket this. He must pay long term capital gains taxes. And all that depreciation he took for so many years comes home to roost, in lowering the cost of the building, and in turn increasing the capital gains tax owed. In this case the $17,308 in annual depreciation reduced the owner's cost basis by $173,080 over 10 years. Said differently, the owner must now pay taxes on this so called "unrecaptured" depreciation at a rate of 25%. The balance of the gain will be taxed at the recently enacted long term capital gains rates of 15%.

However this must be weighed against the avoided taxes of $4,181 in the first year and $9,800 in years two through 10 (as a result of a mortgage with a higher interest rate). But more importantly it must also be weighed against the $634,692 ($1.06 million proceeds - $125,308 capital gains taxes - $300,000 initial investment) earned on the real estate investment after payment of all long term capital gains taxes.

The average after tax gain of $63,469 ($634,692/10 years) per year is the equivalent of $97,644 pre tax income in a 35% bracket. Adding this to the owner's salary and profit distribution of $97,500, means that diverting the cashflow that normally went into rent toward ownership of real estate doubled his income.

As you can see, it's as if he made the business twice as big but never added a single square foot to the operation. That being said, it's safe to say that adding real estate into the business equation can have a very material effect on the wealth of principals in a business.

Simple, But Required Real Estate Calculations Every Investor Should Know!!

THE THREE COMMON REAL ESTATE INVESTING CALCULATIONS

Crunching the numbers can be one of the most difficult part of the financial due diligence on a property. However, it is important to know what you are getting into financially.
The following key terms are the most important figures you will need to calculate to determine if a property is right for you.

Net Operating Income (NOI):
The net operating income or NOI is the dollar amount that’s left over after you collect all your income (rent) and pay out you operating expenses. This amount is what is used to pay the mortgage, and what’s left after the mortgage payment goes into your pocket! Here is the equation:

Net Operating Income = effective gross income – operating expenses

What is effective gross income? Your effective gross income is the net amount of income after vacancies with the property.

What are operating expenses? Your operating expenses of the property include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, supplies, and repairs.

Cash-on cash Return:

The cash-on-cash return measures how long it takes for you down payment to come back to you. For example, if your down payment was $20,000 on a property how soon would your monthly cash flow (NOI – Debt Payments) it takes to add up to $20,000. General real estate guidelines suggest that a 10% or greater cash-on-cash return is preferred.

Capitalization Rate or Cap Rate:
The capitalization rate is a measure of a property’s performance without considering the mortgage financing. If you paid all cash for the investment, how much money would it make? What’s the return on your cash outlay? Cap rate is a standard used industry wide.

Cap Rate = net operating income / sales price

Since a cap rate measures the property’s profitability it can also help you determine the appropriate sales price for the property. For example, let’s say you want to earn at least 10% on your property investments. The property you are currently evaluating is listed at $2,750,000 and has a $250,000 NOI. Well for you to earn 10% on your money, you would want to negotiate a purchase price of $2,500,000 ($250,000 / 10%).

How Banks Affect Business Value!!

I THOUGHT MY BUSINESS WAS WORTH $2,000,000

For most businesses sold in America, the buyer has to rely on bank financing to fund the majority of the purchase price leaving a few dollars for an equity contribution to the purchase price. Banks have very strict credit lending standards, and typically look for three sources of repayment: Cash flow, Collateral, and Personal guarantee. What banks don’t tell you is that the primary governor on the availability of a loan is collateral.

Loan amounts are based on collateral values, then cash flow coverage. Furthermore, banks hold the cards in terms of what is acceptable collateral. While a buyer or you as the seller might think your customer list is the largest component of value for your business, this means nothing from a collateral support to a bank. In other words, if I took your customer list to a bank and asked for a loan they would simply laugh.

Banks best form of collateral includes account receivables, raw or finished goods inventory, fixed assets, and real estate. All other assets are nice and perhaps valuable, but not to a bank. Banks, however, like to margin against the full value of the assets, something called an advance rate. Yes, that’s right a bank will not lend to you 100% of the value of your assets (not even CASH). The following table shows the range of advance rates for each asset:

Lending Institutions Asset Advance Rates


Advance Rate Range
Asset Low end High End
Cash 90% 100%
Account Receivable 60% 85%
Raw and Finished Inventory 25% 50%
Fixed Assets 75% 90%
Real Estate 70% 85%


So what does this mean to you, the seller. Well if your available buyers are looking to rely on bank financing to buy your business, the buyer would be required to come up with a substantial down payment to facilitate the difference between the asset value and the advance rates. The ability of the buyer to raise this money creates risk for you in terms that you perhaps never thought of.

Example:
Let’s assume that you and the buyer agree on a purchase price of $2,000,000. Your business earns $600,000 in annual cash flow. This would create a 3.3x multiple. You feel that this multiple and value fully captures the essence of your business. However, the buyer is looking to borrow from a bank to fund the purchase price. So let’s look at the following scenario:

Asset Asset Value Advance Rate Net Lendable Value Purchase Price
Account Receivable $300,000 80% $240,000 $2,000,000
Finished Goods Inv. $200,000 50% $100,000
Fixed Assets $100,000 90% $90,000
Real Estate $500,000 75% $375,000
Totals $1,100,000 $805,000 ($1,195,000)

As you can see, the buyer would have to come up with $1,195,000 in cash to cover that shortfall from the bank. This is a difficult proposition for most buyers for companies of this size. While there might be specific State or Federal (SBA) programs that might increase the advance rate for each of these assets, the impact will not move the needle in a significant way.

So the buyer has three options: Bring in a partner, Walk away from the transaction, or Seller financing. In most situations the sellers are asked to provide seller financing to bridge the gap ($1,190,000) in the above example. So let’s say that you agree to finance the gap, and you and the buyer sign a ten year $1,195,000, 10% note subordinated to the bank, that’s right subordinated to the bank. This means that the bank gets its money before you and in the event of liquidation they get the proceeds before you do.

At closing you receive $810,000 in cash and a $1,195,000 note earning interest at 10% but doesn’t amortize until five years from closing. In total. you received $2,000,000 in consideration, but not $2,000,000 in cash. Using a 10% discount rate over ten years, the present value of your note is really $439,594.00. The following table shows the real value of your business, driven mostly by the advance rates of today’s financial institutions:

What’s my business really Worth?

Consideration Total Consideration Adj. Consideration
Cash $810,000 $810,000
Note $1,190,000 $439,594
Total $2,000,000 $1,249,584

So what started out as a $2,000,000 purchase price, turned into real consideration of $1,249,584 – a $750,000 difference. Wow, bank financing does affect the value of a business.

Easy Bake Commercial Loan Dictionary!!

EASY BAKE COMMERCIAL LOAN DICTIONARY

When its time to go talk to the bank do bad memories or nightmares come to mind. They asked you questions with words and terms that sound from a far, far away land. Well, I’ve compiled a list of the most important and interesting terms for the next time you talk to a bank or more importantly to help better you understand before signing that loan!

Advance Rates: This rate expressed as a percentage determines how much the Bank will lend on certain assets. For example, accounts receivable typically carries an 80% advance rate. So if your company had $100,000 in account receivable, the bank would lend you $80,000. Machinery and equipment and inventory are typically margined by advance rates. Real Property typically is valued at 80% of the appraised value.

Affirmative Covenants: Affirmative covenants are the contractual provisions in a loan that the company and its management agree to fulfill after the loan is complete. In other words, this is what you PROMISE TO MAINTAIN OR DUE POST CLOSING. Common affirmative covenants include:
· Access to records. The company will give the investor or bank and its representative’s reasonable access to company records and personnel.
· Financial reports. The company will furnish the bank with regular financial reports on the status of the company. Balance sheets, profit and loss statements, and cash flow statements are usually provided monthly, quarterly, and annually. Audited annual statements are often required. Sometimes a short "state of the company" statement is also required from the company president on a monthly basis.
· Budgets. The company will prepare annual budgets which must be approved by the board of directors.
· Existence and maintenance of property. The company will preserve its corporate existence and all rights necessary to conducts its business and own its properties. The company will keep its properties in good repair.
· Insurance. The company will maintain adequate insurance. Often, the company also agrees to purchase key man insurance on the lives of management.
· Payment of debts and taxes. The company will pay its debts and taxes in accordance with normal terms.
· Compliance with laws and agreements. The company will comply with all laws applicable to it and perform its obligations under its agreements.
· Litigation and other notices. The bank will be promptly notified of any lawsuit, default under a major agreement, or other event that could have a material adverse effect on the company or its operations.
· Proprietary rights protection. The company will take reasonable steps to protect its patents, trade secrets and copyrights. These steps may include securing secrecy or non-competition agreements from company employees.
· Use of proceeds. The company will use the funds provided by the investor or in the manner described typically in the loan application.
· Accounting system. The company will maintain its current accounting system.

Borrowing Base: A borrowing base typically a monthly calculation that is attached to a line of credit or revolver. The borrowing base is the total amount of lendable assets – after the application of an advance rate. This number represents the total amount a bank will lend you for that month. If your borrowing base falls below the amount borrowed the bank will seek a reduction on the line of credit balance to below the new borrowing base.

Capitalization Rate or Cap Rate:
The capitalization rate is a measure of a property’s performance without considering any mortgage financing. If you paid all cash for the investment, how much money would it make? What’s the return on your cash outlay? Cap rate is a standard used industry wide.

Cap Rate = net operating income / sales price

Since a cap rate measures the property’s profitability it can also help you determine the appropriate sales price for the property. For example, let’s say you want to earn at least 10% on your property investments. The property you are currently evaluating is listed at $2,750,000 and has a $250,000 NOI. Well for you to earn 10% on your money, you would want to negotiate a purchase price of $2,500,000 ($250,000 / 10%).

Cash-on cash Return:

The cash-on-cash return measures how long it takes for your down payment to come back to you. For example, if your down payment was $20,000 on a property how soon would your monthly cash flow (NOI – Debt Payments) takes to add up to $20,000. General real estate guidelines suggest that a 10% or greater cash-on-cash return is preferred.


Defaults or Events of Default: This is here as a reminder that you and your attorney need to understand what triggers a default in your loan. A default can result in higher fees, higher interest rate, and even an acceleration of the loan – meaning the bank wants the entire loan paid back today. Other defined terms in this dictionary are triggers for default such as affirmative and negative covenants.


LIBOR Rate: LIBOR stands for the London Interbank Offering Rate. It is the basic short-term rate of interest in the Eurodollar market and the rate to which many Eurodollar loans and deposits are tied. The LIBOR is similar in concept to that of the prime rate in the United States except that it is less subject to individual bank management.


Loan to Value: The ratio of money borrowed on a property to the property's fair market value. On a purchase contract, the bank will use the lesser of the appraised value or the purchase price of the property. Most commercial banks advance 80% on the appraised value of the property.

Interest Rate Swap: A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans. These can be either the same or different currencies. The advantage to this is that one company may have access to lower fixed rates and another company may have access to lower floating rates... so they trade.

Prime Rate: The interest rate that commercial banks charge their most credit-worthy customers. Generally a bank's best customers consist of large corporations. Default risk is the main determiner of the interest rate a bank will charge a borrower. Because a bank's best customers have little chance of defaulting, the bank can charge them a rate that is lower than the rate that would be charged to a customer who has a higher likelihood of defaulting on a loan.

Material Adverse Change: While this might seem obvious, but this provision in a loan agreement can give the bank substantial room to call a loan. Essentially, this provision protects the bank in the event a negative event happens to the borrower that would impair the borrower’s ability to pay back the loan. Examples might include the loss of a big customer, a substantial lawsuit, loss of a key owner/manager. Many borrowers don’t try to limit the range of this provision – What is Material? If its not changed then the definition is defined by how the bank wants to define it. Make sure you and your lawyer look at this provision and are comfortable with its range.

Negative Covenants:
Think of a negative covenant as a promise not to do something. Usually, negative covenants limit the amount of dividends a firm can pay to shareholders and restrict the ability of the firm to issue additional debt. Generally, the more negative covenants exist in a loan, the lower the interest rate on the debt will be since the restrictive covenants make the loan safer in the eyes of bank. This is very important aspect of the loan agreement. For example, let's say you bought a property for its net monthly cash flow. If your loan agreemetn prevents dividends or distriubtions then any payment of the net monthly cash flow would be a violation of the loan agreement.

Net Operating Income:
The net operating income or NOI is the dollar amount that’s left over after you collect all your income (rent) and pay out you operating expenses. This amount is what is used to pay the mortgage, and what’s left after the mortgage payment goes into your pocket! Here is the equation:

Net Operating Income = effective gross income – operating expenses

What is effective gross income? Your effective gross income is the net amount of income after vacancies with the property.
What are operating expenses? Your operating expenses of the property include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, supplies, and repairs.

Due Diligence Checklist for the First Time Commercial Real Estate Buyer!

Due diligence is the process of doing your homework on the property that you’re thinking about buying as an investment. It’s the process of checking, double-checking, and confirming any important information that was used to determine whether the property is good, average, or a bad deal.

The following list regarding due diligence is not all encompassing and you should explore every detail on a property before pulling the trigger. It is also important to recognize what you know and don’t know. Hiring the right advisors (accountant, inspector, and lawyer) is very important and valuable. While being expensive, remember this: “Being cheap is sometime expensive”. The due diligence items usually fall into three categories: Physical, Financial, and Legal.

Physical Due Diligence:

• Site plans and specifications: This group of documents includes all the construction documents, building plans and schematics, floor plans, and use of the land documents.
• Photos of the property: Photos of the exterior, interiors, and the surrounding land and structures should be taken.
• Structural Inspection: Inspect the walls, roofs, and foundation.
• Interior Systems Inspection: Inspect the interior of the property for wear and tear, including items such as doors, windows, and weatherproofing. Then inquire about the age of the roof, any building code violations, its federal compliance, and the site improvements.
• Mechanical and Electrical Inspection: Make sure that every mechanical and electrical system is inspected. Such systems include heating, ventilation, air conditioning, plumbing systems, and all electrical power systems and controls.
• List of Capital Improvements Performed: Obtain receipts and documents for any capital improvements that were made. Collect these for any improvements over the past five years.
• Pest Inspection: On some types of building, an inspection for pests, such as termites, may take place. Most apartment buildings have this inspection done as part of a lender requirement.
  

Financial Due Diligence:

• Income and Expense Statements: You should obtain annual income and expense statements for the past three years.
• Rent Rolls: A rent roll is essentially an attendance sheet for all tenants. It displays the tenant name, unit space, amount of rent paid, move-in date, lease expiration date, and security deposit.
• Tax Returns: Obtain the property’s tax returns for the past three years. Add up all the income and expenses shown on the tax returns. These numbers should match those from the seller’s income and expense statements.
• Lease Agreements: A lease agreement can be a complex legal document. If all of the leases are the same, such as in an apartment building, have an attorney review the fist few to make sure they’re valid.
• Utility Bills: Obtain the past two years’ worth of actual utility bills for the property. These bills include electricity, gas, water, sewer, trash, telephone, cable and Internet service bills. Compare the totals of each utility category to the seller’s total given on the expense statements.
• Property Tax Bills: Obtain the past two years’ worth of property tax bills. Verify the amounts with those given on the seller’s expense statements.

Legal Due Diligence:

• Environmental Inspection: The environmental inspection most often used is called a Phase I Environment Site Assessment. During this inspection the inspector explores the past use of the property and the surrounding area, looking for onsite and offsite environmental problems and liabilities.
• Survey and Title Inspection: With this inspection, a title company can verify the property size and that the title report has the same description as the survey. You can also review any easements or encroachments.
• Inspection for Building Code Violations: If a violation occurs after a building is built, it’s called a non-conforming use and is considered to be grandfathered in.
• Zoning Code: You need to review the town’s zoning ordinances to make sure that the property’s use complies with what it’s legally zoned for. Its used illegally the property can be shut down.
• Insurance Policy: The property’s insurance policy can be a treasure trove of information if you can get the claims history.
• Licenses, Permits, or Certifications: Often times, you’re required to post business licenses, permits or certificates. Make sure that you’re proactive in notification of new ownership to avoid hefty fines.
• Service and Vendor Contracts: Review all service and vendor contracts to make sure that you have the right to choose or discontinue the services. These services may include maintenance and landscaping.
• Personal Property Inventory: Obtain a list of all personal items, such as equipment, tools, computers, furniture, supplies and appliances, that re to remain with the new owner. Document all these personal items in writing or consider them gone.
• Police Reports: Determine past and current police reports by calling the local police department. Review the type and frequency of calls to the property. Know what’s going on before you buy.

Now, remember that this list is a start and not all encompassing. Your commercial real estate team should consist of a good lawyer, commercial real estate broker, inspectors, and financing partner (I know a good one!). Good Luck.

Storm Clouds Surrounding the Commercial Loan Market!!

"No, as of March 1st, we are no longer offering commercial mortgages with Loan to Values (LTV's) in excess of 85%". That's the message I got yesterday from a commercial lender who prior to March 1st was aggressively offering 95% LTV's. What happened at midnight February 29th? Did the extra day (leap year) in February cause most lenders to change so abruptly?

Here are some of the ingredients prompting the change: This past week, the Wall Street Journal dedicated several columns suggesting that the commercial market was on its way down. To summarize, the Wall Street Journal showed that nonresidential construction was down 1.7% in January versus the prior month, office space sales declined 42% in the fourth quarter of 2007 right as the credit tightening began, and that The International Council of Shopping Centers announced that U.S. store closures could reach 5,770 up from 4,603 last year.

More storm clouds are on the horizon according to another article quoted in the Wall Street Journal. The article suggested that U.S.'s community banks are sitting on a commercial loan time bomb. Community banks have migrated to underwriting more commercial loans as they've been pushed out of the residential mortgage market by Wall Street money. "Small and midsized banks, with less than $10 billion in assets, have a total of $323 billion outstanding loans", the article stated. This represents approximately 285% of the remaining banks' capital.

Let's speculate that approximately 1% of those loans referenced above were written off by the community banks - for a total of $3 billion write off. Not only would that result in several community closing, but it would also reduce the lending capacity of those institutions by at least $32 billion (using a 10x factor due to the leverage employed by most banks). That means $32 billion in potential loans to you and me to buy real estate would evaporate.

Is the sky falling? No, not exactly.

Commercial loan delinquencies are still low at 1.94% in the forth quarter of 2007 (it did rise modestly over the prior year). In the 1990's the commercial loan delinquencies reached 10%, so we still have a long way to go. Many experts suggest the most weakness in the retail segment, which is most susceptible to the downward movement in the national economy. So what does all this mean to you and me, who deal in the small balance commercial loan market? Here's what I think:

• Higher equity requirements. A contraction in the loan to value ratio means higher equity contributions by the owner/investor. Solution: If the cash isn't available to increase the equity contribution to complete the deal, approach the seller about a seller second mortgage. Your primary financing institution will look at the seller second as quasi-equity due to their 1st priority in the transaction.


• As properties come under increased scrutiny, the borrower's underlying credit will become increasingly important. So having a healthy credit score backed by personal liquidity will help you get that deal completed.


• Find other creative ways to finance the deal. For example, you could arrange a master lease agreement with an option to buy (at the current market value) with the owner. Under the master lease agreement you pay the owner a monthly lease payment but you run the property including collecting rent and paying expenses. Your goal is to then increase the value of the property and cash flow during the term of the lease (usually three to five years). Remember your option is based on the value today, not the value your going to create during the lease term. You could also negotiate that a portion of your lease payment go towards the option price.


• Buy on option on the property today for a small upfront fee. This locks up the property while you find a solution to the financing arrangement. Make sure that the upfront option price goes towards the purchase price.

Keep looking at the horizon for those storm clouds and I'll be happy to be your real estate weatherman!! Remember good deals get done!

Help! I'm self employed. How can I get a commercial mortgage?

The majority of small businesses owners are self employed (including myself) making it very difficult to document your income to qualify for a commercial mortgage (even for a residential mortgage). So what can you being doing to prepare for the time when you want to buy that building you've been occupying since you started your business. Here it goes:

1. First, and most important is to keep your credit scores as high as possible. Typically stated income lenders start around 600 and above.
2. Have your tax returns, including supporting schedules such as Schedule E and K-1s.
3. Develop a relationship with an accountant. Have them prepare your tax return and business financial statements. Most lenders will require a letter from your account supporting your self employment status.
4. Buy a high quality property that has nice cash flow and Cap Rate. Commercial lenders look at the property first then the borrower's credit. If the property produces good cash flow (1.25x Debt Service Coverage Ratio and above), and has good quality tenants supported by strong leases, then the lender will rely less on the borrower's credit.
5. Have established checking accounts for you and your business. Show adequate reserves in those accounts. Reserves mean a buffer amount of cash in case your income or the property's income stops).
6. Have strong assets on your balance sheet. Equity in a house or strong liquid assets including those in a deferred retirement plan all help. If you show a healthy balance sheet that helps. Remember, assets will be verified (through statements or calling the bank) even though your income is stated.
7. Consider putting more than 20% down (some lenders may require more) on the property. Lenders love equity cushions, because it protects their interests. So a high down payment may mean a faster approval.
8. Have the appropriate business license. I know it sounds silly but one way to prove that your are self employed is to have a copy of a valid license.

Having or following these items should lead you to a successful loan closing!! Good Luck.