"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.

What is a DSCR and Why does it have to be higher than 1.20x????

Bankers speak their own language and expect us to understand it! One ratio that is very important to them when considering approving a loan is the Debt Service Coverage Ratio - or DSCR . This ratio simple measures the net cash flow of the real estate or business against the annual interest and principal payments on the debt (Debt Service).

Bankers love cushions - no, not the ones they sit on - but a buffer of net or free cash flow over and above the debt service requirements. This ratio begins to be acceptable to banks at 1.20x. So if you have annual debt service requirements of $100,000, then your net cash flow must be at or above $120,000 ($120,000/100,000 = 1.20x).

Certain banker's will go below 1.20x, but be prepared to see that increased risk in the interest rate charged on your loan. Look at it this way, your interest's and the bank's are together in this, because you would also want an acceptable cushion or protection against a loan default - especially if you signed a personal gurantee!

How close should I keep my banker about my business.

To answer that question, it is helpful to understand what your loan officer has to deal with in his or her everyday life.

Did you know how many people look and touch your loan!
In most banks your loan officer has two to three direct and indirect bosses that are repsonsible for loan growth. They are also a watch dog charged to minimize losses on loans. Each boss has ever increasing span of control over loan officers and the sizez of the loan portfolio. Depending on the size of your loan or its current status (past due or current), changes - such as increases or extensions - to the loan agreement could go up to the highest levels of the bank! So for example, if you call your loan officer on Thursday to let him know that you can't meet payroll for your 50 employees on Friday, that problem would make its way up to the top levels of the bank. Well, we all know that scrap (put the right word in there) rolls down hill well the same applies to banks. Your loan officer will probably get a call from the EVP at the bank wanting to know what in blazes is going on with your company. Why, because this issue probably is sympton of something larger - perhaps a loan write-off. The decision/outcome on this problem will come from above, and a lot of pain and embarrsasment will flow down to the loan officer.

It doesn't stop there, there is another side of the bank - a side that you will never see, but has as much impact on your loan as your loan officer and his or her boss does. That dark, secret side of the bank is the credit administrative function of the bank. At least on a quarterly basis (and sometimes monthly depending upon the size and serious nature of the loan problem), your loan officer has to communicate to these unknown giants about the status of your company and the propsects of your ability to repay the loan.

Well, needless to say, I recommend meeting with your loan officer at least once a month alternating the location between the bank and your office. Its important that when visiting the bank you at least say hi to your loan officer's superiors. A human touch goest a long way in the event things go south. So think of your loan officer as the head bowling pin in bowling lane. He or she is the first pen, but there are nine other pins behind that make decisions on your loan. To bowl a strike it starts with the loan officer.

When you sit down with your banker tell him or her about what's going on in your business and industry. Note challenges and opportunities. Many bankers are interested to know that there might be future business down the road. Ask your banker if there are any new products to help improve your business: cash managemnet, foreign exchange, treasury, etc. These brief - limit then to an hour - help cement your relationship and buy you goodwill that you may need to cash in down the road. Remember, your bank is the largest vendor relationship your probably have, and while not an equity partner - they have the ability to make dramatic changes to how and who runs your business. A lunch here and there could make all the difference in the world.

I can't understand Bankers!!!! Here are 10 Ways to Creat A Smooth Loan Process.

Does this look like you during your last loan negotiation? Well it doesn't have to be. It is true that bankers have their own language - a language that sounds greek to most of us. What is an LTV? What is LIBOR and what happend to the Prime Rate? What are negative and affirmative covenants? AGHHH! Wow, I just wanted to borrow money for five years to add a key new machine that will allow me to grow my business over 5% over the next few years. Is all of this worth it?

Be patient, here are a few helpful hints to smooth the process and get to that loan closing and the new machine you wanted.

1. Be fully prepared when you approach your bank for a loan. Here are things you should bring with you to give to your banker: A Cash Sources and Uses table (in other words what will the money be used for), A cash flow projection showing how the loan will be paid back, A copy of your financial statements and/or tax returns on your business for the past three years, and have three business references for your lender to call (this is not required if you already have a relationship with a Bank).
2. Be specific as to your timing expectations, but also be realistic. Banks - by design - typically do not act quickly. Don't walk into a bank and tell the banker that you need the money in two days - its just won't happen. To frame your timing expectations, communicate to the banker that you intend to present this opportunity to several banks, and that among other items meeting your timing is an important factor in your selection process.
3. Hire a lawyer that has completed several commercial finance transactions. I can't stress this enough. The protections provided to consumer borrowers doesn't flow to the commercial borrower - as the regulatory bodies assume that the borrower is sophisticated enough and has hired the appropriate counsel to enter into the transaction. Why a commercial finance attorney? Well they understand the ins and outs of a loan agreement that could literally be over 100 pages. If you aren't careful, you could easily be facing a not so nice consequences as a result of not having another set of eyes looking at your loan aggreement.
4. Know that everything is negotiable. It's not just price and term of the loan, but pretty much everthing in the loan agreement can be and must be negotiated up front. The bank is entitled to get its money back, however, setting and understanding the behavior in certain situations of both the borrower and the bank upfront is key. Nothing ever goes as planned. So default rates, grace periods, use of insurance proceeds, events of default are all things that should be hammered out prior to signing the loan agreement.
5. Control the transaction fees. It is completely appropriate to get caps on the bank's fee for legal counsel, and other miscellanous fees. Also, use the competitve nature of commercial lending to your benefit by entertaining multiple loan proposals.
6. Understand and control the "Conditions Precedent to Funding" language in your loan proposal. Bank issue proposal and commitment letters subject to certain conditions being met. This can range from obtaining a real estate appraisal to enviromental due diligence. These items could take weeks to a month to complete, and once completed each bank has internal specialist to review these reports which adds to the time. Use the proposal letter stage to eliminate any contingencies, that way you move quickly from a commitment letter to loan documents.
7. If things go sideways get the Bank's decision maker in the same room with you. Generally, loan officers report to superiors who have increasing loan authority to make changes or get the loan back on track. So if things go sideways and your tired of the daily "I'll have to get that approved by my boss", call the loan officer's boss and settle this quickly. The loan officer's boss want's the loan volume, and doesn't have a lot of time to deal with these situations prompting quick, decisive decisions to be made. The loan officer isn't intemidated because you helped him or her move the loan through the bank's beauracracy.
8. I know you have to run a business, but always put the ball back in the Bank's court. Set aside daily time to answer any questions the banker might have, and quickly get any additional reports, financial statements or other information back to the banker. Email is a great time saver here. There comes a point, however, whereby you get overwhelmed about the amount of additional pieces of information being requested. This is a sign that the bank isn't to sure it can get the loan done, and doesn't understand your business. If you get to this point then go to Point #7 for guidance.
9. Check out the Bank's reputation, by talking with other business owners. You might gain insight into a bank's behavior and quirks. Also, you make the final choice on the lender, but consult with your lawyer about the reputation of the bank you are selecting. There are banks out there that will submit a proposal letter to seal the business without regard to understanding the business. They think that they will figure it out during the loan process. Accepting a proposal letter from a bank like this guarantees a lengthy frustrating, costly loan process.
10. It's never to late to switch horses! The numbers are still in your favor, there are more banks chasing a low amount of loan requests. The worst thing you can do is to give into process by entering into a long term agreement (read partner) with a bank just because they have beaten you down. Despite time and costs involved in switching, the cost of entering a potentially bad relationship is more costly. Another bank can be brought in at any time, and would even make concessions on upfront costs to get your business.