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.